Macro Analysis /

Pakistan Mid-Year Strategy: Towards a better H2 19

    IMS Research Team
    Intermarket Securities
    17 July 2019
    • The IMF Executive Board approved Pakistan’s request for a three-year US$6bn EFF programme earlier this month, and the first tranche of cUS$1bn has already been disbursed. If successful, the programme can lead to more equitable growth for Pakistan and a path to escape from its historical boom & bust cycles. The macroeconomic adjustment, in line with pre-programme conditions, has been painful, but sustainable long-term benefits can ensue if discipline sustains.   
    • We are encouraged by Pakistan’s new-look macroeconomic policy making, which is now coherent and better coordinated. Interest rate setting is more proactive, the exchange rate is no longer artificially managed, and the tax culture in the country can sustainably improve if the Federal Board of Revenue continues to enjoy the government’s support. Taken together, these are significant changes.  
    • Low investor confidence led the KSE-100 to hit its 2019td low earlier in the week. Confidence should now improve, particularly if the belief that interest rates have peaked permeates through the wider investor base. There are near-term challenges, but for those willing to look through the cycle, the Pakistan market offers potential for significant alpha over the medium-term. We believe the risk-reward is favourable where our revised index target for Dec’19 is 35,000pts (bull case: 38,000pts).   

    Visible changes in macroeconomic management

    This IMF programme (formal approval accorded on 3 July) will arguably be one of the most ambitious that Pakistan has undertaken. Programme conditions have led Pakistan to alter its approach to macroeconomic policy-making, with the changes most visible in interest rate and exchange rate management. As opposed to a carefully managed float earlier, the exchange rate now follows a “market-based” regime that has seen the PKR depreciate by 13% this year (and by c35% in this cycle). Interest rates are now more cognisant of forward guidance for inflation, which has led the central bank to lift the policy rate to 13.25% (325bps increase in this calendar year). Based on the mid-point of the SBP’s CPI guidance for FY 20f (11-12%), real interest rates stand at +1.75%, which is adequate, in our view. These adjustments have been painful, but have the potential to deliver major long-term positives. We are particularly encouraged by the onset of structural reforms on the taxation front, underpinned by the recently passed FY 20 Budget, which is supportive of a better tax culture. 

    The risk-reward is favourable 

    The KSE-100 Index peaked around its upgrade to Emerging Markets status (mid-2017), before losing 38% since then. At this rate, the Index is on track to close in the red three calendar years in a row, which has not happened since 1994-96. That being said, if interest rates have peaked, which we believe is likely, there is a strong case to be made that the KSE-100 is also near its trough. There are challenges – the upcoming results season is expected to be a poor one, the pending FATF decision casts a long shadow, and investor/business confidence remains low. However, these are balanced by valuations now at cross-cycle lows. By our estimates, Pakistan trades at a 2020f P/E of 5.8x vs. a long-term average of 9.0x. We are further comforted by the low market cap-to-GDP; on a 2020f GDP of PKR44,003bn (government estimate), the Pakistan market is valued more than one standard deviation below its long-term mean. We believe this limits downside risk, and offers strong re-rating potential through the cycle. Our revised Dec’19 Index is now 35,000pts (bull-case: 38,000pts), with momentum likely to extend into 2020f as prospects build up for monetary easing.  

    Top ideas

    We continue to favour defensive themes, at least in the next 3-6 months when monetary easing does not seem to be on the cards. The large banks (UBL, HBL, MCB) offer good value-for-money and we have Buys on all three. Under the IMF, energy reforms (including focus on eliminating circular debt) should bode well for the likes of OGDC, PSO and HUBC. EFERT has a stable business model and offers a very attractive dividend yield, enabling it to make it to our list of top picks. While the more cyclical sectors such as cements and autos are tempting, given how much they have fallen, they will likely need lower interest rates to depict a sustainable rally, and this may not occur before Q2 20, in our view. For those not averse to the prevalent higher risk in these sectors, we prefer LUCK and INDU.

    Risks: (i) Further sharp interest rate increases, (ii) an adverse FATF ruling, and (iii) continued low investor and business confidence.