Macro Analysis /

Pakistan Strategy – Macro stability warrants lower discount rate

    Intermarket Securities
    9 December 2019
    • We are reducing our risk-free rate assumption from 12.0% to 10.5%, which is close to the avg. historical yield on 10yr PIB. The change is driven by our outlook of greater macro stability and return of pro-growth policies in the near term, which warrants a lower discount rate for the market. 
    • We expect the SBP to cut the policy rate by 100-125bps across 2020, on the back of declining twin deficits and receding inflation. Our estimates for CPI for FY20/21f are 11.0% / 8.0%, where we expect CPI in high single-digits by July 2020.
    • Overall, our target prices for IMS Universe (new TPs on Page 3) change by 13% on average, with the greatest impact on Banks and leveraged sectors (up to 20% higher TPs). We remain Overweight on Banks and E&Ps and advocate stockpicking among the cyclical sectors.

    Reduce our risk-free rate to 10.5%

    We are revising our assumption for risk-free rate to 10.5% from 12.0% previously. This is the long-term average yield on 10yr PIB (a suitable benchmark of a risk-free asset for the market, in our view). Our underlying thesis is that Pakistan’s economy has stabilized considerably on the back of greater macroeconomic discipline, with both the external account and fiscal balance have shown sustainable improvements. The trend is expected to continue, in our view, given the IMF program and a reform-minded government in place. Our base-case also assumes that the present civil-military harmony will remain intact, which is crucial for effectively continuing tough reforms in the future. Therefore, we expect Pakistan is likely to move towards a moderate growth and interest rate cycle, and that warrants reducing the required rate of return on the market, in our view. 

    Average inflation expected at 11.0% in FY20; 8% in FY21

    Despite Nov’19 CPI of 12.7%, inflation has averaged 10.8% in 5MFY20 (on 2015-16 base), within the SBP’s target range of average 11-12% for FY20. We expect CPI to average 11.0% yoy in FY20f and 8.0% in FY21. Key assumptions include international oil prices expected to remain in the range of US$55-65/bbl (Brent). Secondly, the recent surge in food prices was caused by controllable supply disruptions and we expect that the authorities will be able to stabilize prices in the near term. Thirdly, most of the energy price adjustments have been done, in our view, and future energy-sector reforms under the IMF program will likely focus on privatizations. Lastly, we do not see a major slip in the exchange rate given gradual and consistent buildup of Fx reserves. Therefore, inflation readings will likely moderate, partly due to the high base effect, from January 2020 onwards. We also assume that Pakistan will be able to contain the C/A deficit at US$6-7bn (2.5% of GDP) and fiscal deficit at about 7% of GDP (close to IMF estimates). 

    Expect 100-125bps cut in policy rate in 2020

    While we are not expecting a sharp recovery in overall economic activity, we believe the authorities will be inclined to weigh pro-growth policies – including monetary easing, potentially as early as January 2020. But, achieving moderate inflation (10% or lower) and building SBP’s forex reserves beyond 3mth import cover remain incomplete tasks, in our view. Therefore, we expect only a moderate loosening of the monetary policy (100-125bps) during 2020.