Macro Analysis /

Pakistan strategy: New interest rate assumptions

    Saad Ali
    Saad Ali

    Head of Research

    Intermarket Securities
    28 May 2019

    Following the higher-than-expected 150bps increase in monetary policy in May and our revised inflation outlook, we revise Pakistan's interest rate assumptions and risk-free rate for our coverage universe.

    Inflation: We estimate the headline CPI will average 7.0%-7.5% in FY 19, before increasing to an average of c10% in FY 20f (CPI could peak at c11% in some months during H1 FY 20). Three key factors which will likely push inflation into double-digits:

    • Upcoming increase in gas and power tariffs. The previous such tariff increase elevated the monthly CPI readings by 1ppt.
    • Recent 7% PKR depreciation amid the shift to a “market-determined exchange rate.” Every 1% devaluation raises the CPI by c15bps, all else being equal.
    • Budgetary measures, where a potential 1% increase in GST, along with higher import duties, will substantially increase prices of goods and services.

    CPI readings of c11% are expected to last only a few months, and thus may not trigger further interest rate hikes, in our view. We expect CPI to average 9.8% in FY 20f and normalise at 8% from FY 21f onwards, partly due to the base effect from high inflation readings in FY 20f.

    Interest rates: We now expect the discount rate to remain at 12.75% for the remainder of 2019. In our view, the recent 150bps increase in the benchmark rate was another preemptive move by the central bank, as prospective real interest rates (spread between discount rate and headline CPI) will largely remain above the +2% watermark until end-2019. Real interest rates have averaged +2.5% since 2011.

    Based on our outlook for future inflation, we think interest rates have likely peaked. However, risks to this assumption include: (i) unforeseen disruption in supply of key food items, (ii) oil prices crossing the US$80/bbl mark, which will have a bearing on both the currency and future gas/power tariffs, (iii) further sharp PKR depreciation, and (iv) greater-than-expected inflationary effects of upcoming budgetary measures. Delays in sourcing non-IMF external flows, and the consequent extension of BoP issues (the import cover is again hovering near 2-month), is another possible risk. However, we assign a low probability to continued balance of payment concerns, given the current account deficit is expected to remain below 3% of GDP in FY 20/21f.

    We think monetary easing could potentially commence in Q1 CY 20, led by expectations of inflation coming back to single-digits, particularly if the country’s twin deficits have seen a sustainable improvement by then. This will likely allow room for some pro-growth policies.

    Risk-free rate increased by 1ppt to 12%

    We are increasing our risk-free rate by 1ppt to 12%. Although the 10y PIB yield has had a cross-cycle mean of 10.5%, and we do see interest rates coming off from next year, we believe benchmark interest rates in Pakistan are unlikely to come below 12% over the next 12 months. In our view, this warrants a higher required rate of return, at least for now. However, our market risk premium remains at 6%.

    The IMS Universe is trading at a forward PE of 6.3x, which is close to cyclical lows, and well below the long-term mean PE of 8.5x-9.0x. This should serve to protect against further downside. That being said, meaningful valuation re-rating may take time and will likely require: (i) monetary easing to commence, (ii) more comfort on the BoP position, and (iii) greater visibility on the government’s reforms agenda.

    For our non-financials coverage, the above revised macroeconomic assumptions change our valuation estimates by 6-9% for non-leveraged companies, and by 20-30% for leveraged sectors (cement and steel). We will be incorporating these revised assumptions in our EPS estimates and target prices going forward.