Reading into market behavior is a difficult task. Having a contrarian negative view is even more difficult in the face of criticism one may attract. The recent exuberance exhibited by the KSE post disqualification of Nawaz Sharif by the Supreme Court caught me by surprise. While a certain element of political uncertainty has been removed a lot of new uncertainties have been introduced. Most importantly I am concerned about who is going to be in charge of the economy given the multiple challenges we face on that end.
Pakistan entered its 16th IMF program, the EFF facility in 2013 to address; 1) Anemic economic growth, 2) Balance of Payments crisis leading to precarious FX reserve levels, 3) High fiscal deficit, and 4) Unsustainable subsidies to the energy sector. Despite the passage of 4 years, since Pakistan agreed to bringing about structural changes to address these issues, not much has changed. Couple this with the political vacuum, upcoming elections, and continuing legal battle between the state and Nawaz Sharif I find little reason to be optimistic that the worst is behind us.
Historically, as you can see in the below graph, Pakistan MSCI forward P/E has averaged at 8.5x. During times of distress the market has dipped all the way down to 3.5x and during times of exuberance, the heydays of President Musharaff’s era, the market peaked at 13x. Market participants are using Pakistan’s inclusion in MSCI EM Index and the ongoing CPEC projects to justify the current forward P/E multiple of 10.5-12x. I believe significant downside risk remains given that structural imbalances leading up to the 2013 IMF facility have still not been addressed. With heightened political uncertainty, the government is going to be further constrained in addressing the imbalances. And until the imbalances are addressed foreign portfolio flows will remain weak. This I believe will lead the market towards its long term P/E average of 8.5x. Until then investors should remain cautious.
If one must remain invested they should focus on sectors which stand to benefit from potential changes in economic policy in view of the structural imbalances. I believe potential changes include devaluation of the PKR and increase in interest rates to address the BoP crisis and FX reserves. Additionally, we should see restructuring of the energy sector and reining in of the fiscal deficit through increased revenues and reduced spending but both require political will which is lacking in the current environment. This leaves us with devaluation and interest rates. Hence, one should look for a dollar hedge with an unlevered balance sheet. IPPs provide a dollar hedge but have cash flow constraints due to the burgeoning circular debt. Banks with the shortest asset repricing cycle stand to be beneficiaries of increase in interest rates but offer little protection from devaluation.
A bottom up approach to identify companies benefiting from devaluation and increase in interest rates would likely be the top performers in view of the current economic challenges. Happy hunting!