Brexit keeps Pakistan market under pressure

To begin with, it may be true that the local equity market remained under pressure due to Brexit, which was an overreaction. The decision by the public is yet to be approved by the British parliament. It will be a long drawn process but meantime the business will continue ‘as usual’.

The panic trickling down to Pakistan Stock Exchange plunged the benchmark PSX-100 index to 37,390 levels, down 3.58%WoW, after losing 1,412 points intraday. Regional markets also witnessed similar trend while crude oil tumbled, along with other commodities on a stronger dollar.

Barring Friday, lack of triggers kept market activity dull during the week where average daily volumes declined by more than 15%WoW to 155.7 million shares. Foreign participation remained under pressure, with foreigners selling equities worth US$20.6 million during the week against a net buy of US$19.58 million last week.

Key news flow impacting the market included: 1) National Assembly finalizing amendment in 2016 Finance Bill, 2) Current Account deficit for May’16 rising US$792 million as against a surplus of US$23 million a month ago, 3) the World Bank approving US$1.02 billion in developmental loans for Pakistan under the CGDPF and Sindh Resilience Project, while ADB approved US$100 million loan for the construction of Shorkot‐Khanewal section of the M4 motorway, 4) yields slipping by 3‐ 5bps in the latest Market Treasury Bills auction with the GoP raising Rs138 billion and 5) news source indicating rise in petroleum prices in the range of Rs1.75‐Rs4.5/ltr for July’16. Leaders at the bourse were: MTL, FATIMA, HMB, FCCL and AGTL; while laggards included: BAFL, MCB, AICL, NML and NCL. Volumes leaders were: KEL, DCL, PAEL and DFML.

Bouts of volatility are likely to be witnessed in the week ahead as investors react to uncertainty in the global outlook following ‘Brexit’. Negative implication for the bourse can also emanate from any extended downside in commodities, particularly crude oil. With volatility in major currencies, Autos on (JPY) and Textiles (on EUR and GBP) could see further downside.

After recording surplus for three consecutive months, current account balance returned to the red zone in May'16 recording a deficit of US$792 million expanding, consequently, 11MFY16 current account deficit to US$2.48 billion, up 1.2%YoY higher than the balance in 11MFY15, primarily reflecting a worsening trade deficit. The trade data depicts 22.6%YoY widening in the trade deficit in May'16 as rising imports (up 7.6%YoY) added to the burden of declining exports (down 6%YoY). With similar trends to continue analysts expect current account deficit to further deteriorate. Resulting pressures on current account and hefty debt repayment in FY17 can likely have spillover effects on the Pak rupee exchange parity. However, rising foreign exchange reserves and improving foreign investment outlook should keep erosion in rupee value limited.

Resolving Pak Afghan Conflict

Afghanistan started a new era of relationship with Pakistan, after the fall Taliban government and appointment of Hamid Karzai as new President of the country. Now there is a new president and a ruling junta which does not consider Pakistan a friend. The situation got real precarious lately after exchange of fire in which people from both the sides were killed.

One of the prime reasons for Afghan hostilities was construction of a gate at Torkham border. Ironically Karzai’s allegation that Pakistan does not want good relations between India and Afghanistan and wants ‘no bilateral trade and no access to Central Asia for India’ sound completely illogical.

Historically, Pakistan has offered transit trade facility to landlocked Afghanistan. The situation is likely to change to some extent after construction of Chabahar port in Iran by India, which offers an alternate route to Central Asian countries through Afghanistan. Now, there remains no binding on Afghanistan to use Pakistan’s ports, road and railway links. It is at liberty to undertake its international trade through Chabahar.

Therefore, the accusation that Pakistan is a hurdle in Afghan trade is completely baseless. Knowing that Afghanistan is no longer dependent of Pakistan it is trying to open Pandora’s box by taking about old but settled conflicts. No one can deny the fact that Afghans always have a hostile attitude towards Pakistan; they have not accepted the border.

In one of hisstatements Karzai has openly termed the formation of Durand Line a 'result of British imperialism' in the region. He even went to the extent of saying that Afghanistan has never accepted this border since 1893, nor will they ever accept it in future.

"When Pakistan came into being in 1947, they received it this way, so we are not blaming them but Durand Line is a blow which no Afghan can ever forget. We do not accept this border but will not fight over this issue," said Karzai.

He maintained that terrorism and extremism is a menace which has not only affected people of both Pakistan and Afghanistan but added that "we (Afghans) think they have found safe havens and are getting aid from Pakistan."

Despite having remained President of Afghanistan and witnessed cross border terrorism, he has deliberately avoiding taking about militants living in Afghanistan and their involvement in cross border terrorism against Pakistan as well as Iran.

Trade going on under the disguise of ‘transit trade’ has been causing colossal damage to Pakistan’s economy. May be the time has come to let Afghanistan decide itself, if it wants to use Pakistan or Iran as transit route.

As stated above if Afghanistan wants it can route all its international trade through Iran and let Pakistan build fence and gates at the common border. This border, spread over hundred to kilometers is highly porous and terrorist can very conveniently pass it.

The movement of Afghan and Pakistanis should also not be allowed without passport/visa and the old system must be discontinued immediately. If the ground realities are changing the ‘rule of the game’ must also change. Let Afghan chose between Pakistan and India but once the decision is made the new rules will have to be followed stringently.

Need to revisit Pakistan’s foreign policy

To begin with it may not be wrong to say that since independence Pakistan’s foreign policy has been dictated by the United States. During Ayub Khan Era Pakistan got the maximum aid, grants, and loans, which some analysts also called cold war era. During this period, an airbase in Pakistan was used by the United States for spying against the then USSR.

When USSR attached Afghanistan, Pakistan was dragged into the proxy war in the name of Jihad during Ziaul Haq Era. Then in Musharraf Era Pakistan was once again assigned a role to eliminate Taliban, the Jihadi group created and funded by the United States to avert USSR attack. Pakistan is still fighting the US proxy war in Afghanistan. The fallout of Pakistan’s involvement in Afghanistan is cross-border attacked that also includes an attack by the United States on Sala check post. 

Pakistan has fought three wars with India, which have dented two-nation theory and resulted in the creation of Bangladesh. Pakistan spends billions of dollars every year in a bid to maintain minimum deterrence level and to counter Indian war mania. Both the countries have attained the status of nuclear powers but Kashmir remains the biggest thorn, which has kept both the countries in the constant state of war since independence. Over the decades both the countries have failed in developing even working relationship with each other. It may not be wrong to say that all the efforts to normalize the relationship between the two countries have been sabotaged by hawks present on both sides of the border. Despite enjoying common border, rail and road links, official trade between the two countries is a fraction of total trade conducted through a third country or smuggling.

 Worst have been the relationships with Afghanistan, which still refuses to accept the demarked borders. It was the only country that opposed Pakistan’s entry in the United Nations. The country during the monarch era enjoyed the most cordial relationship with India and USSR. Most of the modern day Afghans consider Pakistan their worst enemy as it has been accused of killing hundreds of Afghans in a war against Taliban and cross-border terrorism is most common. Lately, in a bid to contain Afghan infiltration, when Pakistan decided to construct fence and gates, Afghanistan once again started talking about disputed border.

For decades, Pakistan has been providing transit facility to Afghanistan, which is not considered a favor but its inherent right. To undermine Pakistan’s importance India is contracting a port in Iran, Chabahar, and road and rail links up to Central Asian countries passing through Afghanistan. It is necessary to point out that India was involved in the construction of this Iranian port at a time the country faced worst economic sanctions. It may be said that the United States kept its eyes and ears closed as it also wanted an alternate route.

During Shah’s era Pakistan enjoyed an extremely cordial relationship with Iran but after the Islamic revolution, Pakistan’s foreign policy went into the shadow of the United States and Saudi Arabia. Despite recent withdrawal of sanctions imposed on Iran, Pakistan and has not come out of this dictate. Pakistan has not been able to establish banking links with Iran, a must for boosting trade between the two countries. Not a drop of crude oil is being imported from Iran, contrary to the fact that India remained one of the major buyers of Iranian oil even when sanctions were there.

China is often termed a time-tested friend but the response from Pakistan is often disappointing. Many anti-China groups have emerged in Pakistan, mostly based in Baluchistan. They are also trying to spread disinformation about China Pakistan Economic Corridor (CPEC). It is also on record that many Chinese engineers and workers have been attacked and killed. One has all the reasons to doubt Indian support to the militant groups because Gwadar port will reduce the importance of Chabahar.

To conclude, it may be said that ever since PML-N government headed by Mian Nawaz Sharif has come into power, the cabinet is without a full-time Foreign Minister. Mian Sahib’s tilt towards Saudi Arabia is a major hurdle in improving the relationship with Iran, as he himself overseas Foreign Ministry. Ironically, Saudi Arab and the United States relationship have deteriorated after withdrawal of sanctions imposed on Iran.

It is feared that tweaked foreign policy is pushing Pakistan towards isolation. It may be true that Pakistan enjoys geopolitically important position but it has not been able to take advantage of its location. Pakistan needs a vibrant foreign policy and a young and more articulated full-time Foreign Minister. The current advisors are part of past legacies and also see the world with tinted glasses.

Pakistan reclassification in MSCI EM provides new impetus

After Pakistan’s reclassification in the MSCI EM space, the PSX-100 index skyrocketed reaching its all-time high to close the week ending 17^th June at 38,777 level, up 4.97%WoW. The key drivers were Cement, Bank and Fertilizer sectors. Additionally, Oil & Gas sector remained volatile due to weakness in global oil prices.

Participation during the week remained stayed strong, with average daily traded volumes rising to 183.2 million, up 20.7%WoW as compared to 151.9 million shares a week ago despite shorter trading sessions on account of Ramadan.

Key news flows guiding the market included: 1) MSCI announced to reclassify Pakistan in the MSCI EM (Emerging Market) Index in its Annual Classification Review this week, coinciding with the May'17 Semi-annual index review, 2) National Assembly Standing Committee on Finance recommended 7 key amendments in Finance Bill 2016 that includes maintenance of zero-rating sales tax regime on dairy and milk products, 3) ECC of the cabinet in its meeting ordered increasing the price of RLNG by about US$1.2/unit by allowing a series of factors in its price previously rejected by the OGRA, 4) SECP approved draft amendments in Non-Banking Finance Companies (Establishment & Regulation) Rules 2003, and Non-Banking Finance Companies & Notified Entities Regulations 2008 for smooth transition of Micro Finance Institutions (MFIs) into Non Bank Microfinance Companies  and 5) Ministry of Petroleum & Natural Resources sought approval of the ECC for the award of second LNG terminal contract to the successful bidder.

Gainers at the bourse were: HBL, MCB, BAFL, DAWH and MLCF while scrips losing value were: MTL, HASCOL, PSMC, PPL and EPCL. Volume leaders were: KEL, PIBTL, EFERT and TRG. Foreign participation also stayed positive, with foreigners buying US$19.6 million worth equities during the week as compared to net buy of US$70.2 million a week ago.

The market rallied significantly on MSCI driven sentiments, where analysts expect this momentum to continue in coming week also. While benefits to derive are numerous, increased foreign visibility and participation particularly along with potential multiple re‐rating are likely to be the most profound. Post reclassification in MSCI Emerging Market index, investors are likely to shift interest to scrips that are likely to enter the EM index, namely LUCK, ENGRO, HBL, UBL, MCB, OGDC, PSO and FFC.

Lucky Cement (LUCK) price performance remained volatile during the year likely due to 1) fears of possible pricing indiscipline owing to expansions announcements, 2) persistent foreign selling due to market volatility on global growth concerns and 3) tumbling exports amid anti‐dumping duty imposed by South Africa. However, LUCK's recent rally (+47% returns to date from its low in February) on expectation of inclusion into MSCI Emerging Market Index in spite of increased taxation (increase in FED on local cement price and re‐imposition of super tax for another year), more than made for the earlier losses. Budgetary implications have resulted in an increase in cement prices where prices in the northern region have risen by Rs22/bag to Rs530/bag. That said, southern region has not yet passed on higher costs as the price in the region was already at a premium. Additionally, LUCK continues efforts to diversify its energy needs by 10MW WHR at Pezu Plant (expected COD last month of 2016). This will likely contribute in after tax operational savings of Rs1.37/share from FY18 and onwards. LUCK trades at a slightly higher price owing to recent bull‐run on inclusion in MSCI EM Index. Higher multiples are also reflective of associated lower premium and fast paced earnings growth (5‐year forward CAGR of 21%).

Does Brexit mean anything to Pakistan?

As part of my daily chores, I read a lot of content pertaining to commodities, currencies and stock markets. I often wonder if this flood of information makes decision making by Pakistani investors easier or force them to make investment decisions that ultimately become loss yielding for most of them.

At present a lot of being talked about Britain’s exit from the European Union (Brexit). Whatever may be the outcome of the referendum scheduled for 23^rd June, it will be of little consequence for Pakistan. This may sound a sweeping statement but if one keeps various factors in mind affecting trade between the two countries, understanding the likely implications will become much easier.

Britain may be a major buyer of ‘Made in Pakistan’ products but most of the trade is USD denominated. Therefore,the involvement of three currencies i.e. GBP, EUR and USD often nullify the benefit emerging from the movement of one or more than one currencies.

Most of the investors prefer to convert their saving into USD, which they consider more trustworthy, simply because PKR value depreciates regularly. Many of the exporters try to without their payments outside Pakistan in anticipation of erosion in PKR value.

Movement of international gold price is also of little consequence. Pakistan consumes around 250 tons of precious metal per annum. Out of this, 50 percent demand is met through ‘recycling’ and remaining quantity is ‘smuggled’ into the country. Official import is around half a ton for 10 months of the current financial year. On top of this price in the local bullion market is driven by domestic demand rather than international price.

There are two global benchmarks of oil, Brent and WTI, these carry hardly any relevance for Pakistan because the country buys ‘Middle East Crude’ where price is driven by ‘geopolitical’ considerations rather than prevailing international prices of Brent and WTI.

There is also a lot of hype about Pakistan’s inclusion in MSCI Emerging Markets and the overall perception is that up to USD1.5 trillion can make inroads into Pakistan. The statement sounds highly exaggerated keeping in view the inflow/outflow of foreign funds. Overseas investors already hold 30 percent shares of the blue-chip companies. According to some estimates, often monthly outflow comprising of dividend/capital gains exceeds inflow. Therefore, one of the possible fallouts could be outflow surpassing inflow.

Last but not least the hype about the US Fed increasing interest rate sounds like ‘exchange rate maneuvering’. On one or the other pretext the Fed has been deferring interest rate hike for more than a decade and hoping any hike in near future is hoping against hopes.

Pakistani’s should pay more attention to factors affecting its economy and ruling junta should try to remove the impediments affect GDP growth and exports rather than introducing news tax measures. It has been reported in media that the incumbent government has already exceeded its expenditures by more than PKR250 billion against the target, exports have nosedived and there is a visible deceleration in remittances. Many experts warn that debt servicing has become unsustainable and the government is borrowing more and more to pay off the debts.

Pakistan reclassified in MSCI Emerging Market

MSCI has announced to reclassify Pakistan in the MSCI Emerging Market Index in its Annual Classification Review, with a proforma weight of 0.19% (amongst the lowest in the EM group). Pakistan’s leading brokerage house, AKD Securities estimates gross passive inflows of US$500 million upon formal inclusion.

While benefits to derive are numerous, increased foreign visibility and participation particularly amid continuous foreign selling (CYTD net FIPI outflow of US$36.4 million) along with potential multiple re-rating (PSX-100 index traded at an average P/E multiple of 10.2x over 2006-08) are likely to be the most profound.

Despite rallying by 8% since May'16 in anticipation of a favorable decision, brokerage house believes the reclassification announcement is likely to make room for a further continuation of the recent bullish momentum with select stocks (included in the MSCI EM index) leading from the front. PSX-100 Index can statistically gain 15 to 20 percent surpassing 43,000 level over the next 12 months.

It is widely quoted that up to US$1.6 trillion is benchmarked to the MSCI EM Index (including both active and passive). A proforma weight of 0.19% should result in Pakistan attracting at least US$3 billion in both active and passive flows. Assuming passive investment constitutes 15 to 20 percent of overall funds benchmarked to the MSCI EM Index, roughly US$500 million in gross passive inflows into Pakistan can be expected upon formal inclusion.

While Pakistan is now set to compete with EM economies, brokerage house remains optimistic on Pakistan's attractiveness in the index backed by a promising macro environment. Favorable macro trends (decade low inflation and interest rates coupled with external stability) support Pakistan's economic growth trajectory. Major growth themes are 1) spurring industrial activity and consumer demand, 2) investment in infrastructural development and energy generation, likely boost GDP growth above 5 percent over the medium term. With positive implications for corporate profitability, strong consumer demand and development initiatives are now reflecting into a robust topline of Cements, Paints, Glass, Automobiles and Food Producers (excluding sugar).

Wary of continuous selling pressure, brokerage house sees Pakistan's reclassification into the MSCI EM index as a key confidence booster for the market. However, the latent risks exist in the form of: 1) political, both domestic and foreign policy related and 2) Brexit can cause turbulence due to heightened risk aversion of global investors.