In April, the Fund went down 9% in SEK as compared to the benchmark MSCI IMI Pakistan Net (SEK)’s return of -4.5%. The main underperforming exposures this month were Materials whereas the outperforming exposures were Financials and Consumer Staples. We conclude that the fund has been severely punished due to its overweight in Materials (mainly cement and steel) where we have lost almost 10% compared to our new benchmark in 2019. Unlike previous cycles, this time it has taken considerably longer for Pakistan to reach an agreement with the IMF, which historically has marked the bottom of the market. The protracted uncertainty has hit particularly hard on growth-driven sectors, especially cement and steel. If we exclude Lucky Cement, which is a conglomerate with significant operations outside of cement, the average valuation of the cement companies we owned at the end of the month measured as Enterprise Value/installed capacity is now at around USD 20/tonne capacity, which can be compared with a normal replacement cost valuation over a cycle of about USD 100 and peak valuations (April 2017) of USD 175. The valuation of the sector is of course far too low in a medium-term perspective. We conclude however that we have been too early in our allocation and misjudged the degree of uncertainty that the market has been willing to discount into valuations.
The economic impact of a 33% devaluation and a cumulative interest rate increase of 5% lies like a heavy blanket across the country. In fact, the previous government’s strategy of borrowing foreign capital to keep the currency stable and investing in power generation and road infrastructure has not resulted in the necessary inflow of foreign currency – neither in the form of increased exports nor foreign investment – they need in order to a) pay off the loans and/or b) meeting the current account deficit (a side effect of an overvalued currency). Clear improvements are now visible, the current account deficit has moderated to an acceptable 2.5% of GDP (from the peak of 6% GDP). With oil prices at current levels, Pakistan should be able to reach a current account deficit of 2% of GDP. The FX reserves have been kept steady at 7-8 week’s worth of imports and Pakistan successfully repaid the maturing Eurobond of USD 1bn. The former Finance Minister, Asad Umar, was a proponent of a staggered monetary tightening and currency depreciation. It is said that, in September, the IMF proposed to raise interest rates significantly. At the time, the need for an IMF bailout was almost USD 20bn. This was addressed through geo-economic diplomacy (China USD 4bn, Saudi Arabia USD 3bn + USD 3bn in oil credits), bringing the bailout package now discussed with IMF down to USD 7-8bn.
Currently, IMF’s proposal – according to unconfirmed reports – require an immediate 20-25% hike in the power tariff, further monetary tightening, and a Fiscal Adjustment of 2% to attain a primary balance in Fiscal Year 2020. Such measures would bring the Fiscal Deficit from 7% to 5% through an increase in indirect and direct taxation, removal of subsidies, and further administrative measures to enforce tax collection. The Government has already lost PKR 100bn (0.2% of GDP) in tax collection owing to Supreme Court’s decision to stop the government from collecting taxes on mobile phone usage. That decision has recently been reversed. Amidst the initial bail-out talks, the Market was surprised that the Finance Minister, Asad Umar, was removed and replaced with the seasoned ex-Finance Minister, Hafeez Shaikh, who led talks with the IMF in 2008. The reason stated was to alleviate the criticism that the government mismanaged the economy in connection with the current account crisis in the fall.
In April, the market took hold of the deteriorating economic outlook. With an increase in raw material and product prices, coupled with a 2x increase in Finance costs along with a reduced purchasing power, the earnings have collapsed to near break-even for various pro-growth cyclical sectors. In addition, an increase in Fixed Income returns have made local investors less interested in the Equity Market along with falling present values of diminishing cash flows. However, we have seen these phases in Frontier Markets before and they usually do not last for more than a year.
Key events in the out-going month included a somber inflation reading (8.8% YoY), USD 822m Current Account Deficit (CAD) for March, the Prime Minister Imran Khan´s visit, the signing of new Free Trade Agreement (FTA) with China, and USD 8bn investment in setting up a new railway line.
The month of May could be an inflection point and has major key events lined up; the IMF’s package, budget presentation, FATF’s meeting, and the MSCI Semi-Annual Review. However, the government does have several unorthodox catalysts in the offing; USD 2bn from RLNG plant privatization, USD 1.2bn from telecom spectrum auction, USD 700mn from Etisalat, USD 1bn from Panda bonds and investment interests shown from Huawei, Volkswagen (USD 130m), Exxon Mobil chief is meeting with the Prime Minister Imran Khan to discuss further investments, the Turkish dairy player SUTAS JV with Nishat Dairy, and impending Saudi Refinery in Gwadar Port.
The KSE 100 Index has fallen sharply from the peak and many fundamentally strong companies have lost 70-80% of their market capitalization in USD terms. The Government seems to work actively to change the direction of the economy towards investments and exports, the boom (May 2017) and bust (Apr 2019) provides great opportunities for long term investors. The hatching period could extend for a few quarters until the sales decline bottoms out, the FX reserves touch 3 months import mark, clarity around the debt repayment is witnessed, exports start increasing and inflation – and thus, interest rates – peak out.
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