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Pakistan Strategy: V, U or W for market performance?

Nation-wide polls (due by Sep’18) will be the most keenly tracked event in Pakistan this year, coinciding with a challenging macro environment and likely spike in geopolitical temperatures. Domestic political noise, risk of US-Pak relations sliding down a slippery slope and pressure on the external account can together cause turbulence relegating market performance to be anything but smooth (at least until firm grounds for election emerge). Emerging political clarity has the potential to lower market risk premium where fundamental themes like: 1) double digit corporate earnings growth (10.1% in 2018), 2) currency devaluation (estimated further ~7% depreciation in the PkR/US$ parity) and 3) monetary tightening (DR +75bps in CY18) should gain prominence.  In this backdrop, our blended KSE100 Index target of 47,346 offers a potential return of 17% during CY18. Valuations have also become increasingly appealing - KSE-100 fwd P/E (7.9x) at 16% discount to the last 3yr historical average of 9.5x - furthering our investment thesis. In this backdrop, our top picks include MCB, BAFL, OGDC, ENGRO, LUCK, PSO, NML and ASTL.

Political crescendo yet to peak: An immediate checkpoint would be the upcoming Senate election (Mar’18) after which the PML-N is expected to emerge as the leading party in both houses ahead of the general election. However, news reports indicate that a no-confidence motion is currently being envisioned in the Balochistan assembly (PML-N majority) which can likely impact the upcoming Senate election (especially if it spreads to KPK and Sindh). Additionally, geopolitical temperature has suddenly spiked with the US suspending its entire security assistance (reported US$900mn) to Pakistan which can lead the US-Pak relationship on a slippery slope. In terms of market sentiments, our calculations of market risk premium (MRP) suggests that average MRP is statistically higher during 6 months prior to general elections with a significant reduction in the same (avg. 155bps) in the post 6 months period on emerging political clarity.

Election outlook - coalition expected: We expect a weakened yet regrouped PML-N to still be part of the next government, however, under a coalition albeit with a comparably thin majority relative to 2013 results. PPPP, the second largest party, is expected to remain limited to Sindh with a risk of losing ground in key districts due to poor performance. For Imran Khan and PTI to capitalize will depend on whether the current swing in momentum and public opinion can be maintained in their favor during the run up to the elections.

PkR - room for further devaluation: After remaining largely flat since CY16, the Rupee (PkR) recently depreciated against the US Dollar (US$) in the interbank market by ~5% (since Dec 7’17) with the currency parity stabilizing around PkR110.6/US$. That said, weakness in external account metrics (CAD FY18F/FY19F: 4.9%/5.0%) is expected to keep the currency under pressure. We estimate the PkR/US$ parity to depreciate by another ~7% from current levels in CY18F. A trade weighted perspective also indicates overvaluation where the PkR REER index is hovering at ~20% above its 17-year avg. of 103.18x.

Investment perspective: Our blended KSE100 Index target of 47,346 offers a potential return of 17% during CY18. However, uncertain domestic politics along with a volatile geopolitical environment can keep a lid on market performance until general election 2018 (the market retesting its recent low of 37,919pts in the run-up cannot be ruled out). That said, the market should bounce back thereon with the following fundamental themes gaining prominence: 1) double digit corporate earnings growth, 2) commodity cycle uptrend benefitting index heavyweights, 3) economic themes of devaluation and monetary tightening gaining prominence and 4) implementation progress on CPEC driving economic growth and business opportunities. We push for thematic exposure in Banks, Oil&Gas Exploration, Textiles, Fertilizers, Steel while maintaining preference for selective names in Cements and Autos space.

AKD Research