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Pakistan Market Strategy: COVID-19 Outbreak – The Black Swan

COVID-19 outbreak has disrupted an already fragile economic recovery

Fast paced viral spread is deepening worries: COVID-19 outbreak is the only hot topic as the death toll from the novel virus continues to rattle global economies. Continuing lockdowns and their ensuing effects on economic activity has led the International Monetary Fund (IMF) and other International Financial Institutions (IFIs) to slash global growth forecasts. In Pakistan, this outbreak has brought the economic recovery process to a screeching halt. As the case load in Pakistan continues to grow, the incumbent PTI govt. has found itself in a situation where it has to weigh between repercussions of an extended lockdown or risk fast-paced viral spread from resumption of lifting the lockdown. As per govt. estimates, suspected case load of up to 50,000 patients as compared to currently diagnosed number of patients of 5,038 only (as of 01:39pm, 12th-Apr’20). 

Benign commodity prices are helping tame local inflation: Waning global demand for commodities and the oil price war between Russia and Saudi Arabia is a silver lining amidst difficult situation for Pakistan. The implications of weak commodity prices for domestic inflation, especially food and energy, are relieving amidst strained income levels in the economy. The signs of decelerating inflation are already visible with headline NCPI likely to fall into single digits after 8 months of double digit readings in Apr’20. We expect NCPI to average between 11% YoY during FY20 and at 6% level in FY21. 

Fiscal concerns will take center stage: Fiscal situation deteriorates with every single day of lockdown and slowdown in trade activity. FBR tax collection numbers during 9MFY20 depict a shortfall of PKR459bn as compared to targeted levels. During the month of Mar’20 only, the deficit in tax collection expanded to PKR263bn vis-à-vis average of PKR40bn in 8MFY20 period as the country remained in a state of partial lockdown from mid Mar’20 onwards. With govt. officials indicating continuation of lockdown (in some form or the other), we expect tax collection to suffer in Apr’20 as well and overall fiscal deficit for FY20 to settle in the range of  9%-10% mark. Keeping current situation into consideration, we believe support from IFIs will be essential to finance fiscal response of the government. Current news flow suggests fresh funding to the tune of USD1.4bn has been approved by the International Monetary Fund (IMF) under the Rapid Financing Instrument (RFI) in addition to USD1bn approved by the World Bank (WB) and USD1.5bn by the Asian Development Bank (ADB).

Circular debt will swell – drastic measures will be required: Another side effect of slow down in industrial activity is faster paced accumulation of circular debt as peak load has started to show double digit decline as compared to last year. Overall stock of debt is likely to go well above PKR2tn in case of an extended lockdown. Issuance of PKR 200Bn Sukuk in the near-term is expected soon, which will reduce some cash flow burden of the energy sector. Deferment of electricity bills to support the masses will further amplify buildup.

IMF likely to be kinder: In the present situation, IMF’s aggressive tax collection target of PKR5.2tn, ceiling on primary deficit of 0.6% of GDP and power sector arrear targets seem like a distant dream but underperformance in prevailing situation is unlikely to invite any undue pressure from the Fund. For the time being, the second review of the ongoing IMF EFF program has been deferred and USD450mn tranche has been held back in the light of funding from the IMF’s RFI facility.

Low private indebtedness is comforting in current environment: Private sector credit in Pakistan stands at just 14% of GDP, which indicates room for local corporate sector to absorb this shock of unprecedented scale. Recent measures taken by SBP i.e. reduction in policy rate by 225bps, reduction in Capital Conservation Buffer (CCB) requirement by 1.0% to 1.5%, relaxation Debt Burden Ratio (DBR) to 50% from 60% for consumer loans, increase in loan limits for SMEs, deferment of principal repayments, relaxation in loan provisioning requirements etc. are some of the positive steps taken by SBP to protect against corporate defaults.

Policy response by SBP and govt. seems sufficient to spur domestic activity: A number of measures were taken by SBP and the govt. to spur industrial/investment activity and shield local banks from negative ramifications of current headwinds. Construction package announced by the govt. last week will go a long way in kick starting frail economic activity as the sector is linked to at least 40 different industries and is the second largest employer. 

Equity market poised to bounce-back 

Base case index estimate revised down to 38,500 pts: We have revised our index target downwards to 38,500pts based on expectations that forward PE of the market will revert to pre-COVID-19 levels seen in Jan/Feb 2020 by calendar year end. COVID-19 is a classic Black Swan event of our time and offers opportunity for investors to build positions at current attractive levels. Further, our analysis of bear market trigger dates (defined as 20% decline in KSE-100 index in two months) indicates that KSE-100 index provides an average return of 37% in the subsequent 24 months period. 

Top picks: Our top picks are: 1) OGDC (TP: PKR 152); 2) POL (TP: PKR 358); 3) EPCL (TP: PKR 34); 4) HBL (TP: PKR 148); 5) MEBL (TP: PKR 105); 6) LUCK (TP: PKR 530); 7) KOHC (TP: PKR 135); and 8) FFC (TP: PKR 115). Our top picks offer a mix of growth and yield prospects especially in these uncertain times and are available at steep discount to their fundamental value.

Further policy rate cuts likely: Slowdown in domestic consumption, lesser imported inflation and base effect will help National CPI (NCPI) to post consistent improvements over the coming months, creating room for further policy rate cuts. SBP has already slashed policy rate by 225bps in Mar’20 and has kept its medium-term inflation target of 5-7% intact. The key question for SBP going forward will be: how to support and ensure materialization of growth targets as consumption weakens and local corporate sector battles with cash flow difficulties? The response until now has been two pronged i.e. 1) ensuring supply of credit at easy terms in times of dire need and 2) reduce the cost of credit. That said, we believe that lower NCPI in coming months will create room for SBP to support growth by reducing policy rate by another 100bps cut in May’20 and another 100bps during the rest of 2020.