EUR 45.60 For Business Accounts Only

JKSB Sri Lanka Market Strategy_July 2017

Executive Summary

Sri Lanka’s GDP recorded 3.8% YoY growth for the first quarter of 2017. A contraction in the agricultural sector due to the drought was offset by growth in production in industrial and service activities. The recent flooding in the southern and central parts of the island will depress an element of an already slowing down consumption due to fiscal and monetary tightening as well. We estimate GDP to grow at 4%-5% over the medium term with this year tending to the lower end of that range.

Ongoing infrastructure projects which are unprecedented in terms of ambition and scale (the expressways linking the Southern, Central and Western provinces, the Port City in Colombo, water and irrigation network improvements) will ensure growth for the construction sector over the medium term. Textiles and apparel which is also a significant subsector should benefit after the resumption of GSP+. As lower income segments keep transitioning to the middle class we should see improvements in consumption over the longer term.

We expect interest rates to gradually start easing over the course of the next 12-18 months by about 50-75bps. Improved fiscal consolidation should also lead to a gradual easing of VAT and revenue taxes over a longer time frame. While inflation has been appreciably higher, reaching the 6% levels over the last quarter we expect it to start easing over the next year. We expect food prices to stay broadly stable for the rest of the year. We do not expect any major revisions to energy prices although inflation remains highly sensitive to global commodity prices and petroleum prices in particular.

Exports should improve in CY17 thanks to stronger global tea prices, and GSP+ helping with apparel, although imports have also shown growth. The BOP should be supported by higher earnings from tourism and marginal growth in inward remittances. FTAs with both China and Singapore are expected to be finalized during 2018, while FTAs with India and Pakistan are already in place. Easier access to a market of over 3 billion people in the Asian region is expected to catalyze export growth beyond the traditional markets of the EU and the US.

Over the last twelve months activity levels have been flat in equities with most of the volume driven by JKH, Hemas as well as HNB and COMB. Over the last twelve months the broad index has been range bound trading in a 12%-14% band. The market has moved higher since April 2017 on the back of renewed buying interest from foreigners, with the ASPI advancing by 11% since the start of April.

Despite recent buying interest, SL valuations remain attractive compared to other regional markets and our coverage universe trades at a FY18E P/E slightly over 10x, which is cheaper than most markets surveyed with the exception of South Korea and Pakistan. Moderating rates and easing of macroeconomic pressures should also lead to improved turnovers with local players increasing their participation. Over the next 18 months our expected earnings growth expectations will see mid cap counters approach increasingly attractive valuations allowing the index to trend higher.

Earnings growth for the next two years for our coverage universe is expected to be approximately 9% - 10% with the large caps (ie. conglomerates, banking, and construction counters) contributing to this. We feel this earnings growth should support price and that current multiples should remain at existing levels.