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Pakistan Market Outlook 2019: Weak Macros to Limit Market Upside

• Pakistan ongoing economic problems exacerbated by high fiscal and external account deficits, will likely limit market upside in 2019, we believe. Though there is lack of clarity on the Govt. Economic Plan, we think, there is high probability Pakistan will get International Monetary Fund (IMF) loan for economic stability.
• Given tough economic environment of low growth and high interest rates, we expect market to trade at forward PE 7-8x for 2019, lower than last 10-year average PE of 8.5x. This would be in line with PE seen post IMF in 2008 and 2013 and also during periods of low economic growth. Resultantly, we expect the KSE-100 Index to trade in the range of 40,000-45,000 in 2019, providing a gain of 3-16%, lower than required rate of return.
• Delay in getting IMF and other funding may result in market trading below PE of 7x (below 40,000) while a significant fall in oil prices may re-rate PE to 8x plus (above 45,000).
• Given increase in SBP’s Policy Rate of 425bps in 2018 to 10%, longer tenure govt. paper has started trading higher than 12%.  Periods of high interest rates have historically kept the market forward PE low as local investors prefer to invest in high yielding bonds.
• Spread between earnings yield and T-Bill yield in 2019 is expected to narrow to 150bps (2017 spread of 545bps and 2018 spread of 270bps). This is due to steep rise in interest rates while earnings yields will rise by fraction of this supporting our view of flows moving to bonds.
• The recent global markets sell-off has brought down forward PEs across the board including Emerging Markets (EM). Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Asia is trading at forward PE of 11.6x compared to 14.0x a year back. Given this contraction, despite the decline in Pakistan Market, the discount to MSCI EM is currently around 31%, in line with past trend. This is in line with our assertion of range bound market movement in 2019.
• Due to fiscal and monetary tightening, corporate profit growth will also be affected. Corporate earnings growth for 2019 and 2020 is expected to clock in at 11% and 5% respectively. The range is also dependant on where international oil prices settle for next year. Exploration & Production (E&Ps) and Banks will be major anchors to growth in 2019.  Excluding E&Ps and Banks, corporate earnings for 2019 are expected to be flat.
• The new year 2019 may not be exciting given expectations of limited upside in the market. However, selective stock picking can generate above average returns, we believe. High quality non-cyclical stocks with stable business (that will gain from weak PKR and high interest rate) should be preferred for 2019. Banks, E&Ps, Textile, Fertilizer and Technology sector can provide better return than others.
• Our Top Buys for 2019 are Oil & Gas Development Corporation (OGDC), Engro Corporation (ENGRO), United Bank (UBL), Lucky Cement (LUCK), Meezan Bank (MEBL) and Nishat Mills (NML) while our Top Sells are Engro Foods (EFOODS), Fauji Cement (FCCL), K-Electric (KEL), and Pak Suzuki (PSMC).
• Some other mid and small cap stocks that we like are Glaxo Pharmaceuticals (GLAXO), National Foods (NATF), Gul Ahmed Textiles (GATM) and Avanceon (AVN).