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Pakistan Strategy: Market rallying with rising leverage; MTS rate at 12%, future spread at 15%

• Pakistan market has recovered sharply with benchmark KSE-100 up 49% from its recent low on Mar 25, 2020, when the world’s financial markets including Pakistan were hit by the COVID-19 outbreak.
• The recovery in prices has been accompanied with significant improvement in volumes with average traded value improving to around Rs23bn/day (US$133mn) over the last week, levels which were last witnessed in Jun-2017.
• To get perspective, the average traded value in FY20 stood at Rs7.2bn/day or US$46mn/day.
• The reported leverage (MTS, MFS and Futures Open Interest) has also substantially increased to around Rs23bn (from Rs5.7bn on Mar 31, 2020).
• This is 0.7% of the market’s Free Float capitalization and 0.2% of the market’s Total capitalization.
• These ratios in FY20 (Jul 2019 to Jun 2020) averaged at 0.4% and 0.1%, respectively.
• The leverage in the market in absolute terms is similar to what was witnessed in 2016-17. However, relative to capitalization, it was lower then and far higher now.
• Open Interest in single stock futures has increased to Rs13.4bn from Rs2.7bn in end of Mar-2020. This is highest since Dec-2019.
• Average annualized spread yesterday was at 15%. In few stocks it is over 20%.
• Margin Trading System (MTS) leverage has shot up to Rs6.0bn, which is 1.5-year high.
• The last few days have also seen average MTS rate shooting up to around the 12% mark from its recent low of 8.4% on July 14, 2020. This in certain stocks, has shot up to as high as 15.36%.
• It is also surprising as 6M KIBOR has come down over the past few months, with the spread between the MTS rate and 6M KIBOR rising to 3.7% vs. long term average of 2.7%.
• Margin Financing System (MFS) value stood at Rs4.0bn, not seen since Aug-2018.
• Interestingly, short position in futures have not increased substantially in absolute terms. Short position stood at Rs1.4bn as of August 11, 2020, compared to Rs0.4bn on Mar 25, 2020 as per PSX data.
• While the increase in leverage can potentially be also due to recent regulatory changes by NCCPL allowing profit distribution in futures, the trend is somewhat concerning for the market in the near-term in our view.
• The trend suggests high demand for leverage with relatively limited liquidity. Generally speaking, if the rate goes higher or if leverage is not available, than investors will look to offload positions.
• In spite of the recent run up in Pak stocks, the discount to MSCI EM (Asia) stands at 56% compared to historical average discount of 40%. Pakistan market currently trades at 2021 P/E of 7.3x with a dividend yield of 6%.

We are currently Over-Weight on Oil & Gas Exploration, Cements and Autos. Our top picks include Oil and Gas Development Company (OGDC), Mari Petroleum (MARI), MCB Bank (MCB), Meezan Bank (MEBL), Lucky Cement (LUCK), Kohat Cement (KOHC), Engro Corporation (ENGRO), Indus Motors (INDU) and Pak Elektron (PAEL).