KSE100 vs Global & Pakistan Interest Rates

 

Over the past year, central banks all over the world have hiked interest rates like there is no tomorrow. Pakistan’s central bank has been no exception: State Bank has hiked interest rates by 1125 basis points since January 2022. Interest rates in Pakistan now stand at an all-time high of 21%.

Unsurprisingly, the stock market has been bleeding red. The KSE100 index started off 2022 at 45,374 points. It ended May 2023 at 41,665 points. The story has been similar across the major stock exchanges all over the globe. In fact, they’ve suffered an even deeper and steeper downslide than KSE100.

So why do equities crumble under a rising interest rate environment? Well for one, the interest rate determines the risk-free rate in an economy. So, the rate at which investors discount future earnings or dividends revises upward as interest rates go up. Resultantly, the present value of future earnings or dividends falls when interest rates rise translating into lower share prices.

There are alternative explanations too. When interest rates rise, bonds pay a higher coupon relative to their price. So, a falling stock market is an indicator that investors are simply moving away from equities and into bonds because they are more attractive. Or it can also be thought of in this way: rising interest rates increase the risk of a recession so future profitability becomes uncertain leading to falling stock prices.   

Now that the relationship between interest rates and equities has been established, one might wonder: how have interest rates affected the Pakistani stock market?

There are two interest rates that are important for Pakistani stocks: Karachi Interbank Offer Rate (KIBOR) and global interest rates. KIBOR is important because it is the rate at which banks lend to each other and is the benchmark for most lending in Pakistan.

On the other hand, global interest rates are important for a different reason. Historically, Pakistan has ran a current account deficit which has been funded by foreigners (capital account surplus). Unfortunately, most of Pakistan’s capital account inflows have been volatile, debt flows instead of the more stable and productive FDI flows.

The rate at which Pakistan receives loans from foreigners is determined by global interest rates, hence making them relevant to Pakistan’s macroeconomic stability – which impacts the stock market. Global interest rate is heavily influenced by the interest rates in the West and largely follows the US interest rate. Hence, we will use the US Fed funds rate as a benchmark for global interest rates.

KSE100 v KIBOR

The above graph clearly shows that KIBOR has been inversely related to the KSE100 index over the past 20 years. In particular, the recovery of KSE100 from 2009 to 2017 happened under a low and falling interest rate environment. This makes sense because lower interest rates translate into lower financing costs, thus boosting profitability of KSE100 companies.

Also, the correlation of KIBOR and KSE100 comes out at -0.1. It confirms the negative, linear relationship between KIBOR and KSE100 although indicating that it is a weak relationship. The weak relationship between KSE100 and KIBOR can be supported by the fact that most publicly listed companies have high pricing power. This allows the companies to pass on higher financing costs onto customers in the form of higher prices, thus protecting profitability.

KSE100 v Fed Funds Rate

On the flip side, the Fed Rate appears to have no relationship with KSE100. This is confirmed by the correlation of 0.03 between KSE100 and Fed Rate. This appears to make sense as companies in the KSE100 have very little foreign debt. Most of their debt is domestic. Hence, changes in global interest rates do not have an immediate impact on the earnings of companies in the KSE100 index.

As for the Pakistani government’s debt, most of its debt is bilateral rather than commercial. Consequently, Pakistan’s macroeconomic stability depends more on other factors like geopolitics or its foreign relations rather than global interest rates.

What does this mean for KSE100?

Although further rate hikes or future rate cuts by the State Bank would temporarily sway the KSE100 index one way or another, they would not cause a sustained rally or slump. Instead, investors must focus on the growth potential in the top-line and bottom-line of the companies in the index. Remember, the value of anything is the present value of all future cash flows.