KSE100: Where Will It Go From Here?

After returning 55% (24% in USD terms) in 2023, the KSE100 index has flatlined in the first quarter of 2024. Some commentators have begun questioning the foundation of the magnificent rally that occurred in the second half of 2023. However, this short-term view suffers from a lack of understanding (or ignorance) of market cycles.

A very well-acknowledged fact about the Pakistani stock market is that it is very sensitive to the ‘macros’. Macros being certain macroeconomic variables like interest rates, foreign reserves and the value of the PKR. This is in contrast with stock markets elsewhere in the world.

In most other nations, the growth rate of the economy (which determines earnings growth), equity risk premium and dividend payout ratio matter for stock market performance. This has its theoretical origins in the basic Gordon growth model. Thus, usually the market goes through boom-and-bust cycles primarily based on changes in equity risk premium or growth rate of the economy.

For these reasons, you frequently see global stock markets tanking when the economy goes into a recession or rising when speculation is rampant (equity risk premium falls) – dotcom bubble for instance. The key difference between these economies and Pakistan’s economy is structural.

Consumption as a % of GDP

In most other nations, the economy is well-diversified with growth being channelled through a mix of investment, consumption (imports) and exports. On the other hand, Pakistan’s growth model is heavily import and consumption reliant. This causes Pakistan to run into persistent balance of payment crises when growth heats up.

Consequently, there’s a counterintuitive trade-off between growth and creditworthiness (confidence) of (in) Pakistan which doesn’t typically exist in most other countries. This friction causes the Pakistani stock market to boom for four to five years followed by a period of stagnation for the next four to five years.

Generally, the market booms when the PKR is stable, interest rates are low/falling and foreign reserves are rising/stable – invoking confidence. These conditions trigger investors to realize the value of earnings which had been rising and accrued in the period of stagnation.  

From the trough to the peak, the PE ratio of the market varies from 3 to 12. Despite the persistence of these cycles, investors always get duped by pessimism during the period of stagnation and the optimism of a ‘new future’ during the growth phase.

This market cycle is not only observed in the stock market but also the real estate market in Pakistan. Real estate prices tend to double within a couple of years and then stagnate for four to five years. The last cycle was observed in the 2016-2021 period. From 2016 to early 2020, the real estate market stagnated and then catapulted itself to new heights from mid-2020 to 2021. Now, it has returned to the stagnation phase.

For the KSE100, the market cycle is much easier to observe through data. The above graph uses a metric called the ‘5-year annualized return’ to succinctly display when one should enter or exit.

When the 5-year annualized return shoots above 10% in a certain year, the market enters the growth phase and when it plummets below 20% in a certain year, it enters the stagnation phase. In 2024, the 5-year annualized return shot above 10% highlighting that the market may have entered the upswing cycle.

There are fundamental reasons to support this assertion. SBP foreign reserves have recovered from a low of $3.1bn in early 2023 to $8bn in March 2024. Interest rates are expected to begin their path downwards this year – possibly from April with inflation trending down. Lastly, the PKR has been relatively stable with expectations of sharp depreciation low. The balanced current account also eases pressure on foreign reserves and the PKR.

There is genuine cause to believe that the Pakistani stock market is in for a few good years. Whether those few good years turn into a good decade or two depends on whether structural reforms are implemented or not. But considering history, betting your money on that would be risky.

The better gamble would be to go long for the next 3-4 years. The rally of the second half of 2023 has shown that one cannot time the exact movements of the market but staying committed will reap rewards.

One cannot know when SBP will cut interest rates this year, but when it does a rush of money will flow away from fixed income and into other assets primarily riskier assets like stocks. This is an occasion where buy-and-hold is a solid strategy. At least for a few years, that is.

An Oddity in Real Estate: DHA Phase 10 Files

 

Following the 2020-21 boom, Pakistani real estate has stagnated. Some localities have witnessed a 10% correction while others have barely slugged along. None of this is surprising given that interest rates stand at 22%; investors presently prefer to keep their cash at the bank.

Liquidity has dried up too. DHA Lahore used to witness over 100 property transactions every day back in 2021. However, now that rate is down below 50 per day.

In the grander scheme of things, this is just part of the market cycle. Having been through the boom phase a couple of years ago, real estate is taking a backseat and is in its slump phase.

Generally speaking, there’s a four-to-five year gap between the peak of the boom and peak of the slump for the real estate sector. As per this rule of thumb, the current property market slump should begin wrapping up in 2025.

Within any real estate slump, the property files market is the first segment to see a sharp retreat. And this time around, the retreat has been even sharper.

As per Zameen.com’s price index, DHA Phase 10 has experienced a 3% fall in the past month. But one must note that Zameen.com’s index does not accurately track real estate prices. Due to stickiness of listing prices, the index lags true property prices by six to twelve months.

Instead, one can utilize online rate lists posted by real estate agents as an accurate reference of the files market. As per LahoreRealEstate’s Phase 10 residential files rate list, 5 marla trades at 32 lacs, 10 marla at 56 lac and one kanal at 99 lacs. This is in stark contrast with DHA Phase 10 residential file rates back in May 2023.

Back in May 2023, the rates were 45 lacs, 61 lacs and 108 lacs for 5 marla, 10 marla and one kanal respectively. At current prices that represents a 29%, 8% and 8% pullback in 5 marla, 10 marla and one kanal rates respectively.

These rates are consistent with rate lists posted by other real estate agents and websites such as dharealestate.pk. Consequently, there is no question about the veracity of these figures. Having read the above, a student of finance would tell you that this is a possible case of mispricing. They would recall a little concept they learned in class: the law of one price.

The law of one price states that the price of an identical asset should have the same price. In this case, the files will be balloted at the same time and the location of the land they possess a claim to is unknown. Consequently, if DHA Phase 10 files market sees a recession, then files of all sizes should see a similar downtrend. However, we witness a vast variation in price drop.

From the above rate lists, one would also notice another oddity: 5-marla files trade at a premium to one-kanal files on a per marla basis. However, this is standard in the real estate market as relatively developed areas such as the next-door neighbor DHA Phase 9 Prism has 5-marla plots trading at a premium to one-kanal plots in the same locality.

Roughly speaking, 5-marla plots trade at a third the value of one-kanal plots with the same characteristics. This is reasonable as demand for 5-marla housing is higher due to their relative affordability and there are fewer fees/taxes associated with them.

Returning to the previous oddity, 5-marla files in Phase 10 have seen greater volatility. This could be due to their higher trading volumes, which allows for greater price discovery. Or it could be a result of their lower base/price. However, this base effect would be beneficial for investors when the market picks up, as returns would get amplified.

If the Phase 10 files market takes an upswing, it’s likely that files of all sizes will touch their 2022 peaks. Assuming this, 5-marla, 10-marla and one-kanal files would give a 41%, 9% and 9% return, respectively.

5-marla would be the best option due to its potential upside. However, this potential upside can be a concern for greater volatility/risk in the short-term.

Before coronavirus hit the world, Pakistan’s property market was going through a terrible slump. At that time, 5-marla files in DHA Phase 10 were trading at a bottom of 25 lacs. If you were to assume this as a support level, then it gives a potential downside of 22% from current price levels.

On top of this, who knows when the DHA Phase 10 files market would pick up? There can be two significant positive triggers for DHA Phase 10 files market. One could be that the property market returns to its boom phase but that is possible 2-3 years away. Secondly, DHA could start Phase 10 balloting which would generate immense investor interest.

Balloting for a new phase takes place roughly every eight to ten years. DHA Phase 9 prism was the last phase to be balloted back in 2015. That would mean that DHA Phase 10 balloting should be expected by 2024-25. But DHA only does new balloting when the property market is in its boom phase. Therefore, the key pre-requisite for DHA Phase 10 files to give upside is when the property market pulls itself out of the present slump.

Nonetheless, if an investor is looking to enter the property files market, 5-marla files in DHA Phase 10 should be their go-to when the market picks up. Until then, they can continue to enjoy a cool 20% per annum return on their bank deposits.  

Banks Selling at a Discount: Debt Restructuring Fears

Beyond the glimmer of attractive dividend yields, there lies a dim reality for banks. The market still fears domestic debt restructuring is a very real possibility. Consequently, banks continue to trade at steep discounts.

After my last blog, a couple of people inquired: how can we quantify the ‘debt restructuring’ discount for banks? Before diving into this, one has to first provide a background of valuing banks.

Historically, banks had been valued using a basic dividend discount model which most or every finance/economics undergraduate would be familiar with. Often also called the ‘Gordon growth model’ (GGM). However, the 2008 financial crisis revealed the fragility of using GGM for valuing financial companies.

The main issue with GGM (for valuing banks) is that it provides or incorporates no information on the regulatory capital of a bank. A bank might be paying really high, regular dividends. However, if those dividends are backed by significantly risky investments, the bank might be left undercapitalized.

This is where an equity reinvestment model jumps in. In such a model, free cash flow is found by taking net income and netting out investment in regulatory capital (tier 1). Then to obtain net income, you work your way back. You can look at the chart below to understand this (made by Aswath Damodaran):

So, in this model, the key determinants for determining the value of a bank are cost of equity, growth rate (banking assets growth rate), return on equity and target tier 1 capital ratio.

Using this FCF model, you can predict the fair value of a bank. However, you can work your way back and find the implied target tier 1 capital ratio. Or what the market thinks a bank’s future tier 1 capital ratio would be.

 For the first three key determinants, we can use historical averages. Cost of equity currently stands at 28% (22% risk-free rate plus a historical 6% ERP), while long-run cost of equity would be 14% (8% historical average risk-free rate plus 6% ERP).

Similarly, banking asset growth rate has stood at 16% for the past five years but 10% in the long run. Lastly, ROE can be computed on a bank-to-bank basis. For instance, SCB’s 5-year average ROE is 25% which is heavily inflated due to windfall profits in CY23. Historically, banking sector ROE has been 18%.

Based on this, and SCB’s current Tier 1 capital ratio of 18%, the market is expecting that SCB’s tier 1 capital ratio (in perpetuity) would be 3%. That means a significant wipeout of capital which would push SCB’s CAR below SBP’s minimum requirement. This cements the view that the market is still pricing in a significant debt restructuring discount for banks.

The story is very similar for other premier and non-premier banks. So, if interest rates start coming down, that would actually bode well for banks. Why? Because every 100 BPS reduction in interest rates leads to a reduction in debt servicing costs of approximately Rs 250 bn for the government.

This would reduce the chances of federal debt restructuring as the government would obtain more fiscal space. Moreover, is such a steep discount justified for banks when domestic federal debt restructuring has never taken place in Pakistan? Even while external debt restructuring occurred, local/rupee-denominated debt was never restructured.

Markets have a tendency to underweight unlikely or tail events. However, this might be a case of the market overweighting a tail event – domestic debt restructuring. Perhaps, one should be overweight on banks?

Why I’m Bullish on Banks

Since 23rd June 2023, the KSE100 index has rallied 61%. On the other hand, the Banking Tradable Index (BKTI), which constitutes Pakistan’s major banks, has rallied 75%. And this is despite the fact that the KSE100 index is a total return index (incorporates both capital gains and dividends), while BKTI index is a price return index (only includes capital gains).

The banking sector is one of the few sectors which have outperformed the broader-market indices over the past year. And why wouldn’t it when it offers an attractive dividend yield? The average CY23 expected dividend yield for BKTI stands at 12.3%. If you swap out Bank of Punjab for Standard Chartered in the index, that number goes up to 15.6%.

That contextualizes a major reason behind the banking rally: yield compression. Simply-speaking, assets of similar risks must deliver similar yields. When the IMF announced the Staff Level Agreement in late June 2023, the risk associated with Pakistani assets went down, thus yields on stocks had to compress – especially those that pay high, regular dividends. Moreover, with expectations of interest rate cuts in 2024 rising and macros getting better, that risk continues to fall thus boosting asset prices.

But why does the banking sector trade at a dividend yield far beyond 10% when the market as a whole is trading below that cutoff now? The market might still be pricing in idiosyncratic risk associated with the banking sector. Aka the risk of (domestic) debt restructuring.

However, the chances of domestic debt restructuring might be far lower than the market expects. Why? Well, commercial banks have been simply doing what the Finance Ministry and SBP expects of them – acting as a chain between SBP and the government for lending.

Wiping out bank capital is not exactly a good reward for obeying such ‘indirect’ orders. It would permanently damage confidence in the domestic debt market and make it difficult for the government to reliably issue debt over the long run. Hence, no domestic federal debt restructuring has taken place in Pakistan’s history even as external debt has been restructured.

Moreover, it is not domestic debt which is unsustainable but rather external debt. Much of the government’s international borrowing took place at an interest rate of 6-9%. This is far higher than the long run growth rate of Pakistan at 4.8% (i > g here). If you further deconstruct the borrowing, the unsustainability of it becomes clear.

Borrowing externally at a rate of 6-9% and adding in natural long-run depreciation of 5-8% translates to a rupee cost of debt of 11-17%. Historically, rupee cost of local debt has been 8% in Pakistan.

And in fact, since 2022, when external financing conditions deteriorated, the government was forced to issue more domestic debt to replace maturing external debt. The graph on the right shows net external debt ($) of the government. One can notice the graph deviates from a natural trendline from 2022 – only showing a slight uptick towards the end of 2023.

As external financing conditions improve, the need to borrow from domestic markets will reduce, thus making local debt more sustainable.

What’s the best news among all this? Banks might actually be the biggest winners from falling interest rates. Sounds counterintuitive but it’s true. Yes, net interest margins would reduce slightly affecting profitability but falling interest rates would reduce the government’s debt servicing bill and give it some fiscal breathing room. That itself would largely alleviate the risk of debt restructuring, thus boosting asset prices. Interest rates being at 22% are not the norm but rather an anomaly (remember: historically, interest rates have averaged 8% in Pakistan).

Furthermore, falling interest rates would mean further yield compression as more investors rush to equities. There are still several banks which trade at attractive dividend yields – a couple offering even more than the risk-free rate.

So which banks would be good targets? Certainly, banks which offer a tasty dividend yield. They would benefit most from the yield compression and would act most as bond proxies which generally tend to rally in a falling interest rate environment. If you go back to 2021, banks like UBL and MCB were trading at a PE of 8 and at a dividend yield of 10-12%. 

Besides this, banks which could potentially increase payouts would unlock significant shareholder value. This is because excess cash sitting on the books would be returned to shareholders.

With banks like Standard Chartered and Bank Al-Habib doing just that over the past year, there would be pressure on other banks to follow suit given the massive increase in earnings as of recent.

MCB and Bank Alfalah (BAFL) could be potential banks increasing payouts. 5-year dividend payout ratio for BAFL and MCB stands at 53% and 80%, respectively. EPS for CY23 is expected to come in at Rs 23 per share and Rs 50 per share for BAFL and MCB, respectively. That leaves massive room for a large Q4 dividend if BAFL and MCB stick to their dividend payout ratio trend of the past five years.

The earnings season fever might be the trigger to unlock further value in banks. And it lurks just around the corner now…

Solving Inflation: Funding the Fiscal Deficit

Many commentators have recently suggested that monetarism is dead in Pakistan. That the monetary base or money supply going up is not one-to-one linked with inflation in Pakistan.

The thing is money supply doesn’t have to perfectly correlate with inflation all the time. In the basic equation of monetarism MV=PY, there are three variables which affect the price level P. Money supply (M), velocity of money (V) and output (Y). A basic understanding of math would reveal that inflation is linked positively with money supply and velocity of money, but negatively with output.

So, if money supply is going up by 10% and inflation by 20%, it might very well be the case that the other 10% of inflation is being caused by an increase in velocity of money and/or a decrease in output (negative supply shock). Pakistan’s recurring balance-of-payment crises have created negative supply shocks (aka import restrictions) time after time, hence a key reason why money supply has not one-to-one correlated with inflation in Pakistan.

Beyond this, many commentators have also suggested that expansionary fiscal policy or large fiscal deficit is the major cause of inflation. The government’s spending binge might very well be a crucial cause of inflation, but the way it funds its deficit is even more important.

Let’s look at two ways the government funds its debt: printing money or raising it from the public via bond financing/sale. In the former case, the government introduces newly minted money in the system which raises aggregate demand – more money chasing same number of goods.

Usually, we say that when the public sector (government) runs a deficit, the private sector must run a surplus. In this scenario, the private sector does run a surplus, but that surplus is dissipated without repayment as the value of money held by the private sector reduces due to money printing. So, the revenue earned from seignorage via money printing is, in fact, a transfer of resources from the private to the public sector. We can also analyze this via a basic IS-LM model.

When government spending expands, the IS curve shifts right. When the government funds that deficit by printing new money, the LM curve shifts right. Thus, the effect of fiscal expansion on inflation is amplified.

Now, let’s say the government decides to fund its deficit through sale of bonds to the public. In this case, the private sector directly funds the government’s deficit. Because, when the government sells bonds to fund its consumption, the public buys them. In the process, the private sector consumption translates to government consumption.

This is possible since the sale of bonds raises the interest rate (reward for saving), hence nudging people to save (reduce consumption). Consequently, increase in government spending through bond financing is somewhat cancelled out by decrease in private consumption. So, the amplified inflation seen in the previous scenario doesn’t occur.

In the IS-LM model, when the government finances its spending through bond sales, money demand increases (due to rise in wealth) so real money supply falls and the LM curve shifts left (the IS curve would shift rightwards again but we’ll ignore that since it gets too complicated). Hence, the economy doesn’t overheat, and inflation remains in range.

This model, of course, assumes government bonds are net wealth which isn’t always true. When government bonds are not net wealth, the LM curve remains static. In non-economics terminology, this means that the public buys bonds by selling other assets (stocks). So still, inflation doesn’t run as high as we saw in the first scenario.

Takeaway: government should always finance a deficit via bonds and not money printing.

How does this all relate to Pakistan? Well in Pakistan, the government does fund its deficit through bond sales – at least on paper. Before SBP Act 2021, the government could borrow money directly from the State Bank (SBP). Since the SBP is owned solely by the government, profits made by the State Bank from lending went back to the government. Hence, borrowing from SBP was essentially the government printing new money.

To put an end to this, IMF demanded that there be a complete restriction on government borrowing from SBP. The government adhered to this. But then the government found a loophole. It could make SBP lend cash to commercial banks, via open market operations, and the banks could lend cash back to the government. Hence, a new formula for money printing.

Once you realize this catch, the extraordinary inflation of the past two years becomes quite clear. What’s the way out of this then? Well, the government must fund its deficit truly through bond sales – in spirit, not just on paper.

Currently, the government sells bonds mostly to commercial banks – its main buyer. The liquidity from this avenue has been stretched to the max. However, there is potential to extract additional liquidity from the system by selling bonds directly to the public. Making it easier for the public to buy/sell bonds would do just that. The current procedure to do so is overly cumbersome in Pakistan.

Alternatively, SBP could promote and support the development of financial institutions such as microfinance banks, pension funds and insurance sector. All these savings institutions would extract existing liquidity from the system which can be utilized to fund the government deficit. For instance, microfinance banks attract deposits which the banks cannot or do not want to.

Making it more accessible for the public to buy/sell bonds and promoting new financial institutions would not only reduce inflation but also produce spillover benefits. It would reduce the government’s reliance on commercial banks for borrowing. Moreover, government’s borrowing costs would fall since the spread charged by banks would be squeezed with more competition from the public and other financial institutions.