The International Monetary Fund (NYSE:IMF) announced on July 3 that its executive board has approved a 39-month agreement to lend around $6 billion to Pakistan. Out of the total approved amount, $1 billion will be disbursed immediately. The IMF expects that the agreement could help usher in $38 bn from Pakistan’s other international partners. The funding will help stabilize Pakistan’s currency and plug the country’s current account deficit (average of $871 million per month in 2019 so far) until positive effects of structural change and the recent PKR devaluation can be seen.
The ETF that tracks Pakistan, the Global X MSCI Pakistan ETF (PAK), rallied in the run up to the IMF announcement, but has since declined as investors booked profits. While the IMF program will help the country’s external position in the near future, there is still a long way to go before the economy gets back on track. The IMF too thinks that further austerity measures are in the cards, as it calls the latest such steps in the FY 20 federal budget an important “initial” step. (Please refer to our previous report for a detailed analysis of the effect of the federal budget on PAK). The austerity measures already implemented, and prospects of future austerity measures are likely to keep market sentiment low in the coming months.
Further, the IMF has forecast Pakistan’s economy to grow by only 2.4% in FY20. The last time Pakistan’s GDP growth rate was that low was in 2010, when it was 2.58%. At that time, most of PAK’s top 10 holdings were trading at lower P/E multiples than the multiple they are trading at currently. The table below compares the current P/E ratios of the top 10 holdings with their P/E ratios back in 2010. Oil and gas exploration and production companies (E&P) are the only ones that are currently trading at lower multiples than the level they were trading at in 2010.
From the table we can reach the conclusion that most of PAK’s holdings may see a contraction in their P/E multiples in the coming months. Consequently, we expect PAK to face downward pressure in the rest of 2019.
Below is a discussion on the two biggest sectors of PAK’s holdings, energy and financials.
Energy: Flexible Exchange Rate Not a Problem
PAK’s weighting in the energy sector was 26.18% as of June 28, 2019. Apart from the overall sentiment in the market, the energy sector will also be affected by the IMF’s encouragement of a flexible exchange rate. Oil and gas exploration and production companies (E&P) in Pakistan receive a price on most of their oil wells that is benchmarked to Arab Light crude oil price in USD terms. Therefore, devaluation of Pakistani Rupee (PKR) against USD benefits these E&P companies as it increases their revenue in PKR terms, and hedges against PKR devaluation in USD terms.
As of June 28, 2019, the three biggest E&P companies had the following weightings in PAK.
Please note that we have a bearish view on future crude oil price, which is disadvantageous to E&P companies, and consequently to PAK. But Pakistan’s E&P companies are already trading at relatively very low P/E multiples; therefore, we believe that they have upside from their current market prices.
Financials: Low Economic Growth May Affect Credit Losses
The IMF forecasts Pakistan’s GDP to grow by only 2.4% in FY20, which bodes ill for Pakistan’s banks because low growth leads to prospects of a rise in credit losses. The last time Pakistan’s GDP growth fell that low was in 2010, when GDP was recorded at 2.58%. At that time Pakistan’s net non-performing loan to net loan ratio was a high 5.4%. Before 2010, the last time economic growth dipped this low was in 2001 when GDP was recorded at only 1.967%. The table below compares the current asset quality with the asset quality of the two low growth periods of 2010 and 2001. While we believe that the credit quality situation won’t get as bad as these two periods because banks have become a lot more prudent in lending since the global financial crisis, we do believe that credit losses will pick up to some degree. The greater credit losses will harm profits of the banks, and consequently affect PAK’s price.
The IMF has also forecast Pakistan’s inflation at 13% for FY20. As the current target policy rate is 12.25%, the prospects of negative real interest rate in the future could also propel further monetary tightening. The IMF has also mentioned in its statement that Pakistan needs adequately tight monetary policy. Rise in interest rates can benefit Pakistan’s banks as their deposit rates are stickier than rates on loans, which means their net interest income will increase. However, rise in interest rates also has negative implications for banks as they worsen the ability of creditors to service their debt.
Overall, we feel that following the re-entry in the IMF’s program, banks should perform poorly in the next six to nine months. This will have a negative impact on PAK.
Conclusion: Still Some Pain Ahead for PAK
While the IMF’s program will help Pakistan’s external position and stabilize PKR, we feel that there is still a long way to go before the economy stabilizes. Austerity measures already taken by the Pakistan government through the federal budget of FY20, and any future austerity pressures will dent corporate earnings. Further, the top holdings of PAK, with the exception of E&P companies, may see a further contraction in P/E multiples. Consequently, we believe that PAK’s price may fall further in the next six to nine months, and therefore we are adopting a bearish stance on it. We advise holders of PAK to reduce their exposures to it. (We do not give short recommendations due to the high risk involved).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.