The KSE-100, the benchmark index for the equity market in Pakistan, crossed 100,000 points for the first time in its history. The index has effectively provided a total return of more than 150 per cent during the last eighteen months despite political and economic volatility.
The naysayers call it a bubble, like the last 50 times they called something a bubble, and it wasn’t a bubble — while the proponents point towards stable balance sheets and growing earnings of publicly listed companies.
During the last seven years, since the time the index reached its peak and then plateaued for more than half a decade, cumulative inflation has been more than 120pc. Inflation during the last five years has been more than 100pc. The increase in equity values over the last five years has largely covered inflation for the last several years, effectively playing catch-up.
On a price-earnings basis, the KSE-100 index is at 5.3x, suggesting that, on average, the price of KSE-100 constituents is roughly 5.3 times their annual earnings. The same metric on a ten-year average is in the range of 8.3x. Equity markets in other emerging jurisdictions trade anywhere between 10x to 20x, depending on growth expectations associated with a certain market.
Among the top ten companies listed on the PSX, eight out of 10 are dependent on the government in one form or another
Pakistan has long been plagued by stilted growth, with GDP growth largely fluctuating between 2-3pc annually, barely crossing the population growth rate in some years.
The lack of macroeconomic stability and an economic growth model that remains heavily dependent on import-fueled consumption led to a scenario where any growth more than population growth requires the availability of foreign currency liquidity to drive consumption, only to crash when the same liquidity dries out. Such a macroeconomic environment increased the overall risk associated with Pakistan, hence keeping equity valuations depressed.
Over the last two years, there has been some semblance of stability but not growth. A leading indicator of stability is a gradual reduction in incremental borrowing by the sovereign, resulting in a reduction in interest rates. As interest rates reduced, capital which was seeking higher yields gravitated towards equity, improving returns in the process.
Any run-up in equity prices or valuations is a function of liquidity, which is largely a function of interest rates and other macroeconomic dynamics. As interest rates continue to decline or flatten out, there will be a gradual transition of some of that capital to the equity market.
Another source of liquidity that completely dried up in the later part of the last decade was liquidity that was pumped into real estate and remains stuck in dead capital, losing its value in the process in real terms. As fresh capital is not gravitating towards real estate, the same is potentially being redirected towards the equity market, providing necessary liquidity in the process.
Any similar run-up in the future would largely be contingent on sound macroeconomic policies and whether the country is able to transition away from a consumption-oriented model to an investment and export-oriented growth model. As such, a macroeconomic transition takes place, and the same will be priced in by the equity market. Currently, the market mimics the dysfunctional macroeconomy of the sovereign, and any improvement would be contingent on improvement in overall macroeconomic dynamics.
Among the top 10 companies listed on the Pakistan Stock Exchange, eight out of 10 are dependent on the government in one form or another, whether the government is a major shareholder or a major customer (borrower, in the case of banks), or provides some kind of concessional input. Not many companies among these are actually competitive businesses, and their competitive edge on a global stage would fizzle out once the government largesse goes away.
As the overall macroeconomy transitions towards a more market-oriented model, so will the composition of the exchange. As an example, the significant run-up in prices of banks is largely a function of profits they may generate by lending to the government — and not due to any competitive forces or better risk management.
Similarly, companies operating in the fertiliser segment continue to play the arbitrage between market prices for their end-product and concessional pricing for their inputs — all a largesse of the sovereign. Till the time overall macroeconomy doesn’t change, the competitive nature of market constituents will not change either.
The capital market infrastructure is shallow at best. Over the last fifteen years, product development in the market has stagnated despite the best efforts of the regulator. As mediocrity seeps into market participants, everyone starts seeking rents. There are no serious exchange-traded funds that have sufficient liquidity, and there is no market for derivatives.
It is still not possible to take a short position in the market, and neither is there sufficient liquidity available to support levered trades — which are the hallmarks of any serious active equity market. It has been more than fifteen years since the Global Financial Crisis, but we have yet to improve our risk management to even allow short selling. Without an improvement in the overall sophistication of financial market instruments, liquidity available to the market will continue to lag, and so will its valuations.
The overall return of more than 150 per cent during the last eighteen months is great, but this is just the beginning. Serious macroeconomic reforms need to continue, the sovereign needs to stop crowding out private sector credit, and the largesse available through concessions needs to stop.
Capital market infrastructure has been lagging in the region, and the gap is only widening. It is critical that new products are launched and fresh thought is inculcated in the market. We cannot predict what the future holds or what the expected returns in the future may be, but we can certainly work towards improving macroeconomic fundamentals and capital market infrastructure.
In the absence of the same, any returns would be illusory at best until the greater fool theory kicks in, and the greater fool is the one who keeps holding an overvalued basket of junk.
The writer is the CEO of National Credit Guarantee Company Ltd and assistant professor of practice at IBA, Karachi
Published in Dawn, The Business and Finance Weekly, December 2nd, 2024
