PAK - PAK: Near-Term Catalysts Buy

2023-08-17 03:47:47 ET

Summary

• Pakistan's stock market is currently one of the cheapest in the world, offering potential for growth.
• The market has faced setbacks but has room to run based on local currency returns.
• Pakistan's public debt and inflation are challenges, but the market still trades at a discount compared to other high-risk markets.

Opportunity Overview

Pakistan is currently one of the world’s cheapest stock markets and is an intriguing market despite some of the economic challenges and its hazy outlook. The market has nearly been left for dead, as many investors gave up following disappointing performance following its MSCI Emerging Market upgrade in 2018 . The market was later downgraded to MSCI Frontier Status and, until recently, had an extremely low weighting in this index.

Pakistan equities previously peaked in 2017-2018 prior to its inclusion to MSCI Emerging markets. The Global X MSCI Pakistan ETF (PAK) has declined significantly since 2017.

Shares are trading at record low levels, and it is clear that the market has a lot of room to run based on local currency returns. The Pakistan IMI Index , which includes 16 companies, trades at slightly over 4x earnings and 0.8x book value. The main issue for investors is whether US returns will be favorable and whether the market may continue to trade below 4x earnings in the long run.

This ETF may also be a viable option for US investors aiming to outperform the MSCI Frontier Markets Index. 2023 will likely be a challenging year for Pakistan, as growth will be very slow, and there is little room for rate cuts amid sustained higher inflation. The country’s public debt has also been growing rapidly in the past decade, and new measures implemented under its IMF program , such as the end of fuel subsidies, will likely harm consumer sentiment.

However, Pakistan trades at a discount to other high-risk markets such as Colombia, Sri Lanka, Brazil, Egypt and Kenya. The Global X MSCI Pakistan ETF is down over 30% since I last covered the stock market in 2019. I think now is a wonderful time to revisit this thesis and initiate a position, especially since Pakistan's weighting in MSCI Frontier Markets will increase soon.

Recent Weighting Boost/Past Flop

One of the most intriguing historical aspects of the market was Pakistan's extremely disappointing performance following its MSCI Emerging market upgrade. This event serves as a historical benchmark of how it is sometimes better to have a larger weighting in MSCI Frontier Markets rather than being a smaller MSCI Emerging markets constituent. The index declined by nearly 60% in the following three years.

However, MSCI recently added 15 new Pakistani stocks to its main MSCI Frontier Markets Index. This move could increase Pakistan’s weighting by 2 percentage points or more and provide moderate support for the market. This weighting will be harder for investors benchmarking MSCI Frontier Markets to ignore, which should support sentiment in the equities market. Excluding Pakistan from a frontier market basket could result in tracking errors/underperformance.

Macro Challenges Ensue

Pakistan has faced a plethora of new challenges, including rising inflation and poor currency performance, which have sent its stock market down around another 20% in USD in the past year. The country's economy faced a large number of challenges last year, including floods in FY23 and the sustained impact of higher food and energy prices in 2022.

Most of this poor performance was from the exchange rate loss , as the market rose from around 43,690 last year to its current level of 48,424.

The market will likely perform well in its local currency due to the favorable valuation. However, the main risks to note include 1) performance in USD and 2) Pakistan's rising external debt balance.

The Pakistani rupee had its largest single day decline in decades this year, as the rupee declined over 9% this January. The country's foreign exchange reserves have been on a constant decline since 2022 , which has made it difficult to defend the currency. Current FX reserves can only cover slightly more than a month's worth of imports.

Pakistan's public debt has increased substantially in the past decade. Pakistan’s public debt as a % of GDP rose from 63.5% in 2014 to its current level of over 90%. The country's external debt has also risen substantially in this same time period, which increases the risk of sovereign defaults this decade.

While the IMF loan has provided some needed relief, these measures will put more pressure on consumers following record high inflation. Pakistan has had to hike petrol prices after its latest IMF bailout, due to the pressure of its soaring debt and declining government revenue. This will be difficult for consumers and businesses to absorb due to record high inflation and the higher cost of capital for businesses.

Inflation in Pakistan

Inflation is slowly beginning to decline from its 2023 peak. Pakistan has almost nothing but headwinds approaching this year, and its growth rate will likely be well below that of other frontier and emerging markets. Pakistan recently hiked its benchmark interest rate to 22% this June, which will discourage growth and potentially boost non-performing loans (NPLs).

One of the country’s most recent growth forecasts is only 0.3% , well behind other regional frontier and emerging markets. Industrial output has declined, and unemployment has become a serious issue in Pakistan. The country's finance minister estimated that the country's unemployment rate is between 10-11% .

Two interest benchmarks are Argentina and Turkey, as both of these countries faced similar issues (inflation/rates/currency/etc.) on a much larger scale and still performed well in USD terms. Most importantly, these economies have still not recovered economically, which shows investors may not have to wait for a Pakistan economic recovery to realize gains.

Investing in Pakistan this year is more of an ED trade rather than a bet on the beginning of macroeconomic and political stability in the country. The extreme discount to MSCI frontier markets, following a recent weighting boost from MSCI, makes it much easier to stomach this trade. Pakistan is positioned to absorb more passive, and potentially active flows, if the MSCI boost is well received. Because of this, it is acceptable to initiate a position even if you are worried about the macro risks.

ETF/Stock Market Overview

If you are considering this ETF, it is important to look at the industry weightings. One of the reasons for the lower valuation is the ETF's industry breakdown, as it invests heavily in energy and materials companies. Pakistan ADRs are unavailable, so this is one of the only Pakistan pure plays available for US retail investors.

The market cap of this ETF is relatively low , at less than $25 million, and its expense ratio is 0.8%. I do not think there is a strong chance of this ETF being delisted, especially because of the recent MSCI weighting boost. One of the main issues with accessing on Pakistan on US exchanges is that you are limited to ETF products and can't cherry pick companies with a higher % of revenue derived from exports.

Moreover, rising rates and inflation has also resulted in an uptick in NPLs in Pakistan's banking sector. Banks, which make up over 20% of this ETF's assets, will likely be under increased pressure in 2023-2024.While select areas of the economy, like textile exports , performed well in 2022 amid economic setbacks, these companies represent a small % of this ETF's assets.

It makes sense to include Pakistan as a part of one's frontier market exposure, as there may be near term catalysts in the equity markets. However, I do not expect there to be any significant economic improvements in 2023-2024.

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