Barely six weeks into 2006 and the Karachi Stock Exchange has kicked off the new year with a bang setting two new records of significance.
First, the index has shot above the 11,000 level for the first time ever on Feb 10 closing at 11,053 points. That’s a gain of 15 per cent since January 1 alone. And second, market capitalization has crossed the Rs3 trillion mark (or 40 per cent of GDP) earlier in the year.
This setting of records has not been altogether too surprising. For three years now, the KSE has powered fresh gains on a fairly regular basis, the ups and downs of a share market notwithstanding.
Since the end of 2002, the KSE-100 index has zoomed up over 300 per cent from 2,701 points on January 1, 2003 to 11,053 points at the close of last week. In the same period, market capitalization has risen almost six-fold from Rs595 billion to over Rs3 trillion or $53 billion, a figure which brokers now estimate will rise to $100 billion.
And average daily turnover has risen from 167 million shares in 2002 to over 500 million shares. Still, the last ten months were more than just a struggle for the index. Since it hit a high of 10,303 points in March 2005, the market saw some $16 billion in market capitalization (amounting to about 15 per cent of GDP) being sucked out of the bourse.
The memory has not faded yet and so the comparison with what has come to be known as the March crisis is inevitable. Market experts assure, however, that while some two-thirds of last year’s gains were driven primarily by a narrow base of privatization stocks such as OGDC, PPL and PTCL, the run up this time has been far more broad-based albeit it has been led by cement and banking stocks.
Even more pertinent, perhaps, is the fact that the biggest contributor to the March crisis was mismanagement on the part of the regulators rather than market behaviour itself.
Behind the rally: So what’s driven the run-up this time around? First is the flow of liquidity, not just domestically but throughout the world. In Pakistan, hectic activity on the part of mutual funds—existing and new ones—has contributed significantly to the run-up.
By some estimates, mutual funds have invested as much as Rs15 billion in the last few months alone. Then, banks which scored solid capital gains in recent months continue to invest in the market, able to remain within their investing limits since capital is being increased.
Individual investors, especially those who have won big in real estate are also putting cash into shares, making the stock market one of the major beneficiaries of the process of wealth creation.
“Liquidity is pushing stock prices in several countries beyond the fundamentals,” says Nasim Beg, CEO of Arif Habib Investments, an asset management company with Rs17 billion in funds under management. He estimates that currently Rs25 billion is coming through the CFS while another Rs25 billion originates outside the market and brokerages have borrowed about Rs10 billion from banks and taken their own positions.
The second contributor to the bull run is fundamentals. Despite major worries about a ballooning trade deficit and inflationary pressures, economic performance continues to be positive, at least as far as GDP growth is concerned.
Even more critically, corporate earnings have put on an unprecedented showing in the last three years and still continue strong with all the major sectors delivering positive earnings surprises. That has made stocks across several industries an attractive avenue for long-term institutional and individual investors.
Third is the buoyant return of foreign portfolio investors. After staying away for most of the rally of the last three years, foreign fund managers finally got into the game after July 2005. Between then and now, some $400 million—primarily from the US—has come into the market.
Even though this figure may seem slim compared to the hefty market capitalization, given the limited free float on the market, that level of buying is sure to drive prices up.
Why now, especially when law and order problems persist particularly in relation to ethnic violence and the Balochistan issue? One reason could be that foreign funds waited to see whether the initial economic turnaround was sustainable. Perhaps more critically, the country’s ratings are on the rise.
Recently, S&P put Pakistan on a positive outlook which means that if economic policies stay unchanged for the next year or so, the country could be re-rated upwards. Similarly, the largest public pension fund in the US recently put Pakistan a notch higher as well.
“Pakistan is coming from the margin to the centre of the radar screen now,” says AKD Securities’ Naqvi. He says foreign activity will pick up further if the government offloads more shares in companies like Habib Bank, United Bank and OGDC.
He also sees rising foreign portfolio inflows in the months ahead as international portfolio funds flow rapidly towards emerging markets. India, for example, gets between $8 billion and $10 billion in foreign portfolio investment every year.
The Pakistan market’s weightage in the Morgan Stanley Index has already risen to 0.35 per cent. If this rises to 0.75 per cent, a host of index funds will be bound to invest and if it rises further to one per cent, $1 billion of money will go into Pakistani stocks. Moreover, the word is some foreign brokerages houses are also considering setting up shop in Pakistan.
This is especially the case since on a regional basis, the Pakistan market continues to trade at a 30 per cent discount, offering greater opportunities. The KSE is trading at a multiple of about 11 at the current time compared to a regional average of 14.
Risks ahead: So what now? To start with is the consideration of valuations. Most agree that those still getting in at these high levels are largely players with a trading rather than investment view.
The reason: most major stocks have approached their fair value, leaving little room for further growth. Market experts forecast that the index will hover between current levels and 12,500 points for the rest of 2006. That doesn’t mean, of course, that big brokers are not now hungering for 15,000 points.
But what are the risks ahead? First, is the debate over future corporate earnings growth. One camp argues that the sharp rise in interest rates in 2006 will dent corporate earnings and rising energy costs will also take a toll on manufacturing companies’ bottom lines.
Moreover, the rapid increase in sales seen in recent times is a reflection of the higher capacities added by several major sectors and this quantum of growth is sure to moderate now that most industries approach full utilization.
However the opposing camp maintains that with GDP growth expected at six per cent and inflation at eight per cent, corporate earnings are sure to grow at a nominal growth rate of at least 14 per cent. “People have to wake up to the fact that this [growth] is not just a short-term phenomenon,” argues Nadeem Naqvi, CEO of AKD Securities.
In any event, corporate sector growth will play a major role in determining the course of the market. Another risk is the possibility of restrictions by the State Bank on the extent of exposure banks can take to the stock market. The new governor of the State Bank is reported to have said that the exposure of banks to the market is higher in Pakistan than the regional average and is something the central bank will be monitoring closely.
If she acts to curtail the extent to which banks can invest in shares, the move will dry off one of the avenues of liquidity and could crack the market’s momentum. Then, if oil prices rise rapidly, past the $75 per barrel level, there may be short-term benefits in the share market since the index is oil-heavy but it will derail economic growth and come back to pull the market down. This, however, is a concern markets around the world harbour.
Fourth, as 2007 approaches, politics will also play a more central role in how the market performs. The onset of general elections and re-emergence of the uniform issue will become critical in setting the stage for how investors view the future of the country’s political system.
Then, there are major economic concerns to deal with. The trade account has spiralled to worrying levels and if the decision is taken to devalue the currency, there will be inflationary concerns and if interest rates are raised, growth momentum could be hurt. We are yet to hear how Islamabad intends to deal with this.
There could also be regulatory hitches. Both the KSE and the SECP are now headed by new chiefs running weakened institutions that have lost most of their competent senior staff.
In the short-term at least, that seriously hampers the ability of the institutions to manage risk. While the risk management system and margin requirements have been improved, there are loud demands from the broker community to ease these. Already, a major weakness persists in that individual investors are not usually required to put down a margin with the broker assuming the client’s risk. This always leaves plenty of room for the worrisome creation of asset price bubbles.
Yet, there is always the golden side to consider. If wealth creation continues, the market will continue to generate fresh demand which will keep the upward pressure on. The promised introduction of derivatives is also expected to help power new gains.
And perhaps most critically, the consensus is that foreign portfolio money will come in larger numbers from here on. Some even say future gains will be held hostage to the whims of international portfolio funds.
Records ahead are not unlikely. The only wild card in this game will be whether the regulators finally get their roles right. The way the KSE’s management performs as front-line regulator, what the SECP does as an apex watchdog and extent to which the government’s highest officials can resist keeping out of this business will be critical in determining how the share market does from here on.
Barely six weeks into 2006 and the Karachi Stock Exchange has kicked off the new year with a bang setting two new records of significance.
