Hang on to your fixed-income securities

Updated July 22, 2019

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The paper value of corporate Pakistan (market capitalisation) has plunged to $41 billion from $100bn in two years. — AFP/File
The paper value of corporate Pakistan (market capitalisation) has plunged to $41 billion from $100bn in two years. — AFP/File

The recent increase of 100 basis points in the policy rate provided the stock market with another reason to remain on the downside.

The situation is already alarming as the KSE-100 index has plunged to a three-year low of 32,310 points. For the third year in a row, stocks have been on a slippery slope. They have gone down by 19.1 per cent since the beginning of the year.

The paper value of corporate Pakistan (market capitalisation) has plunged to $41 billion from $100bn in two years.

A major broker said that the stock market came under pressure before the July 16 hike in the interest rate because the decision pushed up the required rate of return on equity. Analysts add premium to risk-free returns. Government securities currently provide a risk-free return of 13-14pc. So the investment in equity requires additional 6-7pc, which means that investors will find investment in shares attractive only if it provides them with a return of 20pc.

Within the stock market, the major beneficiary of the interest rate rise is the banking sector. Banks that have greater exposure towards advances may improve their bottom lines and will benefit more from higher rates of lending.

Owing to 52pc devaluation, high inflation and depleting demand, corporate profits are going to take a hit for at least two quarters

Market strategists also suggest that oil and gas and independent power producers (PPP) will remain unimpaired by the interest rate rise. On the flip side, companies that depend on imported raw material, such as automobile and the pharmaceutical firms, will take a hit.

But the major hammering will be suffered by cyclical sectors and those that are heavily leveraged, such as cement and steel. A number of companies in the cement sector are in the throes of expansion. With a huge jump in financial charges, their cost of operations will suffer heavy overruns.

The policy rate has gone up by 750 basis points to 13.25pc from 5.75pc at the start of 2018. In the previous monetary policy announcement, the SBP jacked up the rate by 150 basis points in line with the prior conditions set by the International Monetary Fund (IMF), according to many analysts.

Owing to 52pc devaluation, high inflation and depleting demand, corporate profits are going to take a hit for at least two quarters. But many market commentators are encouraged by the fact that the SBP has indicated a possible easing in monetary policy going forward.

In a report released last Thursday, JS Global analysts said: “Any further monetary tightening may not bring about the expected results given that our aggregate demand already appears to be on its knees. Nevertheless, we understand that our gross financing requirements could rightfully advocate for further rate hikes. A silver lining in the clouds is that if all goes according to plan, we may eventually see a sharp decline in the policy rate that could provide the much-needed impetus to our struggling equity markets.”

The rebound of the equity market depends on several factors other than the interest rate and inflation. On top is the rejuvenation of investor interest in the market. Although it would have done little to create excitement in the market, the promised Market Support Fund is still to materialise. A week ago, the finance minister assured the market that the fund would be active in four to five days. That did not happen.

The absence of leverage has saved the market from going bust. In the stock market crisis of 2008, the biggest damage was suffered by leveraged investors who were unable to meet margin calls. Greater controls have also prevented troubled brokerages from fleeing abroad with bagful of investors’ money.

Insight Securities CEO Zubair Ghulam Hussain commented that the central bank’s stance while announcing the July 16 policy rate decision suggested that the interest rate had peaked. It also hinted at the start of an easing cycle by the end of 2019-20 or early 2020-21. It can bring clarity to the market participants and help them in decision-making.

Mr Hussain asserted, however, that mere clarity was not enough for a stock market rally. “Looking at the economic activity, we (expect) 2019-20 will be tougher than 2018-19 as a large part of the currency devaluation and the interest rate hike took place towards the end of 2018-19, which will take a toll on aggregate demand over the next months,” he said.

It means that the average household disposable income can shrink further and will stall consumer spending while denting cyclical sectors’ demand. Investors may stick to safer fixed-income securities that provide attractive returns.

Published in Dawn, The Business and Finance Weekly, July 22nd, 2019