Pakistan: An Attractive Frontier Market Pick in Asia

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Macroeconomic Outlook

After years of full of challenges, Pakistani economy is now out of the woods with high-single digit GDP growth rates projected for the upcoming two years. Even if the country still faces some significant political risks and has some vulnerabilities due to high indebtedness, we believe the provided risk-reward profile is very compelling at this point.

Pakistan is one of the few frontier markets that are expected to receive a credit rating upgrade this year. As of now the country is rated as B-by Standard & Poor’s with positive outlook with opportunities and risks recognized.

Pakistan GDP Growth and Sectoral Composition

This year is crucially important for Pakistani economy as about 40% of the country’s outstanding debt, which amounts to $45 billion, is due to mature in 2016, of that $41 billion is in local currency. However, we believe that existing IMF funding and the Chinese investment in an economic corridor will offset the pressure as we see no reason to panic for the outlook of the economy.

The government embarked on a number of reforms, many under the aegis of an Extended Fund Facility (EFF) arrangement with the IMF, which included strengthening the State Bank of Pakistan (SBP, the central bank) autonomy through an establishment of an independent monetary policy council for rate setting. Following that, an interest rate corridor was introduced with a ceiling rate of 6.5% and the floor rate of 4.5%. Given the core inflation prints in 3-3.5% range and Pakistani Rupee trading in the narrow range of 104-105 for the past year, the improved monetary transmission mechanism has been successful to stabilize the economic indicators, which will lead a less hazy economic outlook and lower fundamentals risks.

Secondly, The China Pakistan Economic Corridor (CPEC) is a $46 billion FDI pledge from China which will serve as a catalyst for increased economic growth as well as risen geopolitical interest from other countries. Some other counties including Russia, the UAE already announced billion dollar mega projects. Eventually, we will be able to see infrastructure developments needed to boost the economic growth in the long-term which the country has lacked for years.

At the end of 2015 total public debt to GDP ratio stood at 61.5%, showing an improvement of 20 basis points y/y. Meanwhile, total external debt and liabilities rose to 7,2 trillion rupees which amounted to 23.4% of GDP. Having improved its risk profile, Pakistan could have managed to lower its borrowing costs from global financial markets. Moreover, in domestic credit markets, we saw the average rate for outstanding loans in Pakistani banking system coming down to 8.58% in February 2016 from 10.59% in the same month of 2015, while outstanding rates for deposits lowered to 5.03% from 6.7% within the same timeframe. Thanks to the stabilized inflation rates and the new monetary policy framework, we foresee the continuation of the benign trend in the credit markets.

Equities

Pakistan - Karachi Stock Market Performance versus Emerging Asia ETF

Founded on September 18, 1947 in Karachi, the largest city of Pakistan, Karachi Stock Exchange has more than 650 companies listed with total market capitalization of $72 billion. It ranked third in 2014 amongst the top ten best performing markets in the world according to analysis by Bloomberg. Our views on specific sectors are as given by.

As discussed above, the ongoing trends in credit markets are in favor or banks. Not surprisingly, total assets grew by 17% system-wide last year, reaching a record level of 14,143 billion rupees (investments and advances grew by 30% and 8%, respectively). In such a growth period, NPLs only totaled 11.4% of total loans (12.3% in 2014). Moreover, Pakistani banks built provision that covered 85% of total NPLs, lowering net NPL ratio to 1.9%. Despite the fact that credit metrics were still not good, banks showed a major development in terms of quality. Commercial banks averagely recorded a ROE of 25.8% when tax excluded up from 24.3% in 2014, as they posted a Tier-1 ratio of 13.1% for full-year 2015, up from 12.9% in 2014. Thanks to increasing profitability and strong capital structures, we are of the opinion that Pakistani banking stocks provide a good environment for not faint-hearted investors looking for opportunities in frontier Asia. The following is our picks from Pakistani stocks.

Pakistan - Stock Selection

We believe that Pakistani banking stocks offer attractive value, thus we pick four of the banking stocks with the greatest market cap. Additively, we add an industrial to the list, Lucky Cement, which, we believe, solidifies our portfolio with an outlook for increased spending on construction materials due to the infrastructure deficit and its rarely seen profitability metrics.

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