Review of Macro Environment by MCB Arif Habib
PSX went through a bloodbath yesterday as KSE-100 Index lost 1,302 points (2.9%) to close the day 43,830 level. This was in response to the Russian invasion into Ukraine, which led to chaos in markets around the globe, where all major stock markets tumbled and sent a shockwave across major commodities like Oil (8%), LNG (7%), wheat 11%), coal (2%) and metals like (Aluminum 6% and Gold 4%). Here we will discuss what this crisis holds for our economy and PSX investors.
Russia is a major player in Energy Market
Russia is one of the largest exporters of crude oil and the biggest natural gas supplier to the European Union. Any disruption in the supply of both will take their prices further north from here. Here we briefly discuss the major implication for both these commodities.
Oil
Crude oil supply was already turning deficient for world demand, waking up from the post Covid slumber, pushing crude oil price upto 95 per barrel even before the invasion compared to an average of USD 71 per barrel in CY2021. Chaos pushed the prices northwards to USD 103 per barrel before cooling off below three figures later in the night. This has the potential to keep oil prices elevated in the short run. Going forward some respite may come from Iranian oil supply if US and EU are able to struck a nuclear deal clearing the path for approximately 1.0mn barrels per day from Iran.
Gas
Similarly, this winter have seen LNG prices reaching all time high of USD 38 per mmbtu amid post covid demand recovery. Now combine this with the fact Russia is the largest gas supplier to EU, which is transmitted through pipelines. Any shortage in pipeline gas will shoot LNG price northward for EU cargos.
Pertinent to mention here Germany has pledged to defer its import of Russian gas using Nord Stream 2 pipeline, which was expected to commence later this year. If lingered beyond 2022, this could keep the LNG price higher in coming winters as well.
Please note that we had already seen a few of our LNG suppliers defaulting on their committed cargo due to higher EU prices. We even had to rely on spot buying of LNG cargos to the north of USD 25 per MMBtu, compared to the contracted price of ~USD 13/MMBtu.
Coal
We have seen coal inching up once again close to its all-time high of USD 250/ton last witnessed in Nov21 as higher LNG prices pushed the consumers looking for alternative fuel sources for energy. As discussed above, higher LNG prices in the aftermath of the Russian invasion could further boost coal demand, which coupled with supply disruption may keep dirty fuel pricier. Please note that every USD 10 per ton increase in coal price can increase CAD by USD 200mn.
Wheat
Wheat prices also jumped by 11% since the conflict started taking shape as both Ukraine and Russia are among the largest wheat exporters in the world. Please note that we imported wheat of around USD 0.8bn last year from Ukraine and Russia to meet domestic demand. If fertilizer shortage did result in a lower than expected harvest, we might have to purchase wheat even at higher prices than the last year.
Macros may continue to post challenges in short-run
This commodity shock if prolonged will have consequences for our macros. A 10% increase in prices of the above commodities can widen our CAD USD 2.5bn, exerting further pressure on the exchange rate, which has already lost 12% against the greenback during the fiscal year. In addition, rising crude, wheat and palm oil price coupled with PKR depreciation will further push inflation upwards. However, we stick to our estimates of a modest rise in interest rates to 10.5% from the current 9.75% going forward. We believe the situation remains fluid for the moment and will continue to pose challenges in short term. However, what we have seen in the past geopolitical tensions is that commodity prices tend to revert to their mean as the situation stabilizes. The current crisis should not be an exception either.
Limited Trade with Russia & Ukraine
Pakistan has limited trade with Russia and Ukraine as the country's total export to the two countries was a mere USD 217mn out of total export of USD 25.6bn in FY21. Similarly, Pakistan's import was USD 892mn out of a total import of USD 53.8bn. Thus the ongoing war will not lead to any broad-based impact on our trade.
Valuations remain too Cheap to Ignore
PSX has been on a thorny path for past five years now, loosing around 14% from its peak achieved back in May 2017. During the period it had seen all, full blown balance of payment crisis (2018-2019), two interest rates easing and tightening cycles (from 7% to 13.25% till Feb 2020, dropping to 7% post covid and now rising back to 9.75%), steep PKR depreciation (68% since May 2017). In addition, we saw foreign investors on a selling spree, dumping around USD 2.3 billion worth of stocks since 2016, which further squeezed the market valuations. Combined effect of all these led to where we are, valuations are as low as they were back in 2008 financial crisis and March 2020 lockdowns. Please note that this was even before this crisis emerged, while the recent fall in PSX has brought valuations at all time low as highlighted below.
Corporate Profitability at Historic High
Now combine all this negativity with the fact that corporate profitability is at all-time high with major blue chips companies are outpacing consensus earnings estimates in this result season. KSE-100 companies are expected to achieve 21% YoY growth in corporate earnings taking it one of the highest yearly profit in 2021. On top of this high base, we expect corporate earnings to jump another 11.8% in 2022 as well. The ongoing result season have shown the results have generally been better than expectation, beating estimates by on average 15%.
Foreign holding lowest since 2008
Foreign investors’ share in the PSX’s free float stands the lowest since the financial meltdown of 2008 when PSX suffered the exodus soon after the market floor was lifted. We expect foreign selling to ease significantly going forwards. This will help to end the foreign supply overhang and help the market to perform.
Market Multiples shouting their cheapness
We have analyzed market relative attraction using different parameters and found it even below the crisis period multiples that is on 2008 financial meltdown and March 2020 Covid lockdowns. If history has given us any lesson, then it is very simple, these very low level of valuations do not sustain for long. Just like in above mentioned cases, market staged a strong pull back posting 101% and 68% returns in just 1 year after 2009 and 2020 troughs.
Fortune favors the Patient
We performed an analysis to calculate the rolling 3 Year and 5 Year Returns of KSE-100, which reflect that over medium to long term investors have rarely experienced negative returns. The market has always moved in cycles with entry in the bearish market providing an opportunity to experience super normal returns in the following years.
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