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Rally caught in the geopolitical crosswind

It seems tensions in the Middle East have found a permanent spot in investment risks globally, whether or not they are specifically mentioned. The recent assassination of General Soleimani is an unforeseen escalation that could have serious geopolitical effects. Naturally, oil was hit by a raging bull following this development. Pakistan has historically benefitted from a decline in oil prices post entry into an IMF program. Will history repeat itself? A heavily front-loaded IMF program could result in missed targets, in which case unprecedented expenditure cuts remain significant risks in 2020. Having achieved the benchmark index levels of 40-42k that we had called for earlier in Nov-2019, it now seems as if the range could prevail (or even slip) for some time with higher volatility. The impressions that we get from the current environment do kindle a light. We believe due time should be given for these impressions to materialize. After all, they could play a crucial role in putting the country on a path to great success!

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JS Global Research|

It seems tensions in the Middle East have found a permanent spot in investment risks globally. Whether or not they are specifically mentioned, it seems these risks remain an underlying assumption. US-Iran relations, in particular, have been tense and the recent killing of General Soleimani just goes to show that one should always be braced for significant news-breaks.

With respect to Pakistan, we expect the unfolding events in the Middle East to supersede all other headlines on the mainstream media, at least for the time being

Naturally, commodities were hit by a raging bull; gold and oil in particular both shot up. Considering global geopolitical and economic risks, we feel gold could reach new highs in 2020 and could, therefore, provide a good hedge. However, we certainly do not wish the same for oil. Just to give a sense of where these currently stand, let us determine what levels should be viewed as ‘high’. In the past few years, Brent prices averaged under the US$70/bbl mark.

From another perspective, we see that oil prices tend to fall by ~20% 2 years post-entry into an IMF program from the preceding 2 years average. For history to repeat itself, general oil prices should fall to ~US$50/bbl. That is quite a fall considering the current price level of ~US$70/bbl. Here, we would direct your attention to a previous research note (titled Lower oil prices? Yes, please!) where we highlighted:

  • As our economy treads on the edge, we find it necessary to state the obvious: we simply cannot afford higher oil prices this year
  • Here, we should also admit that we are in a much worse tangle than we were in
  • If history has taught us anything, it is that geopolitical tensions have a strong tendency of escalating through miscalculations. In any such scenario, our economy – and by extension, equity markets – are bound to suffer the consequences in collateral damage.

In fact, the way global leaders have reacted to the news gives an impression that event could be counted among the miscalculations stated above. After all who could have expected the situation to escalate to such heights so quickly from the US-embassy attack in Baghdad on New Year’s Eve? The event that transpired was by no means ordinary and could lead to grave geopolitical repercussions.

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Capital markets reacted in their typical fashion; The S&P500 came under pressure as did other global equity markets. With respect to Pakistan, we expect the unfolding events in the Middle East to supersede all other headlines on the mainstream media, at least for the time being. Having achieved the benchmark index levels of 40-42k that we had called for earlier in Nov-2019, it now seems as if the range could prevail (or even slip) for some time with higher volatility.

The recent market high was around the target we had predicted in our 2019 strategy report. With all the negativity built in, our view could not have been clearer.

  • 2019 could be the bitter pill we have to swallow given our excesses in the previous few years… Technically, the market should find support at these levels. If not, it would not be a pretty sight
  • In our view, equity valuations have still not fully absorbed the severity of the economic slowdown… Our universe has an earnings growth of 19% for FY19. If we exclude Banks and E&Ps, the growth falls to -2%. This is reflective of a slowdown in the economy which is expected to become more evident especially in the first half of CY19 earnings.
  • This leads us to believe that a tipping point lurks round the corner, independent of the funding gap scenario. Therefore, buying on dips is an effective strategy to secure reasonable returns: we believe levels below 38,500 are prime investment opportunities. 

(JS Global – Pakistan Market Strategy 2019)

Despite having anticipated the storm that was 2019, we admit the onslaught of numerous waves did frighten us to a great extent as well. Yet, it all somehow felt normal. And that is the beauty of stock markets. After all, what are markets but a representation of collective investor sentiments? The slightest signs of improvement lifted investor sentiments and the rest is history.

“The rally, which was broadly expected to start closer to the end of CY19 or somewhere in CY20 came in like a wrecking ball well ahead of time. On one hand, there was a series of back-to-back positive news flows, while on the other, fears that had previously gripped investors never saw the light of day. Not too long ago, many were apprehensive of highly stringent IMF conditions, minibudgets, a ~Rs200/USD exchange rate and 18% interest rates”

(JS Global – Pakistan Market Strategy 2020)

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This just goes to show that predicting the stock market in the short term is a tall order. We ourselves admit to getting short term predictions wrong more often than not. Lets see what Warren Buffett had to say during the depth of the 2008 crisis:

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year – from now.”

A quick market survey of the index targets reveals a somewhat leptokurtic distribution with a mean around the 50k level. This suggests a fear bias, particularly considering (1) the recent bull rally and (2) where we are coming from. On a side note, we sometimes feel that this phenomenon resonates with Keynes’ beauty contest. That said, the 60K target mentioned in our latest strategy report (one which we recommend investors to embrace with a long term view) is a suggestive target. We can’t possibly know where we will land in exactly a year or beyond. What we do know is the difference between mean reversion and re-rating. And we would like to invite investors to understand the same. Getting to historic averages should not be termed as re-rating.

That said, we would like to touch back on the risks. We mentioned oil prices could be a major threat to the economy. However, a front loaded IMF program, centered around a colossal FBR target has its own hazards. Apart from this target, the IMF program has been more or less do-able. In fact, in hindsight, we would step out on a limb and say that the first IMF Staff level report in Jul-2019 was a turning point for the market!

JS Global Capital Limited uses a 3-tier rating system i.e. Buy, Hold and Sell, based on the level of expected return. Time horizon is usually the annual financial reporting period of the company

Nevertheless, we would like to highlight that one should not confuse macroeconomic stabilization with growth in the real sector, at least in 2020. Fiscal austerity is expected to stay. After all, we are still in the first year of the IMF program. Besides, the improving long term forecasts that the IMF has shared in the staff level reports are contingent upon Pakistan meeting the set targets. We for one would keep a close watch on the debt to GDP ratio considering the underlying message: either we continue to generate high revenues, or we brace for the austerity of proportions unheard of in Pakistan.

And that is precisely why we prefer to look beyond 2020 for direction on the economy. Regardless, the impressions that we get from the current environment do kindle a light. We believe due time should be given for these impressions to materialize. After all, they could play a crucial role in putting the country on a path to great success!

Courtesy: JS Global Research published 6 January

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