The ebbs and flows of business cycles provide ample evidence that a stock market, by itself, is not representative of an economy as a whole. Even in recent memory, one may think of how governments around the world poured in unprecedented amounts of stimulus during COVID-19, much of which poured into equities and caused stock markets to soar, even as the real economy was completely paralysed by lockdown measures. One has to be careful not to see the stock market as a true barometer of the economy at large, and this is particularly true for frontier markets with small stock market capitalisations such as Pakistan, which is where a certain euphoria has set in as the KSE-100 index reaches all-time highs and it is the best performing index year-to-date in Asia.
Is Pakistan’s economy really the best in Asia?
There are evidently many other factors that explain the rise of the stock market that we must understand before misconstruing the stock market as representation of overall economic health. We can divide the analysis into two portions: the international and the domestic. On the international front, it is important to observe that investors have been moving money out of emerging markets (China, Mexico, Brazil etc.) and back into the United States (US). This move has been driven by (1) poor performance of these emerging markets over the past ten years; (2) a deliberate reduction of Western exposure to China, and (3) the massive boom of AI-related tech stocks in the US. This AI-boom is certainly a bubble, but one that short-term investors will be penalised for not participating in now with purchases of NVIDIA and other large players. As a corollary of the shift out of emerging markets, global investors have been looking at non-emerging market diversification options (to complement their growing US positions), and found frontier markets (Pakistan, Argentina, Egypt, Kenya) to be a better hedge because things are not as bad as one had feared.
This point of things ‘not being as bad’ as investors feared is coming true broadly in frontier markets. The panic over Argentina’s radical new government, Kenya’s solvency, or Pakistan’s discussions with the International Monetary Fund (IMF), were all overblown, since each of these countries has taken tough decisions to keep some modicum of stability in the face of extremely difficult conditions, including: dollar contraction, weakening currencies, cost-of-living crises, social unrest, political instability and runaway inflation. In each of these countries, ordinary people are struggling and are expressing their rage with large-scale protests and violent disobedience, or quietly with a brain-drain exodus, but their governments are sticking to austerity paradigms that keep international forces (such as the IMF) satisfied, for the moment. Reading these signals, international investors are moving their exposure out of emerging markets and into a combination of US and frontier markets.
Then on the domestic front, the stock market had been lackluster for the past 20 years, and now its frenetic boom is explained by how Pakistanis view equities as a reasonable alternative among a limited group of asset classes in which they can invest. First, there is good news in terms of continued engagement with the IMF, which was co-author (if not lead author) of the latest fiscal year budget. This indicates that ongoing IMF bailout streams can continue in successive tranches, allowing governments to muddle through without serious reforms in the immediate term.
Second, the stock market has been extremely undervalued for a very long time. Historically, the Pakistani stock market has traded at a multiple of 7x price/earnings ratio, which is very low by global standards. But even after the recent boom in the stock market, it is still trading at less than 4x the multiple. As a result, it is highly plausible that the stock market could easily double, just to attain its own low-bar multiple, let alone attain multiples more common among emerging and frontier markets.
We should also observe, third, that bank stocks are a significant component of the stock market, and so their performance will bear unduly upon the overall index’s performance. The banks have had a delightful run at the expense of the economy at large, announcing record profits quarter after quarter. In the S&P Global Market Intelligence’s ranking of Asia-Pacific banks with the highest total returns over the last quarter, seven out of fifteen (almost half) of the top performing banks were from Pakistan. The extortionary interest rates set by the central bank over the past two years, with the approval of the IMF, have created a distortion in the financial sector, with banks getting risk-free returns while overall business activity comes to a standstill. As the State Bank finally begins to unwind these high interest rates, banks will remain attractive to investors, not from a fixed income perspective but rather from a dividend yield perspective. Therefore, the stock market will continue to provide an opportunity for investment in this distorted financial system from the equity side rather than fixed income side.
Fourth, the unwinding of interest rates themselves reflects an easing of global and local inflation, which was the primary cause of the crisis in frontier markets beginning in late 2021. This easing inflation itself makes equities more attractive as better earnings and lower cost concerns ease reliance on fixed income instruments.
Fifth, domestic investors do not have many other choices to park their money at this time other than in equities for the same liquidity preference. The Rupee has depreciated too quickly in the past five years, making it a poor store of value. Dollars might be a good option, but they are hard to come by, as the dollar supply is carefully restricted by a limited group of bank and non-bank forex dealers. The dollar itself may fall in value as the Fed lowers interest rates. Gold is a counter for inflation, making it less attractive as inflation subsides. The real estate market, normally the major centre for hot money, is entirely frozen, with almost no demand at this time. Where else to go? The stock market remains a long dormant but now quickly rising option.
But this should not be construed as a positive reflection of the economy as a whole. The stock market itself is vulnerable to manipulation, wash-trading and flip-trading (satta), as well as irrational exuberance spread through mediums such as WhatsApp and YouTube. By contrast, Pakistan’s economy requires lucid, courageous, and serious reform at the structural level. From that effort, Pakistani equities will not belong to fringe frontier market status but to a solid emerging market one, and eventually, a developed world equity hub whose economic size will reflect its demographic weight and national importance. Without that effort, local and global investors will simply hop from one asset class to another, in a musical-chairs game that reflects the unattained potential of an erstwhile highly promising economic story.
Dr Usman W. Chohan is Advisor (Economic Affairs and National Development) at the Centre for Aerospace & Security Studies, Islamabad, Pakistan. He can be reached at cass.thinkers@casstt.com.
