The KSE - Overview: Equity Risk Premium paints a bright picture

The KSE-Index closed this week at l383 level, up 28 points from last week's closing at l 355 level. Both badla rates and Average Daily Volumes remained low on account of Ramadan for domestic investors, while the upcoming Christmas and New Year holidays also reduced the desire of portfolio managers from foreign funds to take up long positions. This happened to be the overriding reason for an indifferent market although from Monday, next week, PTCL and SNGPL go spot.

On Monday the market rose by 10 points with news of Pakistan's plan for the reconstruction effort in Afghanistan in several sectors. Cement stocks were particularly enthusiastically traded and average daily volumes of DGK and Lucky rose. There was, however, negligible change in index closing levels on Tuesday with most investor remaining on the sidelines.

As news of the PRGF drifted into the market during mid-week the market rose by 9 points on Wednesday and 6 points on Thursday to settle at 13.80 before the Index closed for the Ramadan holiday on Friday. On Saturday, the Index gained another 3 points to close at 1383.

Although, the market may over the next week continue to be lackluster on account of both domestic and foreign investors making preparations for the holidays, we feel that over the next three months, we are likely to see a reversal in current trends. Why do we say that? The answer lies in Equity Risk Premium.

Pakistan Risk Premium

We decided to study the historic equity risk premium of the KSE-Index from July 1996 to December 2001. The equity risk premium (ERP) is the additional yield from investing in stocks over and above the yield on a risk free investment. In essence it is the ERP, which makes it worth the investor's while to take on the risk of investing in equities as opposed to making a risk free investment.

We shall discuss the historical ERP movement of the KSE-lndex in the following phases:

January 1997-April 1998

There was a largely steady increase during the period in the ERP, which featured one sudden surge in the measure during the period. The smoothed out average would show a rising trend on account of a gradual decline in the risk free rate, which whetted investor appetite for equity investments as the opportunity cost of investing in risk free assets rose. The month-on-month surges in November 1997 may attributed to the GoP's devaluation of the Pakistani Rupee by 8.7% during the month.

May 1998-July 2000

Our second phase in tracing the history of the ERP is from May 1998 (the nuclear detonation by Pakistan) till June 2000 (just before Rupee became freely floating). Interestingly, the ERP did not shoot up significantly but traded in a band of 9% to 14% during the period, only shooting up once to 16% during the period. The trend is explained by the reduction in the risk free rate by as much as 867 bps during the period. The GoP decided to follow an easy monetary policy as the domestic economy felt the full impact of the shocks of the foreign currency crisis and the nuclear related sanctions of the developed world. This it was able to do as the Rupee was restricted to trading in a band as against the US Dollar during the period. Hence, the depreciation in the Rupee and hence a rise in ERP, which would have otherwise been apparent under the free exchange market mechanism, was stifled. The one sharp increase in the ERP manifested itself due to the GoP's devaluation of the rupee by 3.7% in July l998 and 7.9% in August 1998.

July 2000-Current

After the GoP floated the Rupee in July 2000, the ERP increased sharply at first to register the real value of the Rupee against the Dollar, before stabilizing to trade in a band of about 16% to 20% After the GoP left it to the market to decide the Rupee's value, the State Bank increased the risk free rate by 570 bps over the next 12 months so as to put brakes on the decline in the Dollar value of the Rupee, which lent stability to the ERP after the initial hike. By July 2001, the Rupee had gained enough stability for the SBP to ease monetary policy through reducing interest rates. Hence the risk free rate has declined from by about 480bps from then until now. The lower risk free rate over the last six months has resulted in the ERP being sustained at the current high levels.

Oil Marketing Sector

Trying Times Ahead

According to recent news reports and industry sources, the consumption of POL products fell by over l3% during 1Q02. Pakistan, as stated by the Secretary of Petroleum, is expecting US$500-600 mn savings due to a decline in international oil prices and another US$500-600 mn through reduction in POL consumption. Hence, the decline in the oil import bill is due to a) a fall in international oil price by around 15% to 20% b) an over 10% reduction in the consumption of POL products.

Furthermore, the Federal Bureau of Statistics has also suggested that in terms of value, import of petroleum products declined by 36% to US$521 mn during the first four months of current fiscal year against US$8l8mn last year. However, the quantity of the imported POL products rose during the same period, which in our opinion, is attributable to the inventory buildup due to the current regional crises.

Global Slump in trade to weaken oil prices

With Merrill Lynch's (ML) recent downward revision of the world economic growth outlook, and the new ML GDP forecast for 2002 of 1.5% — which is lower than the GDP figure before the 9/11 attacks. There is bound to be a reduction in demand for oil, thus resulting in an oversupply situation whereby the oil prices would see a downward trend going forward. The recent trend in oil prices is evidence of this fact. The revision in oil price forecast by Merrill Lynch indicates continued weakness in oil demand going forward even though OPEC has been trying to maintain the price of crude oil through its production cuts within the range of US$22-28/bbl for some time.

Impact on OMCs

The bottom line of the Oil Marketing Companies (OMC) is going to be markedly lower moving forward as compared to the previous year — which we have repeatedly emphasized in our various morning shouts and other publications. Quite simply, there are certain developments, which need to be monitored closely to ascertain their impact on the OMCs viability in the future.