CAPITAL MARKETS

It is dependent on how the SBP prioritizes and balances its dual goals of achieving economic growth and price stability

By AQIB ELAHI MEHBOOB
Head of Research, AKD Securities

May 19 - 25, 2003

In the stock market, as with horse racing, money makes the mare go. Monetary conditions exert an enormous influence on stock prices. Indeed the monetary climate primarily the trend in interest rates and the central bank's policy is the dominant factor in determining the stock market's major direction Martin Zweig (The Zweig Forecast)

We have quoted Zweig before, and we will continue to do so. Indeed, what Zweig elucidates above is the fundamental philosophy, which forms the basis of all our market calls. Like Zweig, we base our investment opinion on what we perceive as the direction of SBP policy. To be more precise, we believe that the bet on future market performance is simply premised on how the SBP prioritizes (and balances) its dual goals, economic growth and price stability, as the manager of Pakistan's monetary policy. We recognize that achievement of one goal may be at the cost of the other.

The KSE continues to be one of the best performing markets in the world, despite a dangerous global environment, strong domestic opposition to the political structure that was defined by the previous government and continuing tensions with India. Under conditions that were prevalent about 3 years ago, these exogenous factors would have combined to undermine KSE performance. Though, presently there are strong secular trends that make and will continue to make these exogenous risks increasingly irrelevant to market performance. We believe that the stellar market performance is set to continue over the medium term, with an intermediate index target of 3362.

Our views are predicated on the following observations and assumptions:- 1) the SBP accords higher priority to exchange rate stabilization, even above inflation considerations, 2) the US dollar continues to struggle under the weight of its twin deficits and declines gradually (we would venture a sharp decline), 3) the GoP continues to secure concessionary funding from IFIs, and 4) continues to deliver its domestic balance sheet.

The key to understanding where the equity market is headed is, we believe purely a call on where the SBP's policy priorities lie. Fundamentally, the SBP is charged with promoting economic growth and controlling inflation. This contrasts, in some ways, to the change in central bank priorities globally, which in the nineties saw central banks being largely charged with controlling inflation the ECB inflation targeting. With regard to the SBP's priorities, we must admit that we have had a radical change in thinking. We feel that the SBP is not willing to take any policy action that may endanger the nascent recovery that we are presently observing in the economy.

We feel that the SBP's inclination towards protecting growth is also a function of the impending implementation of the WTO protocol, where we feel that one of the most significant factors determining a country's competitiveness will be the exchange rate. Curtailing the Rupee appreciation to 2% in the current fiscal year has been accompanied by reserve money, narrow money and broad money growth of 16.6%, 19.8% and 13.1% respectively. Simply put, this growth in the aggregate money supply should at the least be maintained (if not enlarged) over the next few months. The Rupee strengthening trend does not show any sign of waning. We believe that it should gain momentum as the GoP is working on paying back expensive external debt (some of which will be done before the end of this fiscal year) that can improve Pakistan's external vulnerability indicators.

Once the SBP reaches its 'competitive exchange rate' level, then possibly the rate of monetary expansion will have to be that much faster. If exchange rate stability is a priority with the SBP, then one of the foremost challenges that the SBP faces over the twelve months will be how to deal with a decline in the US dollar's value against global currencies. We do feel that the US dollar has yet to bottom-out. The SBP's stated policy, in this context, is that they will allow a gradual appreciation of the Rupee against the US dollar, and it is a policy that they have been following.

Furthermore, the SBP realizes that the attractiveness of fiscal contraction for the government will only last as long as it plays its part in compensating for the successively lower fiscal deficits as a percent of GDP with an increase in corporate (and consumer) levering. Hence at least keeping aggregate demand stable (and hopefully spurring it). This is particularly significant with the advent of the democratically elected government of Prime Minister Zaffar Jamali, where any downshift in aggregate demand will have unacceptable political risks. Growing aggregate demand can only be good news for listed companies' earnings, which is a trend that we believe will ultimately underpin the liquidity-driven rally at Karachi Sock Exchange.