The rally over the past 12 months or so in the equity markets worldwide have largely been fueled by an increase in liquidity. Governments and in some instances central banks have poured in greater liquidity to stimulate economies in the midst of COVID-19 outbreak, which remains mantra of policymakers over the months.
According to a report by Topline Securities, it remains difficult to gauge/quantify by how much has the liquidity increased in a country like Pakistan due to significant presence of an undocumented economy. That brokerage house believes changes in M2 may provide a good proxy for an analysis. M2 is a measure of the money supply that includes cash, checking deposits and easily convertible near money.
During last calendar year, M2 growth in Pakistan was reported at 18% as compared to its preceding 5-year average of 12%. In absolute terms, increase in M2 was recorded at Rs3.4 trillion during 2020, almost twice its preceding 5-year average of Rs1.7 trillion.
There are two factors that primarily drive growth in M2, government borrowing and/or private sector borrowing. In the year 2020, it was largely government borrowing from scheduled banks, which drove money supply in Pakistan. According to the brokerage house it accounted for 70% of the increase in M2. The government borrowing from scheduled banks increased by 41% or Rs2.4 trillion during this period, whereas borrowing by the private sector increased by 5% or Rs0.3 trillion.
Tracing back into history as well, the brokerage house above average growth in M2 resulted in above-average returns in Pakistan equities.
The point to explore is what does one do with greater liquidity in Pakistan? The options are very limited, therefore, most of liquidity in parked in equity market. This is also reflects in the data provided by NCCPL, where investments by Individuals have increased over the past two years.
The next point to explore is, how does greater liquidity determine buying patterns in the market? When liquidity is the main driver, one of the main ways to pick an investment for retail investor is to figure out what the other person is going to buy and/or buying as opposed to looking at valuations or trusting the fundamentals of any company.
This has transpired at Pakistan Stock Exchange (PSX) lately, where a number of so-called blue-chips having extremely cheap valuations have underperformed stocks, which one may classify as small and mid caps and/or expensive in terms of valuations.
Two heavy-weights sectors, E&Ps and Banks (having an aggregate 33% weightage in KSE-100 index), have been glaring underperformers over the past year or so. While it is understandable that E&Ps have been out of favor because of poor cash earnings (amidst circular debt), it has been very surprising to see banks underperform the market.
The brokerage explains this in a different manner. The brokerage house believes there has been greater Shariah liquidity (meaning investments in Shariah-compliant stocks) as compared to conventional liquidity over the last couple of years, possibly because of increasing share of Shariah focused individual investors in the market.
Its point is backed by increasing ratio of average traded volumes of KMI ALL Share Index as compared to KSE All Share Index. It has averaged at 56% over the last two years compared to its preceding 3-year average of 42%.
The brokerage house expects M2 growth to hover above average rate of 14-16% in 2021 driven by both government borrowing to finance fiscal deficit and rising private sector borrowing driven by Temporary Economic Refinance Facility (TERF).
Liquidity is also likely to be buoyed by an increase in inflows from outside of Pakistan. Roshan Digital Accounts (RDAs) are gaining traction, with total inflows of US$700 million to date, though most of it (65%) is going into Naya Pakistan Certificates.
This should bode well for equity market. If one peeps into the history over the last two decades, it is evident that in 3-4 instances where Pak equities have posted above average returns during period of high M2 growth.
Having another look into the history, indicates that when Individuals are the front runners in market, local Institutions (Mutual Funds and/or Insurance) and/or foreigners have carried on the optimism.
Under the present scenario, the brokerage house does not expect foreigners to join the party and expects them to remain net sellers in Pakistan to the tune of US$200 million to US$300 million in 2021.
However, it expects Mutual Funds and Insurance to share Individuals’ optimism if the overall economic and political situation remains positive. It will be important to track inflation readings given the recent volatility in international oil prices. If inflation picks up and bond yields rise, Mutual Funds and Insurance would reallocate resources towards Fixed Income Securities from Equities.