Can Pakistan's stock market survive an inflation tsunami?

The newspapers and talking heads on TV are at it again. The 'Awaam' will face a wave of inflation as global commodity prices drive the cost of living to unbearably high levels. Most CPI models show inflation spiking to 15%+ over the next few months and possibly higher as the subsidies on petrol and electricity are reversed.

The political ramifications of this are evident from the hesitancy on show by the government. The previous administration had deployed poison pills (aforementioned subsidies) in the face of a hostile takeover and will hammer the government with a very compelling narrative on spiraling inflation over the coming months.

It is unfortunate that economic decision making is so often hostage to political factors and the ramifications of it are becoming increasingly dire with each cycle.

Do stock markets succumb to inflationary pressure? What sort of returns are generated by equities in such an environment? For this we will take a look at the historical record stretching back over the last ~15 years.

First some context — since 2009, we have 153 monthly CPI readings both year on year (YoY) and month on month (MoM). That’s a fairly robust sample size to draw some conclusions on how the KSE 100 reacts to high inflation readings. For accuracy, we have measured the monthly index return the following month i.e. on a T+1 basis to the CPI announcement.

Interestingly, monthly equity returns do not seem to show any inverse relationship to YoY inflation. Average KSE-100 returns are positive during double digit CPI readings (+1.4%) while positive months outnumber negative ones by more than 2:1.

However, markets are more sensitive to MoM CPI numbers but only at the extreme end (2.0%+ MoM increase) of which we have just a few data points (10 instances in total). In such cases average returns turn negative (-0.69%) while positive months drop to 40% of the sample size.

A monthly time horizon may not be sufficient time for the market to absorb the implications of rapidly rising prices. So it may be instructive to look at annual equity returns when CPI was above 9% — 9% was used as a benchmark because average inflation over the past 16 years is about 8.3%. Even then there is no clear trend. We have 6 years where CPI was above 9%, 4 of those years netted a positive return for investors, of the 2 that didn’t 1 was 2008, a year when the global financial crisis hammered markets indiscriminately.

The conclusion is clear. Inflation on its own is insufficient to drag equities down and there is no clear correlation between them. For any significant decline it must be accompanied by sharp currency depreciation and aggressive monetary tightening. Even then the result is by no means a foregone conclusion as we have already seen inflation, depreciation and monetary conditions tighten with no discernible impact on the index (-0.7% over the past 1 year).

2019 is another case in point. Inflation was 12.7%, the PKR lost 10.8% against the USD, the SBP increased rates by 3.3% yet the KSE 100 generated a return of +9.9%.

Conversely, 2017 is evidence that even relative calm on all 3 of these indicators is no guarantee of healthy returns. Inflation was low (4.6%), interest rates remained flat while the currency depreciated by just 6.1%. However, the index lost 15.3% that year and followed it up with another 8.4% decline in 2018 when the PKR dropped 26.3% of its value.

This shows that the discounting mechanism of the market is well and truly alive. In previous instances where macroeconomic indicators were relatively stable the market sold off on expectations that they would worsen over the coming months. This time around domestic liquidity, double digit yields and attractive valuations may be keeping the market range bound.

For equity investors, the key is external USD funding. As long as clarity emerges on that front, we can expect markets to remain relatively insulated. Corporate earnings are strong with the KSE-100 companies posting a record profit of PKR 320 billion in 3QFY22 (+33.7% over last year) while foreign selling should stay muted. Focus on companies with strong balance sheets and ample pricing power. However, if we fail to address depleting FX reserves then rock bottom valuations can get even rockier.

The article does not necessarily reflect the opinion of Business Recorder or its owners

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