Over the past ten weeks, the Pakistan Stock Exchange (PSX) benchmark index, the KSE-100 index, has risen by approximately 18,000 points, or 37%. The recent surge in prices has significantly surpassed the previous peak in the range of 52,000 points, which was established in 2017. Despite a global run-up in equity markets, the KSE-100 index’s performance had been lackluster for the previous five years as it was unable to surpass its peak.
The perpetual circular debt crisis, political unpredictability, policy uncertainty, and an economy heavily reliant on borrowing to finance consumption were all contributing factors to the equities market’s dismal performance.
More significantly, liquidity was redirected towards real estate as an asset class as a result of previous governments’ pivot towards supporting real estate schemes.
A major contributing factor to the market’s generally flat performance was macroeconomic instability. The rupee has sharply declined in value over the last five years due to the volatility in the rupee-dollar parity, which has been much more pronounced than it has been over the previous 20 years. Foreign portfolio investors’ confidence in Pakistan is further undermined by the lack of a clear policy that establishes stability or plots the course of rupee-dollar parity.
Over the past 20 years, Pakistan’s market capitalization to GDP ratio has averaged between 23 percent and 24 percent.
The market is essentially playing catch-up after remaining comparatively flat or choppy for the previous five years, which is why the KSE-100 index has surged.
After remaining comparatively flat, or choppy, for the previous five years, the market is now playing catch-up, as evidenced by the recent surge in the KSE-100 index. The cumulative rate of inflation over the previous five years has exceeded 100 percent. Even with the recent surge in index values and stock prices, the inflation that has occurred over the last five years has not even been fully offset by the growth.
The price-to-earnings ratio is another important indicator of the relative value of equity markets. This ratio shows the potential difference between a stock’s price and earnings. A market is overpriced if the ratio is higher than it was historically, or for any other period of time.
A market is undervalued if the ratio is smaller than the average for the same time period. The KSE-100 index’s long-term average price-to-earnings ratio has ranged from nine times, which is still low for an emerging or frontier market. However, it has remained notably depressed over the past five years, roughly four to five times. As of right now, the price-to-earnings ratio is approximately 5.4 times, even with the significant price movement.
Conversations about sudden price spikes tend to focus on labeling this inflation of asset values as a bubble.
However, given that asset prices have not been able to even somewhat keep up with inflation and that overall earnings growth is continuing, can this really be considered a bubble? Considering that prices are only now relative to historical means, it might be premature to label the current price movement as a bubble.
Similarly, it’s anyone’s guess as to whether the current price increase is sustainable. In any market, interest rates are a major factor in deciding how capital is allocated. Interest rates in Pakistan are still historically high, which deters investors from investing in riskier asset classes, especially when the interest rate at which the government borrows money is still significantly high.
The government’s heavy reliance on borrowing to fund operations and deficits means that any sustained hike in interest rates, or even a small one, will sap the momentum from the recent sharp rise in equity markets. The market did manage to hit new highs thanks to some semblance of stability. However, maintenance of the same must be based on structural changes throughout the economy, whether that means shifting the economy so that we can keep the foreign exchange rate stable by allowing higher inflows of foreign currency relative to outflows, or relieving the government of its need to borrow money to balance its budget.
For the past several years, the equity market has mostly remained depressed and undervalued because of a variety of variables related to macroeconomic and political instability. Any gains made by the market in the last few weeks could be lost if there is no stability in the near-to-midterm. The bull run might continue if any sensible structural changes that could reshape the economy are in the works.
Still, it will not be long before the market returns to its depressed and dysfunctional ways if we continue to cling to a broken economy and a sluggish policy framework.
The most important factors in creating a solid foundation for equity markets and, unintentionally, the expansion of the private sector are lowering economic risk and practicing fiscal responsibility, whether through logical economic policies or political stability. The risk premium attached to an economy keeps rising when risk isn’t prioritized, which keeps equity prices low.