ANALYSTS GAZE AT THE CRYSTAL BALL

Four top equity analysts gazed at the crystal ball and some spreadsheets to forecast how Sri Lanka’s economy and
equity market will do over the next couple of years

The forecasts are pretty downbeat. On average, real returns from equity over the next 18 months may not beat fixed income by enough of a margin to be attractive for investors. However, investors don’t buy an index of the market, but pick stocks; and the analysts we spoke to suggest there are many options. Sanjeewa Fernando of CLSA Sri Lanka, Asanka Herath of LYNEAR Wealth Management, Chethana Ellepola of Acuity Stockbrokers and Nikita Tissera of Bartleet Religare Securities offered their economic and equity earnings forecasts.

Weaker recovery due to poor sentiment

ASANKA HERATH
Head of Research, LYNEAR Wealth Management

Relatively low interest rates indicate Sri Lanka’s economy is near the bottom of an economic cycle, but the recovery will be weaker than the two preceding cycles due to poor consumer sentiment and rates not declining to low levels, according to Asanka Herath, who heads research at wealth management firm LYNEAR. He forecasts consumption picking up in 2019 on the back of higher government spending aimed at winning electoral support among low-to-middle income households and a recovery of farm incomes. Higher consumption in 2019 will improve earnings in listed food, beverage and retail firms.

However, Herath forecasts that the recovery won’t be full blown like those in 2011 and 2014/15 for two reasons. First, the Central Bank’s ability to reduce interest rates to support growth is limited despite low inflation; and second, polarized political views about how the country should move forward are causing uncertainty, hurting Weaker recovery due to poor sentiment consumer sentiment and thereby profit growth.

“When you say consumption recovery, we automatically go back to 2011 and 2014/15,” he says. “It will recover, but the rebound won’t be as strong.”

Herath also points out that the slowdown in construction witnessed in early 2018 may reverse in 2019, but “the fact that borrowing costs haven’t declined significantly means home building and improvements may not contribute as much as they did during the last two cycles”.

Currency depreciation (he forecasts the rupee will be at 165-167 to the dollar by mid-2019) will bring some inflation pressure.

Rising interest rates in the US also constrains the Central Bank, a factor that was not present during the last two rounds of policy rate loosening. A majority of members of the US interest rate setting body FOMC are of the view that there will be four rate hikes this year. It’s also a reflection of the US economy improving, which has historically augured well for the rest of the world, says Herath.

Higher rates may shift portfolios in the short term, Herath believes. “After the initial outflow, funds will start reversing to equity markets in the mid-to-long term. I’m not certain if all outflows (seeking higher US rates) are complete, but these will not be a long-term phenomenon.”

Credit shifts to sub prime

SANJEEWA FERNANDO
Executive Director of Research, CLSA Sri Lanka

On economic growth
Without many headlines, Sri Lanka’s rate of investment has improved over the last decade. Its building of ports, expressways and business expansion improved the investment rate to an average equivalent to 31% of GDP during the last five years.

To grow GDP by 6-7% annually, Sanjeewa Fernando says investments, 5% of which is government, 24% from the private sector and 2% from FDI, must climb to around a 35% equivalent of GDP.

Sri Lanka’s savings rate is 24%, and private sector investment will remain at these levels, says Fernando. “This leaves only one area for near-term focus to increase potential output, which is FDI.”

To improve foreign investment flows, Sri Lanka must improve the ease of doing business. It must reform tariffs and related areas, and quickly build infrastructure to increase economic efficiency.

On inflation and interest rates
Private sector loan growth declined from highs of 29% YoY in July 2016 to 15% YoY by early 2018. A main feature of this decline is the fall in loans to large companies, depicted by declining prime-net interest margins (Prime-NIM) since September 2016. Prime-NIMs declined from 5.2% in September 2016 to 2.2% in May 2018, or three percent.However, retail NIM declined only 0.3% during the same period.

Given changes in the retail tilt of bank credit and following the Central Bank’s April 2018 policy rate cut, credit may continue growing at current levels (around 15% level) or reduce slightly should inflation pick up.

This won’t add pressure on interest rates to increase (including 12-month T-bill yields), especially during the second half of 2018. As a result, 12-month Treasury bill yields may decline from 9.4% now to 9% levels by end-2018.

Oil prices and global geopolitics may blunt a rebound

CHETHANA ELLEPOLA
Director Research at Acuity Stockbrokers

What are your expectations for the economy in 2018?
Agriculture growing and its spillover effect on consumption, and a rebound in manufacturing will be features of the economy over 2018-19. The full effect of GSP will be seen this year (2018). Tarifffree access to the EU was restored in March 2017, and so only impacted a part of that year. A rebound in manufacturing will also boost consumption. Since elections are around the corner, handouts next year (2019) will also boost consumption. This year (2018) will be about fundamentals driving growth.

Oil prices are higher this year than they have been over the last two years. What’s the impact of this?
In 2017, fuel imports excluding coal cost $3.4 billion because volumes increased due to higher needs for generating electricity as the drought has reduced hydro electricity generation. Volumes of fuel imports increased 10% in 2017.

Without a drought, you are not going to see large oil volume increases. The space to watch is oil prices. Global analysts are forecasting a consensus for the full year at $69.4. Oil prices have a substantial impact on the import bill, and in turn, on the balance of payments and the rupee. Last year, because of the drought, the volume of oil went up.

Fuel imports cost excluding
coal
Cost                      Cost per barrel
2016      $2.5 billion         $43
2017      $3.4 billion         $57
2018     $4 billion             $70 (forecast)

Geopolitics is in flux, and may impact trade flows and commodity prices. Will this impact Sri Lanka?
The question is, are the US and China going to enter a trade war. If that happens, it’s going to be a volatile year. Even the prospect of one has an impact, and a full-blown trade war is going to be big. As soon as something happens to impact the Chinese economy, interest in emerging and frontier markets tends to get spooked.

A US-China trade war will have such a huge impact on emerging assets as a whole and we will suffer from that fallout. Can we supply the US should a trade war with China escalate? I don’t think that’s a realistic goal.

Rethinking banking and telco taxes, resets valuations

NIKITA TISSERA
Head of Research at Bartleet Religare Securities

How do you think the economy will do this year and the next?
To a large extent, rural consumption is dependent on the spillover effect from the agriculture sector, provided the weather is normal. Bad weather comes in four-year cycles and its absence should support my GDP thesis for the next two years of higher rural consumption. After nine quarters of consecutive growth, construction has shown a 4% decline in the first quarter of 2018. Given these nine successive quarters of growth, the dip is not base effect related. I think it’s a one-off impact probably related to a dip in government spending on construction. When you look at figures for cement imports and production, steel imports, sales and production of tiles and copper, it doesn’t explain a construction decline.

How will some of Sri Lanka’s large companies do in this environment?
We were expecting the banking sector to lead earnings growth this year, but the turnover levy introduced in the last budget led us to rethink this. Right now, the way things are happening, there may not be a turnover-based levy on banks, but rather, an increase in the VAT rate. A VAT increase is an easier way of implementing the tax and an efficient way of collecting it. Banks won’t have issues passing this cost on to customers. Now we are not cutting the growth forecast for the banking sector. The other sector we had qualms about was telecos, also for the same reasons. The government lifted a 10% levy on call charges, which to some extent was passed down as enhanced data for consumers, for which telco providers have near-zero marginal cost on.

The other is the tax on telecom towers of Rs200,000 a month. If you work that out with Dialog, which has 2,100 towers with a tenancy ratio of 2.2%, and even if they share the cost, it will be Rs2.5 billion or so annually. Without sharing, we are looking at Dialog’s costs rising by Rs5 billion a year.

But, after the discussions we had with the TRC and Dialog, it looks like Rs200,000 per tower will not be per month but per annum, and this reduces Dialog’s potential exposure to Rs400 million. For Dialog’s cash flow, Rs400 million is not very visible, and that wouldn’t move valuations for me.

How well is equity placed as an asset class?
This is not a good year for equity. You are looking at higher interest rates and higher positive real rates after a long time. Doubledigit fixed deposit and bond rates are something our consumers haven’t been used to in the past.