CSE slump may last

The global equity rout and capital flight overwhelmed Sri Lanka’s tiny stock market in early 2016. Three equity analysts answer questions about the chances of a recovery and dynamics that will weigh on listed firms here in 2016

January was a bloody month for global equity. Worries that a Chinese economic slowdown was imminent proved right. Markets then panicked when official data showed that Chinese economic growth fell to a 25-year low.

The equity sell-off started in China and spread quickly across the world. From the start of the year to 26 January, Chinese stocks fell 22%. Stocks fell 11.7% in Hong Kong, 10% in Japan, 10% in Singapore, 6.2% in India, 5.5% in Australia, 4% in Malaysia and 3.5% in South Korea. In the US, the NASDAQ fell 10.2% and NYSE fell 11.8%. European stocks lost 8.1% and the UK’s FTSE 250 fell 7.4%.

In South Africa, Brazil lost 12.3% and Argentina 11%. Commodity prices fell on Chinese economic worries. Crude oil fell 39.3% and gold 11%.

In Sri Lanka, the Colombo Stock Exchange (CSE) fared no better. The All Share Price Index fell 8.3%, with foreign investors selling off Rs2.3 billion worth of shares in the year up to 26 January.

Do foreign investors really move and shake the Sri Lankan market, and do local investors simply follow, unable to make rational decisions? Is there more to the slump than the global selloff, and when will the market bottom out? Echelon spoke to three research analysts to find out why they think Sri Lankan stocks had a bloody start to the year.

Sri Lanka Is Not An Attractive Frontier Market
Kanishka Perera – Head of Research, Asia Securities

What’s driving down value in the stock exchange?
There are three reasons for this. First, global investors are exiting the region on concerns about a slowing Chinese economy. We experienced a similar situation in 2008/9 when cracks in the US economy emerged. Fearing that a slowing US economy would impact global markets, investors exited emerging markets. Today, it’s the Chinese economy. Second, global investors are shifting their assets away from equity to fixed income debt instruments. Since the beginning of the year, there has been an equity sell-off to the tune of $935 million and net buying into bonds amounting to $1.5 billion. The third reason is that we have our own domestic problems on the macroeconomic front.

Is foreign selling really behind the market’s fall this year, or are local investors taking cues and making a bad situation worse?
Foreign ownership is not significant in the CSE, maybe around 10%, but if you look at large-cap tradable counters, a majority are foreign owned, so their participation makes a huge impact. When they move in or out, we see significant movement. For a frontier market, we have thin volumes. We probably have 20 stocks with trades more than $50,000 a day. Usually frontier markets are required to have stocks with a $100,000 daily volume. The best of them will have $200,000 daily volumes, so our large-cap stocks John Keells (JKH) and Commercial Bank (COMB) barely make it. If you look at P/E multiples, the CSE is 14.2 times and Vietnam is 10.6 times. So why would a foreigner want to invest in Sri Lanka when there are other more attractive markets?
China has a P/E multiple of 15.5 times, which is a really cheap level for an emerging market, but you can find good, fundamentally sound stocks that have been oversold.

So what can be done to attract foreign investors?
We need to fix the third problem, the macroeconomic problem. For example, you absorb the currency pressure, and then all of a sudden depreciate it. This is very unattractive to foreigners. Last year, the ASPI dipped 5% and the currency depreciated 9%, so foreigners lost 14% by doing nothing.

The issue with the economy is that there is no policy direction and corporates are not sure what to do. Investments will slow down. This is a teething problem of the unity government: how this is going to sort out is key to how the market performs this year.

There are concerns about the fiscal deficit, which lead to the slowing down of the economy one way or the other. You can print money and get away with it, but it creates inflation. You can go for an IMF loan, and then there will be a clamp down on growth when the government is asked to curb spending. Of the two, I believe the IMF is a better option because it will tackle some of the economy’s structural issues. Then again, we will fall back to the unity government issue with one party for reforms and the other resisting, so this has to be sorted out.

What’s your short-term outlook for the market?
The market return may grow 5% this year, a more optimistic forecast, but all this depends on policy. If the IMF comes in, there will be an improvement in sentiment, but an improvement in earnings will take a bit more time when there is a slowdown in the consumer segment with the government asked to curb spending.

Last year, FMCG stocks did well, reporting double-digit growth, but this was just an on-off thing coming from the government sector wage hike. In the absence of these interventions, consumer growth will go back to single-digit rates. There is no structural change in the economy to see continuous consumer spending.

The banking sector will be impacted by the increase in the statutory reserve requirement (SRR) from 6% to 7.5%. Net interest margins could dip 2.5% to 5.4% depending on how much liquid assets a bank holds. They will have fewer funds to deploy, so they will increase deposit rates. Taxes on banks have also been increased to 30% from 28%. The US Fed rate hike will also impact banks with external borrowings. Most corporates have borrowed at fixed rates, so banks will have to bear the cost. Investment costs will go up; for anyone looking to borrow and grow, the corporate tax reduction from 28% to 15% could offset that.

Despite all these negatives, banking stocks are undervalued to a great extent. Some banks are trading closer to book value, which means the market does not expect them to grow at all, which is unreasonable to think.

More Than Sentiments At Play
Chethana Ellepola – Head of Research, Acuity Stockbrokers

When can we expect to see the market bottoming out?2 It is difficult to say when the market will bottom-out because it’s not just investor sentiment that is at play here. Fundamental macroeconomic vulnerabilities persist such as a wider fiscal deficit, pressure from external debt repayment commitments, a weaker rupee and interest rate pressure.

Volatility in the global financial market could not have come at a worse time for Sri Lanka. Because of its relativelylow trade and portfolio flows with the world, Sri Lanka generally tends to be more resilient to vagaries in global financial markets. But this time, the global market rout impacted equity markets that were already struggling with domestic macroeconomic issues. The year 2016 started on a challenging note for global equities, as continued evidence of a Chinese slowdown and oil prices hitting a historic 10-year low spooked financial markets, particularly emerging and frontier markets. Emerging markets experienced their first  capital outflows since the 2009 global financial crisis. This year is unlikely to be any different, as investors remain ‘risk-off ’ in light of slower growth in emerging markets, the US Fed’s tighter monetary policy and the end of the commodity super-cycle.

We had a tough year in 2015; with the political transition and heightening macroeconomic pressure, the stock market lost 6.1%. Corporate earnings, which grew at 16% in 2014, slowed to 3% in 2015. So the downturn we are experiencing in 2016 is really a continuation of these domestic pressures, coupled with much stronger external headwinds since January.

Can investors find value in all this negativity?
Certain counters in the manufacturing and diversified sectors may do well: companies that can benefit from a depreciating currency or falling global commodity prices may see better earnings. Tourism could also do well as the modest economic recovery in traditional US and EU markets continue. Our market is sentiment driven and tends not to follow company fundamentals enough. Investors fail to see the opportunities that market downturns afford. There are fundamentally sound stocks with healthy medium-term growth prospects and attractive valuations that can generate good returns for investors who are willing to take a 12-18 month view. A downturn gives opportunities to buy and accumulate counters with strong fundamentals. In terms of overall valuation, compared to our MSCI frontier and emerging market peers, which trade at P/E multiples of around 10 to 11 times, Sri Lanka trades at a premium (14 times), so there is still a little more room for a correction.

Will things improve in the short term?
Although the short-term outlook for equities is a little bleak, if you take a medium to longer term view of the country, a completely different picture emerges. The blueprint for a structural shift in the economy is there; what are missing are concrete directives in terms of implementation and policy consistency.

Sentiments should change and markets should see a pick-up once something definitive in terms of the much talked about FDIs or major infrastructure projects comes through. Despite the current near-term stresses, we shouldn’t write-off the Sri Lankan economy just yet, particularly since international reception to proposed policy and economic reform has been positive.

Even If Global Markets Stabilize, The CSE Will Fall
Travis Gomez – Vice President, Frontier Research

Are investors overreacting to what’s happening here and in global markets?3
Our market is very sentiment driven and there is a great tendency to overreact. For example, since the budget last November, banking stocks came under a lot of pressure. The market overreacted and the prices we see now for most banks may not be justified, because in terms of their core business, they are doing well. Asset quality has improved, impairments have come down, term loans have grown and net interest margins have been stable. Banks also tend to be much more resilient than any other sector. Business sentiments are not too negative either, and there is no indication that consumption has slowed down.

There are domestic and external pressures at play. There are concerns about the external position, with a large amount of debt repayments coming up this year. Our current account deficit is expanding and putting pressure on the currency, and this will drive up inflation.

On the external side, there are fears that the slowdown in China will impact commodity prices and have a knock-on effect on the recovery in the US and the EU, precipitating another global slowdown. A delay in the US Fed rate hike will only reinforce these concerns.

What’s your outlook on the macroeconomic front?
The Central Bank will start intervening, and we believe they will tighten monetary policy, raising interest rates by 200 basis points. We expected the currency to depreciate 5-10%. This depends on whether the Central Bank reacts on time. The Central Bank has been in denial about macroeconomic pressures.

There are concerns that we may be downgraded and would have to go for an IMF facility. We have to contend with policy uncertainty as well. Foreign investors are not confident at all.

The budget had many long-term policy measures and this is good, but there was nothing in the budget to ease short-term pressure. We have a lot to do to fix our domestic economic problems. Even if the IMF bailout comes through and government spending is curbed, corporates will worry about where growth will come from. At the same time, foreign investors look at things from a different perspective. They will look at how attractive our market is from a valuation point of view.

What’s your outlook for the stock market?
Assuming there is no worsening of the global situation and we continue as it is, the All Share Price Index could come down to 6,000 points this year. The market is also volatile and sentiment driven. If the IMF bail-out comes through and we are not downgraded, sentiment will pick up, but there is still a bit more downside for the equity market.

The market has declined 8% this year and there is no sight of a bottoming out, but some stocks are still good to buy. Some counters are attractive as long-term investments even now; there aren’t many of them, but we do have companies with strong fundamentals.