Stocks were up by 30% in the year to mid-December 2023. However market-wide earnings in 2023’s March, June and September quarters are all lower than in the same quarters of 2022. Our panel of analysts and money managers suggest a combination of delays and consumption shocks are to blame for the poorer-than-forecast earnings. An agreement with Sri Lanka’s external creditors is still to be worked out and tax rises aimed at shoring up government revenue have hurt consumer spending.

Despite these setbacks, inventors will see the silver lining in the 7% fall in reported market profits in the September quarter as a harbinger of a turnaround. In each of the preceding quarters (March and June), profits were down by around 65% and 70% respectively. Price to earnings at 10.1 times over the last four quarters puts the market near its average PE of 11.4 times. So how should investors craft a portfolio strategy given these challenges within the economy and valuations? Our panel discussed this and other portfolio quagmires.

This year’s panel included NDB Securities’ Head of Research, Nikita Tissera, First Capital Holdings’ Chief Research & Strategy Officer, Dimantha Mathew, and CT CLSA Asset Management’s Chief Executive, Bimanee Meepagala.

What in your view will be the investment themes of 2024?

Bimanee Meepagala:Sri Lanka is emerging from the worst economic crisis slowly but surely. We’re going through painful reforms. Macro variables have improved substantially. Inflation for instance is at about 3.9%, and some of the loss-making SOEs (state-owned enterprises) like the Ceylon Electricity Board, have for the quarter made a Rs1.6 billion profit.In 2024 Sri Lanka is going into an election cycle. Whether politics is going to be a distraction is a concern.

Of course, people are not happy with painful reforms. In January VAT will increase by 3% and the many exemptions will be removed. Local consumption, which is 70% of our economy, will be impacted.

Dimantha Mathew: We’re going into an interesting year. On one side lower interest rates are a huge positive for the economy. Completing the external debt restructuring in 2024 will add to this. An upgrade in the country’s credit ratings is a reason for foreign investment into markets for equity. That said, there are some uncertainties too.

One key reform is the SOEs. We’ve done the easy parts like raising prices of SOE products and services, but does Sri Lanka have the political will to implement the difficult reforms; like the privatizations, even if it had to break up the SOEs and sell stakes? We’ve not been able to achieve that for the last 20-25 years. These reforms will be key for sustainable economic growth.

The other factor is the uncertainty in the political arena with the elections in the second half of the year. Uncertainty is not great for long-term investment. But obviously, the first half of 2024 looks very positive.

Nikita Tissera: I’ll only add what’s incrementally valuable. Low consumption is definitely a concern, but keep in mind we’ve just emerged from two of our worst post-independence years. The base we have is a lot smaller now. The VAT increase is significant. I agree with Dimantha that the declining interest rates and companies will save a chunk on debt servicing.

If things go to plan we anticipate a third tranche of the IMF package in March 2024. The worst-case scenario is that it could be delayed to June. I think the worst hurdle was the second one in December. I think we’ve come through the worst, and even the IMF expects from 2027, 50% of our debt requirements will come from market sources, and the others from bilateral and multilateral lenders.

Help me reconcile this. Do you anticipate economic growth in 2024?

Mathew: We expect the economy to contract 3% to 4% in 2023. The September 2023 quarter recorded economic growth following six quarters of GDP contraction. This trend of quarterly growth will continue. In 2024, we are looking at 3% to 4% growth. Nominal GDP will be higher with the 5% inflation we are likely to experience.

We forecast the economy will continue to recover. However, the consumption recovery is bound to be slower due to higher consumption taxes. State sector wage hikes are planned for December to March and this will increase disposable incomes. It will be a paced-out economic recovery that we anticipate.

 

What are your forecasts for GDP and inflation?

Meepagala:We forecast 2.5% to 3% economic growth in 2024 and around 7% inflation. As Dimantha mentioned, consumption in the first quarter of 2024 will fall. But following government servants’ wage hikes and also ones by the private sector, you’ll see a slow consumption recovery in the first quarter.

We are positive in terms of exports as a driver of GDP growth. Exports haven’t had a good time in the last couple of years. However, the global economy looks much better going forward into 2024 and 2025. Central Banks are trying to balance low inflation with economic growth. They now talk of rate cuts during the second half of 2024. Globally, the worst is probably over.

Our apparel exports and tourism will benefit from the global economic turnaround. Worker remittances too will improve, and that will help us. I think the agriculture sector too will see robust international demand.

Tissera: My nominal GDP forecasts aren’t too far away. I’m looking at real GDP growth of around 2% for 2024. I think tourism and remittances are going to play a big role in this growth. But compared to pre-pandemic years tourists bring in fewer dollars. To remain competitive hotels need to refurbish.

I see remittances as a catalyst to turn around industries like construction, because, historically remittances have been a catalyst for middle-class and lower-middle-class housing, supporting products like tiles.

There is a tremendous amount of goodwill for Sri Lanka. Besides what the IMF is giving us, the World Bank and ADB are also supporting the government’s budget. There is an expectation that a lot of the foreign bilateral and multilateral donor-funded projects that have been stalled now can be restarted soon after the commercial debt is restructured. What are the likely impacts of this on the economy and industry?

Mathew: The budgetary support from the IMF is not going to be enough. To fill the gap, the government has secured support from the ADB and World Bank too. With this, I think the government will look at buying more dollars and releasing the rupees. So your foreign reserve component increases while market liquidity, which is currently negative, may start to improve as the rupees are released into the system.

Economic growth will likely be 3-4% over the next couple of years because we’re now beyond debt-funded growth that we’ve seen in the last decade. We can’t raise more debt for development.

Towards year-end 2024, what do you think market interest rates will be?

Mathew: We think this is as low as Central Bank rates will go. During the first quarter of 2024, government security yields are likely to bottom out somewhere between 10% to 12.5%. To give you a range, we’re looking at 10-11% for the one year, and for five years and 10 years, we’re looking at 11.5% to 12.5%. With inflation likely to increase towards the middle of 2024, and the government restarting some development projects, we think there will be pressure on interest rates because the government will also be competing for credit. So private consumption will only gradually pick up pace. We’re already seeing private sector credit growth of 20 to 30 billion per month. We think private sector credit growth will end up positive this year, a plus 1% erasing all the contractions. Next year private sector credit growth will be around 7.5%. Across the yield curve, interest rates will rise 200 basis points.

Bhimanee, do you agree with that view?

Meepagala: The Central Bank has signalled they are not going to move the policy rates any further. Of course, there is still space for market rates to decline. Currently, they are around 12%. Falling to 9% to 10% is not off the cards in the short term.

Private sector credit growth is one proxy for consumption that we anticipate will boost economic growth. There is also a possibility of the government crowding out credit growth. The government is not clear how it’s going to achieve the 45% revenue increase proposed in the budget. One reason for the fall in consumption during the last two years was an absolute dry-out of foreign funds inflow. Now, with IMF money and more multilateral help, I think foreign liquidity being converted to Rupees would solve liquidity requirements. Higher foreign and domestic currency liquidity in the banking system and low consumption pave the way for more aggressive private-sector credit growth in 2024.

What’s the forecast profit growth in listed companies in 2024?

Meepagala: We don’t broadly track the overall market, but based on our universe of stocks we track, we expect about a 20% earnings growth in 2024.

Roughly, how many stocks are you tracking?

Meepagala: Around 40 stocks.

If I can come to you with the same question, Nikita?

Tissera: Overall we forecast 10% to 12% earnings growth.

What about you Dimantha?

Mathew: We are forecasting somewhere around 10% to 15% market earnings growth. This year was slightly below our expectations, especially during the first half of the year, when earnings fell 70%. We were more bullish for 2024, a quarter ago. But we’ve slightly downgraded our forecast, due to the slow recovery.

Just to frame this conversation, in the March and June quarters of 2023, there were significant dips in overall market earnings, right?

Mathew: Market earnings for the September quarter were down by 5%. But it is a recovery, because during the first two quarters, what we saw were 65% and 70% declines.

Have you had to do what Dimantha did, to cut your initial earnings forecast? Did that happen in 2023?

Meepagala: Yes, we had to temper down for sure. Interest rates declined at a much slower pace than we were expecting.

The Central Bank has also been consciously doing its, inflation anchoring. I think they’ve been extremely successful in anchoring inflation and their projections to the market have been spot on. But like I said, inflation has been something that the Central Bank has taken seriously and they’ve been delivering on that objective.

Bimanee, you pointed out that politics will be a distraction in 2024. From the perspective of Sri Lanka’s equity market, how would you relate the political outcomes to outcomes on earnings?

Meepagala: One election would be tricky enough, but I think we are probably looking at two elections in 2024. We will probably have a presidential election in the second half of 2024, maybe September, and a general election soon after.

As far as uncertainties go, who’s leading Sri Lanka into the next phase would probably be the biggest. I think this is also keeping the valuations depressed.

So, do you think that’s a factor that’s holding back the market?

Mathew: The decline in interest rates was slower than what we had anticipated simply because the external debt
restructuring is delayed. We were expecting external debt restructuring to be completed by September, or latest by
November 2023 and an upgraded rating soon after.

But now it will be in the first quarter of 2024 that the external debt restructuring negotiations will be completed. So far the bondholder negotiations are not complete. That’s one of the key reasons why the interest rates are holding at the current level. At least, that’s what we believe. So, once the debt is restructured we are looking at a steep dip in interest rates, similar to what we saw when the proposals for the domestic debt restructuring were announced.

As soon as the government security interest rates fall below the overall yield curve, the 13% mark, we feel the foreign fund flow will start to the equity market. We’ve already seen this in September 2023, when most investors were selling their bond holdings and transferring money into equity portfolios.

With the delay in the first tranche of the IMF package, we saw interest rates spike up to as much as 15%, and the whole yield curve moved. Now, it’s slowly declining with the progress happening on the debt front. That slowness is what’s prolonging the uncertainty. We are hopeful that the external debt restructuring negotiations will be completed during the first quarter and that will lead to a drastic drop in the yield curve, which will give rise to a positive outlook for equity.

Meepagala: I think taxation will also play a huge role because equity is a tax-positive asset class at the moment. Capital gains are tax-free, whereas fixed income is taxed at 13%.

Tissera:We do say that the political uncertainty is negative for overall long-term investments, but in Sri Lanka, in the run-up to elections, we’ve always seen very positive returns on equity. There’s a reason for that, the higher government expenditure in the lead-up to elections.

Now, compared to the last couple of years, we have a massive capital expenditure planned and that expenditure might start in post-April 2024, when elections are closer, which will help money circulation and that will lead to higher earnings. Lower interest rates, business activity happening and the government pumping cash for development projects will drive an improvement in earnings. At least, until elections, things are likely to be very positive for the equity market.

So, how should one approach asset allocation in this period? If you had two choices, fixed income and equity, what would your advice be? Should they take a short-term view?

Mathew: If you take the asset allocation, with less room for interest rates to decline, if you have an allocation to fixed income, you should start going short-term. Because during the mid to long-term, you’ll see rates rising. Of course, we recommend a significant increase in asset allocation to equity. Obviously, a lot of people don’t invest 100% into equity. They would like a fixed income component that generates continuous cash inflow. So, I would suggest the fixed income allocation be reduced to 40% and allocate 60% to equity.

Does it look like reality has settled in somewhat in the last few months because the external debt negotiations haven’t gone as smoothly as anticipated?

Meepagala:As a fund manager, asset allocation is a critical call. At least in the first quarter of 2024, both asset allocation and stock selection are going to be critical. We will go for a 60-40 allocation where 60% is fixed income. We recommend taking in bond gains and going short-term with that asset class because money market rates are still higher than 15%. We are not saying go into all types of corporate debt but only high-quality debt, because some companies are still impacted by the economic crisis.

We feel local consumption is going to be a little weak, so we will not expose ourselves too much to consumer stocks. But we are quite positive about listed export companies due to the global economic recovery. In the banking sector, we are cherry-picking. We like banks that are ROE-focused and not only showing profit growth with provision reversals. We prefer banks with robust core banking operations. In tourism, we like conglomerates which are exposed to tourism and maybe some of the good hotels.

Tissera: If I were advising clients on multiple asset classes, which I am not, I would have still increased the equity exposure two months ago. But I think it is the element of uncertainty and the fact that the June and September quarter earnings were below consensus was one of the bigger issues for equity. Banks are a large part of the market capitalization. The quality of banking earnings has been lower because it comes from reversals of provisions made last year. In 2024 I would expect NIMs (net interest margins) to be broader and interest rates to come down. We are looking at about 5% asset growth from the banking sector and much better asset quality going forward. The stage three provisionings will be reversed so that is good news for asset quality going forward for banks.

Just for context, the historic four-quarter PE is roughly where right now?

Mathew: So with the decline in earnings, trailing PEs have significantly moved up closer to around 12 times now. And so when you factor in the 20% earnings growth we are looking at somewhere closer to 10 times PE which is not too cheap.

The outlook for Sri Lanka, should we manage to get the restructuring done, will lead to sustainable earnings growth. That will re-rate the market.

As far as equity is concerned we are very positive on the banks. We think that’s going to be the big thing for 2024 in the equity market so we are recommending going big on the banking sector. The second opportunity is the tourism sector. We are very positive about the tourism sector and particularly the hotels that have a large capacity of rooms. As soon as you go higher than 60% to 70% occupancy, you see a massive jump in profitability. And finally, I would like to say we are also gradually becoming positive about consumer stocks. Maybe the liquor segment and maybe Hemas where you have the consumer element. But obviously, my first two preferences would be banking and tourism.

So you suggested roughly a 60% allocation to equity and 40% to fixed income. When you say you will go heavy into banking, what does that mean? Half of your equity portfolio in financial services?

Mathew: Probably half going into financial services, then 25% going into tourism and then I would want to move into more blue chip counters as well as some dividend-yielding counters like Chevron and CTC.

Once we achieve the rating upgrade, there’s likely to be a further increase in foreign interest. We are already seeing a good amount of foreigners investing in the market, especially in companies like John Keells Holdings. Beyond that, we think they will move into the banking sector because there’s plenty of liquidity there.

 

Bhimanee, you’re a bit more conservative at least compared to Dimantha. You are suggesting 40% exposure to equity. Let’s talk about that exposure. You broadly outline some sectors, but if you can narrow it down a little for us?

Meepagala: If you time the market well, given that you have a solid base of fixed-income returns, that portfolio could generate very good returns. Markets now are a little jittery, particularly the consumption stocks where higher taxes have, especially on the hard liquor side, resulted in volume drops.

Export sector stocks have not been doing well at least in the last couple of quarters, particularly MGT despite a good couple of quarters in earnings. So you should be able to cherry-pick some of the export stocks because the global economy is recovering and the currency is expected to modestly depreciate, so that’s going to help.

So help us cherry-pick a few. There’s MGT, which has had two good quarters of earnings growth. What else?

Meepagala: At MGT the orders are picking up but that stock hasn’t moved up.

The AWPLR (average weighted prime lending rate) is down from 26% to about 12%. So companies who have really geared balance sheets with good operations will have massive savings. For example, Hayleys. If you look at their balance sheet, the finance cost savings are going to be huge. So those types of counters are going to be quite good. So, it’s going to be a combination of the savings on interest costs, exports picking up, and rupee depreciation; all of that is going to help.

You also talked about banks with earnings growth from core operations versus provision reversals.

Meepagala: NTB has a unique model, and they’ve been able to deliver a really great ROE. It’s a smaller bank, but their delivery in terms of numbers, the management focus, all of that has been excellent. So that’s one of our top picks. Even banks like Sampath have relatively strong fundamental core business.

The other thing that fund managers will look out for are companies that will not require capital calls in the near term, banks need recapitalization.

Nikitha, you outlined some broad opportunities. Will you help us narrow some of those down?

Tissera: I agree that we need to look at export sector stocks favourably because just like in 2020 we know that the local economy isn’t going to outperform the turnaround in the US or EU. The consensus on Wall Street is that the Fed will cut rates two to three times in 2024. You’re probably looking at some money coming into emerging markets as a result.

We’ve also made a trading call on selected plantation companies. Obviously, this is a highly cyclical industry and in the past, the weather and the increasing prices have made some plantations look particularly attractive. Palm oil companies have been the pick of plantation stocks because they are the least labour-intensive and are the least likely to be affected by cost increases following wage negotiations. With the talk of a palm oil plantation ban being reversed, I think palm oil companies are at the forefront. But this isn’t a buy-and-hold call. This is more of a trading play in the short term.

Very quickly about tourism. Do any companies strike you as being more attractive than others?

Tissera: I like companies like Keells Hotels. In addition to their exposure in Sri Lanka, they’re present in the Maldives, not at the resort level but at a more affordable price. I think that’s one of the better tourism exposures to get your hands on at a very attractive valuation.

There was far more optimism about consumer-related stocks six months ago and we had the impact of the high taxes. Suddenly it looks like consumer stocks are not as much in favour as they were six months ago.

Mathew: We’ve not been too positive on consumer stocks because GDP growth was forecast to be slow; 3% to 4% growth is not very attractive. We were more positive on service-related stocks. Right now, we think you should go big into banks. We are very positive on the bigger banks, Commercial, HNB, Sampath, and of course, NTB where the NPL levels are pretty low. I forgot to mention the apparel sector that Bhimanee has pointed out already. We are very positive about Teejay and MGT. In addition with the significant fall in Hela, we think that’s also a good option.

Now, the problem with tourism is in the market, the liquidity levels are not that great so if you’re parking a lot of money, you may have some issues. Banks, the apparel segment, and consumer stocks are places where you can make significant investments. In terms of consumer stocks Ceylon Cold Stores, Ceylon Tobacco and maybe Hemas are the ones we are very positive about.

You’re at 10% to 15% for market-wide earnings growth, do you feel banks, consumer stocks and possibly tourism will outpace that?

Tissera: Definitely. So four sectors, banks, apparel and textile, tourism, and consumer; those four sectors we think are going to drive the earnings growth.

Meepagala: Sri Lanka’s market isn’t always logical. Sometimes you have good fundamentals, but still, the stock doesn’t move.

What do you think are the catalytic events that will jolt the market?

Meepagala: For a broad-based rally, I think the sentiment and the positivity need to kick in. So for example, our first hurdle will be the successful completion of the external debt restructuring followed by a rating revision. That’s going to be a huge positive. The IMF review comes in May 2024.

From the possible candidates for the presidential election, the market would be looking at real direction with economic policy. If they had the same type of attitude to reforms and the IMF programme, it would not lead to surprises in the equity market. There could be positivity with global oil prices coming down. Yes, there’s going to be the impact of the VAT increase. It’s all about perception. Sometimes markets will go ahead of earnings if the perception of things that we will deliver in 2025, and 2026 is positive.

Do you think, Nikita, that the external debt restructuring and the few things that will subsequently follow will be catalytic enough to jolt the market into a valuation revision? Or do current valuations reflect all this?

Tissera: The EDR (external debt restructuring) process is one big factor. I think the EDR by March 2024 is what the IMF is now expecting of us. Currently, China’s Exim Bank has agreed terms and China is expected to provide all information to the rest of the creditors and be as transparent as possible. The IMF expects us to be transparent with the country’s creditors and the private creditors. But this will be a long process and we can likely conclude these negotiations by March. So a slightly realistic target for the IMF’s third tranche would be June ‘24. If that expectation is built into the equity consensus, I think that would rerate the market.

What do you think are the black swan events that can lead to a rethink?

Mathew: So I’ll first tell you what our targets are and then go into the black swan events. Our target ASPI for this year (2023) was 12,000. The market peaked at 11,800 in September and started moving down due to the delay in all the external debt restructuring. For 2024, we have a target of 13,500, slightly down compared to our earlier because earnings were below forecast. So obviously we have a significant upside of about 25% from here on.

We think the biggest catalyst is going to be the decline in interest rates and there lies the black swan events, where if the external debt restructuring for some reason gets further delayed, then we are obviously going to see an impact.

Also, the other factors are SOE restructuring because one significant event is not sufficient to sustain the market. Even to sustain the economy the reform agenda needs to continue at pace because everything depends on the IMF programme which we cannot depart from because the economy can crash again.

Meepagala: One of the bigger black swan events is social unrest driven by the increase in taxes. The second is that external debt restructuring gets pushed further and we have to keep relying on local markets. Will it then prove that the local debt restructuring wasn’t deep enough? Is the local debt restructuring and what was done with regard to superannuation funds going to be sufficient? If this uncertainty emerges it’s going to be a huge concern for all markets. The third is essentially how geopolitics will play out. We know India will have elections in 2024.

Any final thoughts?

Meepagala: Fixed income is going to still be a very solid base for a portfolio. How you plan a switch from fixed income to equity has to be part of the portfolio strategy. It’s going to be an interesting year and a tricky one as well. I think, with asset allocation and stock selection, you have to be on the ball to make money because as much as you see positivity coming through there is also the potential for trigger events that could change course.

Mathew: I feel that with elections likely scheduled for the second half of the year the government or the president is likely to stick to the reforms. External debt restructuring will likely be delayed. My advice to investors is to take the risk and be bullish on equity. We are very positive that during the first quarter or the first half of the year, there are likely to be strong market returns.

Tissera: I think 2024 is the year that we’ll see some attention from the global funds again after we conclude the EDR. For me, that is June 2024 and that coincides with the middle of the interest rate downward movement cycle in the US. I think we would attract frontier-focused funds back in. And in my view, most large foreign investors haven’t made money in Sri Lanka because they wait until things are “safe here”. I think local investors should move in quickly.