The economy and its stock market don’t always march in lockstep. In 2021, stocks broke multiple records despite Sri Lanka’s economic troubles. Markets do a far better job at price discovery than bureaucrats or politicians. While stock prices were market-determined, companies had to deal with interventions in several other crucial markets including those for foreign exchange, interest rates and commodities.

As a result, portfolio managers had to account for several more variables than they have been used to in the past. On top of this Sri Lanka has been struggling to service its foreign currency debt adding another possible scenario to consider for 2022.

This year’s investment panel discussing portfolio allocation included Lakshini Fernando of Asia Securities, Sanjeeva Fernando of CT CLSA and Udeeshan Jonas of Capital Alliance, all equity analysts who closely track the economy. This discussion was conducted in late 2021.

Can we start with opening comments?

Lakshini Fernando: There are both positives and negatives going into 2022. But it looks like the negatives outweigh the positives.

We must give credit where it’s due, and the vaccination drive in Sri Lanka has been quite good with over 60% of the population vaccinated and booster shots being administered. That was the need of the hour during the pandemic and the government’s taken that up.

Tourism has picked up faster than expected and it looks like December 2021 will end quite strong. Overall, where economic activity and momentum are concerned, given where the vaccination drive is and so on, it’s difficult to see complete lockdowns into 2022. You will see economic momentum on an upward trend in the first quarter.

But there are dark clouds. First, is the external debt repayment schedule. There’s $1.6 billion in reserves and $5.4 billion of repayments, so where that will come from is the question. The Central Bank road map at the end of October forecast $2.6 billion inflows. Timing is key.

What’s going to happen with repayments? Is the IMF in or out? I don’t see a default at play next year but there has to be some restructuring.

Udeeshan Jonas: This year’s biggest concern is external debt repayments. Sri Lanka is down to about $1.5 billion in reserves. Debt repayments are about $4.5 billion, of which roughly $1.5 billion are sovereign debt repayments. At the moment, there aren’t sufficient inflows to meet this requirement.

Although the Central Bank has a road map in place, we haven’t seen much of it materializing. The main issue is that it’s not a one-off problem. There’s the $4.5-$5 billion debt repayment for the next three to four years, so a short-term plan is not adequate. We need structural changes. Now is the time to do that, to put Sri Lanka back on track for steady economic growth.

From a monetary policy perspective, interest rates have been in the low-single digits. The central bank has printed an unprecedented amount of money, around Rs 1.4 trillion. This led to interest rates declining and inflation rising.

Although supply-side constraints have raised inflation, the demand side is also weighing in. Money printing is now contributing to inflation. Inflation was 9.9% (November 2021). We see inflation continuing to rise in the next few months.

The Central Bank may tighten monetary policy and has already started the process. In August, rates were raised by 100 basis points and the SRR was increased.

Globally too, that seems to be the phenomenon especially with the US indicating the Fed will start tapering from November, lowering its bond-buying program from $120 billion to zero in a couple of months. This could mean a tighter monetary policy stance for the next 12-24 months.

Sanjeewa Fernando: We face a challenging environment; essentially for debt repayments. There are development bonds to be paid, immediate near-term and interest payments coming up, and inflation is on the rise. Money printing is exerting price pressures.

There isn’t demand pressures right now, with credit growth falling to around 13% from as high as 15% in August 2021 after Central Bank policy tightening. But liquidity of the financial system is falling. In the first half of next year, banks will raise deposit rates to compete for deposits. That may also mean interest rates continue to rise.

There are three exchange rates right now: an official rate of 203, a grey market rate of 233, which is 15% down, and a black market rate, that always existed, but not at these levels. Because of the dollar shortage, most companies tap into these markets.

If sovereign debt needs restructuring, there will be impairments or a requirement of new capital for some financial institutions. According to some rating agencies, a restructuring could mean a sovereign default, so credit rating downgrades may also happen.

If the international sovereign bonds (ISBs) or commercial debt that Sri Lanka holds needs restructuring, what can it mean for the credit rating?

Udeeshan: By July 2022, there is a $1 billion ISB to be repaid. So there are two options: default or talk to the IMF. If the IMF feels that the debt is sustainable, we might be able able to secure an EFF (Extended Fund Facility) of around $2.5 billion and because of the IMF coming in, the credibility might allow bilateral lenders to give more loans. That is the best possible option right now.

If the IMF does not think that the debt is sustainable and that the primary deficits cannot be reversed with fiscal reforms, a debt restructuring might be required, which means imposing haircuts on foreign currency bond holders, or a postponement of payments. It could be a mix of both, like what we’ve seen in some countries recently.

When you’re forecasting for 2022, how do you work this in?

Lakshini: This has been one of the toughest years to forecast, which is why we went on a scenario basis. From where we are right now, the government has two options: go to the IMF or manage on its own.

The government seems to want to manage on its own. But some funding it had forecast seems delayed.

How we’ve gone about it is by asking, what will the scenario be if the IMF comes in? Or what will the scenario be if the government tries to manage this entire situation on its own, in six months, which is a harder route to take.

Liquidity tends to inflate asset prices, so what impact has the level of liquidity seen in the last year had on assets, particularly on equity?

Sanjeewa: There are essentially three investible asset markets in Sri Lanka: fixed income, equity and property. Because rates were low the fixed income market did not attract investment. There was a notion that property was overvalued relative to prices seen in 2013 and 2014.

There’s been a lot of money printed, around Rs 1.4 trillion from the onset of Covid. In 2021, it’s around Rs 700-800 billion printed. GDP has not grown above 2018 levels. That means a lot of money is chasing behind a smaller production, which will lead to asset prices increases.

How much of the current asset prices is due to liquidity do you think? If in a debt workout there is significant interest rate tightening, what does that mean for asset prices?

Udeeshan: At the moment, most of the printed money has flown into inflation, and inflated equity too. Compared to one-and-a half years ago market cap has increased by about Rs2.5 trillion, which is equivalent to each person in the country having Rs 140,000.

Top companies have secured a large part of the liquidity, which is why they are doing well.

In the next 12 months, if the current situation continues, and the economy starts to recommence operations in full force, inflation can rise. But if the Central Bank starts increasing rates or pulling back the amount of money printing, equity markets might retreat.

This is the phenomenon that we expect not only in Sri Lanka but across the world. Even the S&P 500 is overinflated and global investment banks are expecting a reversal.

Lakshini: Let’s look at how markets work, they respond to expected corporate earnings. Take the manufacturing sector for example, where import controls have set the stage. In the absence of the IMF, at least in the first half of 2022, you’re looking at certain sectors continuing that momentum and spilling over to the equity market, because everyone’s looking at how to beat inflation; real returns are what matters.

Consider the key cycles – rates, inflation and currency. Positioning is going to be based on that. Equity markets may decline if the IMF does come in and puts in restrictions, but at least until it does, there’s more to go in terms of finding that real return.

Over the last year or so, the market index has doubled, approximately. What level of tightening will be required and how will that impact the index?

Sanjeewa: The stock market will be rebased from next year to be liquidity adjusted. But from a monetary tightening point of view, whether there may be interest rate hikes will be the question. Liquidity is drying up and banks will have to offer better deposit rates to attract liquidity.

Should there be IMF involvement and tightening of government spending, what impact will that have on assets?

Lakshini: Yes, assets will be impacted purely because current conditions are unsustainable. If reserves were stronger, I would say no, because then the government has some leeway.

Even if there is no IMF programme rates will have to rise. At the same time, the Central Bank has the imperative to support growth as well, so it can’t raise rates significantly. We expect rates to rise by at least 100 basis points in 2022. If the IMF comes in, it’s probably going to be more than that.

Udeeshan: I agree, but my view on policy rates might be higher: at least 100-150 basis points. In terms of withdrawing the printed money; it’s impossible to do overnight because we are funding the budget purely with domestic sources at the moment. It’s impossible to wipe off that liquidity even over six months. It will have to be gradual.

The import bill can also be clawed back with tighter monetary policy. Given that we don’t have the reserves in place to defend the currency, one way to tackle the import bill is through monetary policy.

Over the past couple of years, banks have traded at around 0.6 times book. That’s also because of the moratoriums, NPLs, and asset quality in general

–Lakshini Fernando

What do you think earnings growth was market-wide for in 2021?

Udeeshan: For 2021, last quarter earnings were up by about 45%. On a cumulative basis for the nine months, we’re looking at roughly 60-65% earnings growth. But this growth is not going to continue into 2022. By March 2022, you might see a slowdown. That’s also because of the higher base and consumers feeling wallet pressure.

The current earnings growth is also driven by pent-up demand from the last 12-14 months. People have been using their savings; they’ve been spending over the last six months or so.

What’s your earnings growth forecast for 2022?

Udeeshan: Earnings growth will be more or less flat. It’s difficult to pass on costs in this environment, so margins are going to take a beating.

Sanjeewa: Once you exclude the logistics sector, the best-case scenario will be high-single digits, or maybe a maximum of 15%. But if there’s a scenario of debt restructuring, impairments will come up, and asset writeoffs and so on will result in earnings being flat.

Lakshini: It’s on a scenario basis. If there is an IMF agreement, corporate taxes will rise; you will see some pain, which we didn’t see in 2021. Without the IMF, there may be more leeway. If import controls continue, some local companies would see an upside including dollar earning companies. There are positives and negatives. Earnings growth may be in the mid-single digits.

What is your forecast for earnings expectations in 2022?

Lakshini: More on the lines of it being in single digits because there are companies that will do well but others that will get hit. There are some winners out there.

Earnings growth will be more or less flat. It’s difficult to pass on costs in this environment, so margins are going to take a beating

– Udeeshan Jonas

What do you anticipate in terms of the budget deficit and the rupee?

Lakshini: Given where we are right now, there has to be a depreciation factored in; it’s difficult to see that not happening. Some of that depreciation may come in the first quarter of 2022, with a gradual depreciation taking place towards the rest of the year.

On that basis, the currency may hit at least 235 by end of 2022. But many factors have to be considered. With the IMF involved, it could be a steeper depreciation.

On the budget, I expected more tightening measures, especially to increase the revenue base because that’s where we’re struggling. I expected more taxation, because going into 2022, it is looking quite tough.

The government has been trying to reduce its expenditure and that’s a key positive. From where we are now, we’re forecasting economic growth of 4.5% for 2022. The budget deficit is at least going to be 10.5%.

Assuming the debt is restructured, where do you think the rupee will be?

Udeeshan: Irrespective of whether there’s a restructure or not, the rupee needs a correction. In November, remittances were down by over $300 million. Worker remittances are the largest component of Sri Lanka’s FX income. If you continue to lose that, that burden itself is about $3 billion. Having this parallel market doesn’t work, and we need to make that adjustment right away. So we’re looking at about 230-240 rupees to the dollar.

Most countries that have gone through a restructuring or potential default have seen significant depreciation of the currency just ahead.

Do you feel there is a credibility gap in the budget as it stands right now?

Udeeshan: The revenue measures were not sufficient. There are only two main tax sources the government will start targeting. It is looking at about an 8.8% deficit to GDP, but that was on account of a significant increase in public investment spending. The government will claw back public investment spending, like in the past. It’s been spending only about 50-60% of what it normally budgets for public investment. So even though revenue is less, the deficit will still be about 9.5%.

What sectors or companies are the most exposed to this macroeconomic challenge?

Lakshini: The pain points this year have been for companies that import their raw materials. Sourcing dollars and opening LCs has been challenging. Until the dollar liquidity sorts itself out and banks can open LCs, there will be sectors that are impacted.

Currency depreciation will impact those who import their raw materials because they’ll have to take a hit on the currency. I don’t think it’s an ‘if ’ but a ‘when’ the currency depreciates.

If the government continues to not have tight and difficult policies implemented, local investors will remain. If other asset classes don’t offer inflation-beating returns, there would be continued interest in the market

– Lakshini Fernando

Several extraordinary taxes were introduced in the budget including a 2.5% tax on revenue. What sort of impact will it have on the market?

Lakshini: It’s difficult to say because it’s not clear for corporates as to who will get taxed. They’re awaiting more details. The government expects to collect a colossal amount through this. It’s a one-off tax.

Udeeshan: It’s not stated clearly, but the government is looking to collect about Rs100 billion, as mentioned in the budget. We still don’t know whether banks have to pay the social security levy of 2.5% and the higher VAT. There are grey areas requiring clarification. The underlying fact is that it’s still not enough in terms of the amount of money.

Where do you think the impacts of the current macroeconomic challenges will be reflected in listed companies?

Sanjeewa: General consumer spending will be impacted because of price pressures. Any company that wants people to spend will face an impact. Financial institutions will figure out a way to pass this on to consumers.

The exchange rate will experience the biggest impact. If it doesn’t depreciate, there will be an illiquid market forcing companies to the black market. If it depreciates, the real impact will come through.

Several important market sectors, from financial services to consumers, are likely to be impacted by the storm clouds now gathering. How do you reconcile this with earnings growth you are forecasting for 2022?

Sanjeewa: Two aspects. The general consumer has not been impacted by increasing personal income taxes. But they will face an inflation tax. Both are taxes. You’re taxing corporates who made money, which is ok in a way. What you need to have is discipline, which is not there.

What are the chances that with an IMF program, VAT rates will have to increase from the present 8%?

Udeeshan: The turnover tax that was introduced is indirectly trying to achieve that. Looking at previous IMF programmes, when Ecuador went into a programme in 2020 for example, its VAT rates were increased by 3%. Especially in low middle-income countries, it’s easier to collect taxes through sales taxes like VAT.

More than charging direct taxes, if you want to raise revenue by say Rs 200-300 billion, it is the turnover related taxes like the VAT and social security levy that should be looked at. So these are highly probable.

So what sort of a rate increase do you anticipate will be required to be credible for an IMF program?

Udeeshan: VAT should move by at least 5% but it shouldn’t happen overnight. The IMF understands the phenomenon. In challenging times like this, you can’t expect economies to bear such a large hit overnight. It will most likely give a target to hit over a couple of years and that will be gradual. But you have to stick to that plan.

Lakshini: The IMF focuses on the fiscal number and government plan to reach that. Taxes will have to rise and fiscal consolidation take place if the IMF does come in. The tax increase will be gradual because the growth momentum needs to be sustained while fiscal consolidation takes place.

What will be the trigger point for the government to go to the IMF? In the absence of a credible plan, why do you think it’s still resisting this?

Sanjeewa: There’s $1.6 billion worth of reserves and of that, $400 million in gold. So how much can you spend? $1.2 billion. But in January, the day of the opening of parliament, there will be a $500 million sovereign bond payment.

Other factors are playing out as well, of remittances, falling and exports picking up. Imports will come into play on the other side. Which imports are going to be cut will be the question.

The exchange rate will experience the biggest impact. If it doesn’t depreciate, there will be an illiquid market forcing companies to the black market

– Sanjeewa Fernando

 Udeeshan: One reason why the government has been delaying going for an IMF programme or restructuring is that it is counting on bilateral funding. Second, is that the government also understands the consumer pressure with inflation being high.

There’s also one large source that is still not coming into the equation, which is tourism. From a longer-term perspective, there is a solution where you can take the $5 billion tourist earnings to $10 billion. But the issue is short-term liquidity.

There’s this bunching up of debt repayments, and there needs to be market access, which isn’t available right now. To facilitate market access, you need the likes of the IMF coming in.

Sanjeewa: The thinking of the government was probably that if it goes to the IMF, it would encounter conditions. Although bilateral funding is relatively expensive, it won’t involve these conditions, so the government can probably meet its political promises and keep taxes low. It’s essentially kicking the bucket down the road.

If you look at Sri Lanka, every government’s problem has been the next five years. We’ve not had a mechanism of governments being responsible for what they do after that. That’s where the problem lies. After 1978, a budget deficit target set by the government has never been met. It’s a matter of being responsible for what you say, which has not happened.

Many banks own significant chunks of sovereign dollar debt. How will they be impacted should there be a restructuring and a haircut on the debt?

Lakshini: If the IMF comes in and there is debt restructuring, a haircut is probably on the cards. There are different ways of doing this. It depends on what the borrower agrees to and puts forward, and what the macro fundamentals are at that point. Given where we are right now, a haircut is quite possible.

Sri Lankan bonds in the secondary market are maybe 65 cents to the dollar, indicating a 35% haircut. Should there be a 35% haircut? How does that translate into the valuations of banks?

Udeeshan: Banking sector valuations have been pricing this in. If you look at the haircuts, 35% is steep. Countries like Ecuador only had about a 9% haircut on their bonds when it restructured.

The problem is not the ISBs with banks but SLDBs (Sri Lanka Development Bonds), which were bought at fair value or face value. Most banks accumulated ISBs over the last two years at a steep discount. You don’t have to provide for large impairments on them. But the SLDB component will take a larger hit if it comes to haircuts.

Private banks have a reasonable capital buffer, but anything over 30% will result in some banks having capital calls, and having to raise equity and so on to manage it. But I don’t think we need a 35% haircut on bonds.

Banks are trading at 0.6 or 0.7 times book. Is it possible a haircut has been priced in? If not why banks are trading at a discount?

Sanjeewa: If you look at the recovery achieved, it should have been priced into the financial system, which has not happened. The reason probably is that investors still believe we may have to restructure debt, in the absence of a credible plan.

Lakshini: Over the past couple of years, banks have traded at around 0.6 times book. That’s also because of the moratoriums, NPLs, and asset quality in general. There is a concern, especially about large banks and what they’re holding. More than anything, it’s the cautionary stance investors are taking on banks, despite their earnings doing quite well.

What is the overall impact likely to be on consumer stocks?

Sanjeewa: You have price pressures playing out, so there will be wallet pressure continuing into 2022.

What are the big consumer stocks that we’re talking about here?

Sanjeewa: Retail companies like CCS, supermarkets, Cargills and so on. The other impact is pent-up demand; people may still want to consume certain items that they did not while working from home. If you look at December 2021 hotel bookings, they’re full of predominantly local tourists. That demand is going to be there on consumption as well.

Hydroelectricity generation is serving the economy well right now. But potentially, the monsoons will be over in several months and that’s about the time the bond payments become due. Is this a clear and present danger?

Udeeshan: There is a danger, but that will be a key priority for the government. Even if you allocate in dollars, the priority is going to be for energy and essentials. The government will likely secure credit lines from the Middle East or India for energy.

For the long term, renewable energy projects the government is talking about will come through. Investments to reduce FX pressure will also come in over the next few years.

Is there the potential that Sri Lanka’s friends – India or China – will step forward?

Udeeshan: One reason why the government has been delaying going for an IMF programme or restructuring is that it is counting on bilateral funding. Second, is that the government also understands the consumer pressure with inflation being high.

There’s also one large source that is still not coming into the equation, which is tourism. From a longer-term perspective, there is a solution where you can take the $5 billion tourist earnings to $10 billion. But the issue is short-term liquidity.

There’s this bunching up of debt repayments, and there needs to be market access, which isn’t available right now. To facilitate market access, you need the likes of the IMF coming in.

Sanjeewa: The thinking of the government was probably that if it goes to the IMF, it would encounter conditions. Although bilateral funding is relatively expensive, it won’t involve these conditions, so the government can probably meet its political promises and keep taxes low. It’s essentially kicking the bucket down the road.

If you look at Sri Lanka, every government’s problem has been the next five years. We’ve not had a mechanism of governments being responsible for what they do after that. That’s where the problem lies. After 1978, a budget deficit target set by the government has never been met. It’s a matter of being responsible for what you say, which has not happened.

Many banks own significant chunks of sovereign dollar debt. How will they be impacted should there be a restructuring and a haircut on the debt?

Lakshini: If the IMF comes in and there is debt restructuring, a haircut is probably on the cards. There are different ways of doing this. It depends on what the borrower agrees to and puts forward, and what the macro fundamentals are at that point. Given where we are right now, a haircut is quite possible.

Sri Lankan bonds in the secondary market are maybe 65 cents to the dollar, indicating a 35% haircut. Should there be a 35% haircut? How does that translate into the valuations of banks?

Udeeshan: Banking sector valuations have been pricing this in. If you look at the haircuts, 35% is steep. Countries like Ecuador only had about a 9% haircut on their bonds when it restructured.

The problem is not the ISBs with banks but SLDBs (Sri Lanka Development Bonds), which were bought at fair value or face value. Most banks accumulated ISBs over the last two years at a steep discount. You don’t have to provide for large impairments on them. But the SLDB component will take a larger hit if it comes to haircuts. Private banks have a reasonable capital buffer, but anything over 30% will result in some banks having capital calls, and having to raise equity and so on to manage it. But I don’t think we need a 35% haircut on bonds.

Banks are trading at 0.6 or 0.7 times book. Is it possible a haircut has been priced in? If not why banks are trading at a discount?

Sanjeewa: If you look at the recovery achieved, it should have been priced into the financial system, which has not happened. The reason probably is that investors still believe we may have to restructure debt, in the absence of a credible plan.

Lakshini: Over the past couple of years, banks have traded at around 0.6 times book. That’s also because of the moratoriums, NPLs, and asset quality in general. There is a concern, especially about large banks and what they’re holding. More than anything, it’s the cautionary stance investors are taking on banks, despite their earnings doing quite well.

What is the overall impact likely to be on consumer stocks?

Sanjeewa: You have price pressures playing out, so there will be wallet pressure continuing into 2022.

What are the big consumer stocks that we’re talking about here?

Sanjeewa: Retail companies like CCS, supermarkets, Cargills and so on. The other impact is pent-up demand; people may still want to consume certain items that they did not while working from home. If you look at December 2021 hotel bookings, they’re full of predominantly local tourists. That demand is going to be there on consumption as well.

Hydroelectricity generation is serving the economy well right now. But potentially, the monsoons will be over in several months and that’s about the time the bond payments become due. Is this a clear and present danger?

Udeeshan: There is a danger, but that will be a key priority for the government. Even if you allocate in dollars, the priority is going to be for energy and essentials. The government will likely secure credit lines from the Middle East or India for energy.

For the long term, renewable energy projects the government is talking about will come through. Investments to reduce FX pressure will also come in over the next few years.

If there were energy-related problems in 2022 what would be the impact on earnings of listed companies?

Lakshini: It’s going to have a massive impact. If factories can’t operate, how is a company going to function? In terms of dollar issues, the government has a priority list.

The rains have been a blessing in 2021 filling the hydro reservoirs and we didn’t have to import much coal.

I don’t factor in an energy crisis right now because the necessary funds would be allocated. Even if you look at global oil prices, analysts say prices are declining – and some expect it to come to about $66 a barrel levels, compared to the $75 in 2021.

Sanjeewa: There are countries where you’re allowed to only pump 1/3 of a tank at a fuel station even if you have the money. I don’t think allowing that kind of scenario will play out well, given the issues and invited crisis we already have with fertilizer, LP gas and so on. It’s a matter of limiting the damage, consolidating and moving forward.

It’s difficult to forecast where the stock market index will land. But do you anticipate the index declining next year because of the risks?

Sanjeewa: There was a lot of money printed and it had to go somewhere, and that was not to property or fixed income markets. Assuming rational and economically sensible behaviour, there can’t be more money printing.

Tightening monetary policy and higher interest rates will impact the stock market.

There’s an earnings slowdown also coming in. Sentiment is a factor that drives the market and much of it stems from earnings. When these slow down, the market will also decline.

Sentiment is driving the market up these days, we have the potential of debt restructuring and the impacts that will have across the economy. What do you think will happen with the index?

Udeeshan: In terms of the index, if the government and Central Bank delay the process of restructuring or sorting out the problem, the market is going to be inflated further.

It depends on timing and government action. If action is taken as soon or fast as possible, the market will retrace. It’ll be multiple negative factors hitting at one point, which is too much for the market to absorb in one go, especially in an overheated market.

If some funding line is obtained and the problem is passed on for another three to four months, the market will continue to move for that period.

By what level do you think it’ll come down or settle down by?

Udeeshan: It could even be a steep reduction of 25% or 30%, to also reflect the new taxes; that’s the kind of adjustment the market will need. The index has moved from 6,000 or 7,000, which is a more sustainable level, to 12,000. Somewhere around 9,000-10,000 is a more sustainable level.

But it depends because you can’t look at the index alone. After all, it has been rebased. Where low liquidity shares fall in the future, it will not impact the index as much.

Looking at the index today, do you think the market will decline next year?

Lakshini: It depends on the scenarios. If the government continues to not have tight and difficult policies implemented, local investors will remain. If other asset classes don’t offer inflation-beating returns, there would be continued interest in the market.

It’s difficult to gauge because the level of volatility in the ASPI will be less once the rebasing takes place given that all those illiquid stocks won’t impact the index so much. The volatility would be less.

If interest rates rise by 200 basis points, that’s 2% there will be a correction because the market is sentiment-driven. But it depends on what the adjusted ASPI would look like.

Is it possible to put a number on it?

Lakshini: It is a broad range. It’s difficult to say. Based on the ASPI in 2021, there’s got to be a correction. I wouldn’t put a number there but it’s a correction nonetheless. What’s key is that the volatility would be less from next year onwards and that is needed in the market right now.

Do you foresee public sector reforms next year that will impact asset prices?

Lakshini: They’ve already spoken about clamping state-owned enterprises. We saw that even in the budget. Public-private partnerships have to be encouraged a lot more. If certain state asset sales go through, that would be a key positive.

There is a positive correlation between inflation and property prices so with elevated inflation expected in the first half of 2022 property could be attractive as well.

In this climate, how do you start crafting portfolio strategy and mitigate the anticipated risks?

Udeeshan: There are two scenarios and it depends on how fast the government reacts. If the problem is dragged on, irrespective of which scenario takes place, the rupee will depreciate, so you still have an opportunity in the equity market especially on export companies. With 15-20% depreciation, companies that have a large part of their top line in dollars and costs in rupees will see a huge improvement in earnings, so export companies will be a good pick if you’re sticking to equities.

You can look at more defensive counters if we’re getting close to a cycle of restructuring. I’d also move my portfolio towards the real-estate investment if there is an opportunity, given that prices have not increased steeply. Land, completed buildings or any kind of commercial property will generate value given the inflation. It is a good inflation hedge and in countries that have experienced similar cycles, has been a segment that has outperformed in this environment. So investors should look at increasing their exposure to real estate. But it’s not an accessible asset for everyone.

The other asset class people can look at – and this is also limited to those who have the capacity – is private equity funds. You might shift from public to private equity investments, which means holding on to real investments. In a situation where inflation is increasing, you need to hold on to real assets. The ones you’re left with are real estate or private equity, which is a proxy for real estate.

So is there not much potential for fixed income in a portfolio next year?

Udeeshan: I wouldn’t ask people to lock in funds in fixed income right now. I will stay short. If I’m on fixed income, I will stay in the fixed income mutual funds.

That’s not many options. Looks like 2022 is a lean year?

Sanjeewa: The economic clock dictates that once the equity market crashes, the property market would pick up. So the thinking cannot be challenged.

In 2021, 60-70% of the market was driven by five to six stocks. When we refer to a correction, it shouldn’t happen to these artificially inflated assets. Except for one or two companies that had real fundamentals playing out, certain companies appreciated based on rumours, and once the minority shareholders get to know the reality of these companies, corrections will happen.

Whether it declines by 20% or 10% will depend on the liquidity adjusted factor on the new ASPI, which we don’t know. Now that it’s going to be adjusted for liquidity, these companies are illiquid, so once they crash, the market may not decline significantly.

It’s a smart move to not reduce the market index. But you may have to look at the real valuations because foreigners aren’t coming in right now as they are going to lose due to the lack of a fair valued currency. If you’re looking at a 20% or 25% downside for the currency, that means they’re losing that amount in their investment. Until that is fixed, Sri Lanka is not going to see foreign investors. Offering Rs 10 is not going to fix the problem. You have to address the issue to get investments in.

If you had to allocate money right now, what are the opportunities in equity?

Sanjeewa: A handful of companies rose and most did not appreciate. There are pending risks. If the government understands and fixes the problem, 20222 will be awesome.

Tightening monetary policy and higher interest rates will impact the stock market

– Sanjeewa Fernando

But they love to kick the bucket down the road. That has been the case concerning delaying IMF involvement. The IMF coming in will entail currency depreciation, having a more autonomous monetary policy and halting money printing, adopting a fuel pricing formula and an energy pricing strategy.

The IMF will support a plan, which will require the government to have more discipline. It will erode its political capital as it will essentially go against political promises.

Lakshini: I wouldn’t lock in my money but would go short-term. If you look at mutual funds and money market funds, some are quite attractive.

I would invest some in the market because there are opportunities in and undervalued companies with potential. I would put very little on fixed income. If there is an opportunity to buy physical commodities like gold, I would go in there. If you’re giving me enough money to buy property, I’ll do that as well.

If property were a difficult asset class to access for most people, which areas in equity have the potential to deploy capital right now?

Lakshini: Those that are going to do well in the middle of currency depreciation, so export-oriented stocks and companies that have rupee costs. Given that it’s an inflationary cycle, you would go into stocks that do well during high inflation times.

You would go into certain stocks that are defensive as well. No matter what happens in the economy, some stocks are solid and fundamentally strong. I would look at the long-term trajectory as well and lock in funds given their cheap valuations right now.

I wouldn’t lock in my money but would go short-term. If you look at mutual funds and money market funds, some are quite attractive

– Lakshini Fernando

There are companies in Sri Lanka – telcos or even conglomerates – that have foreign currency liabilities without significant foreign currency income, thus carrying a large forex risk. Do you anticipate telcos and even conglomerates taking a beating in earnings?

Udeeshan: Listed telcos have significantly reduced their FX liability over the last 24 months, anticipating this. So the depreciation impact of the recent past is not going to be there with telcos because they’ve built in dollar reserves to manage that situation.

Most conglomerates are in positive territory when it comes to rupee depreciation. Many of them have foreign assets. They have exposure to tourism for example, which is a sector that will do well.

Especially if there’s 15-20% depreciation, Sri Lanka will be a cheap destination, and that’s going to bring in a lot of money. The numbers coming in right now are encouraging. January to March forward bookings are at least 50% of the pre-Covid level. Tourism is a sector that can change Sri Lanka’s outlook in the long term.

Sanjeewa: Conglomerates with a tourism angle will recover. Casinos are also likely coming into play in 2022. That will be a positive for tourism-related companies and conglomerates as well.

Most telco companies have been reducing their external debt exposures. It has been the government that was not allowed them to repay their dollar liabilities in full, although they wanted to. There will be capex delays if there is a dollar crisis, which is out of these companies’ control.

Economic recovery will be positively correlated with the financial sector, especially the banks. Interest rate hikes may also mean their margins improve, so there will be a positive impact.

All this depends on how taxes are applied. We believe that the social security levy will be applied on the value-added, but if it is applied on revenue, it will be a completely different scenario. It won’t make economic sense. From a rational point of view, the sectors indicated will benefit.

Isn’t the absence of a credible macroeconomic recovery plan a big risk factor?

Udeeshan: It can buy some time through bilateral borrowings or swaps, which are all short-term in nature. But you can’t postpone it for a long time. Even tourism kicking in is not going to be overnight; it might be 2023- 24. So short-term liquidity is a concern and we don’t see anything material happening.

From a government perspective, there is nothing much it can do at the moment. It is doing whatever it can in terms of allowing market forces to determine prices. It might allow areas like gaming to come into operation, private parties setting up terminals and bringing foreign partners in for PPP projects. But the problem is the short term.

Sri Lanka’s problem can be solved. If we get through the next 12-24 months, we’ll be on a sound footing. With tourism and the ports kicking in, if we can put SOEs back into place by selling a few non-strategic ones, we will be in a good position.

Our economy is small; the potential that Sri Lanka has to grow is enormous. It just needs a corrective decision for the short term. We’ve seen countries going through this phase and 24 months down the line, they turn around. This is possible with Sri Lanka as well.

Lakshini: We expected 3Q 2021 earnings to be flat or even negative, but 4Q is where the numbers are going to be. You saw the resumption of activity and tourism pick up. Manufacturing and services sectors did quite well in the fourth quarter. The third quarter did have many restrictions on travel and tourism was badly hit, and that’s probably where the negative number came from.

The next 12-24 months are crucial. Short-term funding needs to be sorted out, in the absence of which, going to the IMF is inevitable. Could the government have done it without the IMF? If these funding lines came in and there wasn’t a further downgrade, yes. But given where we are, it’s very difficult.

That being said, the longer-term trajectory of Sri Lanka remains. It’s just that Covid hit, we couldn’t go to international markets, had a twin deficit and everything piled up, with tourism not continuing, which came from the Easter Sunday bombing. So it was many things that unravelled in the past two years.

It’s a matter of relooking at everything, tightening belts for what’s to come next year and looking further on to the long-term positives for Sri Lanka.

The 1.5% negative growth in 3q 2021 is also because of the base effect from the third quarter of the previous year, which was a good quarter

– Udeeshan Jonas

Udeeshan: The 1.5% negative growth in 3Q 2021 is also because of the base effect from the third quarter of the previous year, which was a good quarter. That’s also a reason why the numbers are not reflecting the improvements, but corporate earnings have been good for the third quarter.

Sanjeewa: If Omicron does not play a massive role and we are headed for recovery, tourism will take the baton. Until that time, the government may have to manage. That’s the silver lining. Managing the next 12 months, especially the the major issues, will be key.