Incompetent economic management and arrogance landed Sri Lanka in an unprecedented crisis in 2022. Besides the universal hardship, it caused people the resulting currency collapse and inflation, the crisis decimated investment portfolios too. Assets across the board were impacted but the hit on financial assets, fixed-income and equity, was fierce. Over time, real estate would adjust for the effects of inflation.
Investors are now beginning to appreciate how they might navigate and rebuild their portfolios eroded by inflation, high interest rates, a collapse in consumption and the looming impact of restructuring Sri Lanka’s commercial debt. To help untangle how these will impact assets Echelon hosted a round table discussion featuring Trisha Peries, Head of Research at CAL, Sanjeeva Fernando, Executive Director of Research at CT CLSA and Dimantha Mathew, Head of Research at First Capital.
They discussed the impacts of the commercial debt restructuring and how they would weigh on economic factors and shared their forecasts for 2023. Excerpts of the discussion are as follows:
How market interest rates will behave will possibly be the most important factor impacting asset prices in 2023. What do you think are the economic factors that will weigh on interest rates in 2023?
Mathew: By the third quarter of 2023, we are likely to have single-digit inflation. With the economy gaining some relative stability after interest rates were raised we’re expecting inflation will fall significantly. Another area to watch is market liquidity. Three months ago market liquidity was negative Rs600 billion, by mid-December 2022, the liquidity short in the market was Rs200 billion. Through the reverse repo, the central bank is reducing liquidity, and credit has already contracted.
Private sector credit has been contracting consistently now for several months. What do you think will happen with credit in 2023?
Mathew: GDP will contract between 4% to 6% in 2023 on top of the 9% to 12% contraction we forecast for 2022. So, I expect credit to the private sector to shrink in the first half of 2023. It will recover in the second half ending the year with 2% credit growth.
Dimantha suggests the economy will contract by as much as 6% in 2023. What do you forecast?
Peries: My GDP growth forecast for 2023 is a little bit more positive, albeit still negative. I think the economy will contract by 2% in 2023. The single biggest factor impacting growth will be the restructuring of Sri Lanka’s commercial debt and how it progresses; its timing and how soon Sri Lanka can reach an IMF board-level agreement.
If, somehow, an IMF board-level agreement is secured in the first quarter of the year, that significantly improves our growth prospects for the rest of 2023, because we can probably attract greater foreign investment coming in and thing can stabilize sooner. A delayed agreement will constrain growth due to the lack of stability and confidence. Higher taxes from January will impact consumption. Business spending will also be impacted due to higher taxes on companies. On top of this, higher prices have added pressure too. So consumption will remain constrained. Higher taxes and interest rates and cost escalations will constrain private investment and credit. Even when interest rates do come off their present highs, they won’t decline to single-digit levels in 2023.
Public investment has been curtailed too. For over a decade now public infrastructure spending has contributed to economic expansion.
For growth what we are left with is anything from the external side; exports, minus imports, and any foreign investment. So our growth prospects will improve with an early IMF board-level agreement. The longer it takes the deeper the impact on the economy.
Whether Sri Lanka’s domestic debt will be restructured or not will be a significant consideration on interest rates. On what is supposed to be a risk-free investment, there is currently a 10-12% premium for the possible impact of the domestic debt restructuring
Dimantha your forecast for 2023 is far bleaker for the economy. What in addition to what Trisha says is weighing your forecast?
Mathew: The difference is private consumption, the single largest factor that’s going to weigh on GDP. I think, following a plunge in the level of private sector consumption, it’s difficult to reverse that spiral. I’m expecting an additional quarter in 2023 of negativity, that’s probably the reason for the difference. I’m expecting three-quarters of economic contraction and only one-quarter of growth.
If the economy indeed contracts sharply in 2023, Sri Lanka’s GDP would have shrunk by over 15% in a four-year period ending in 2023. What do you think will happen to GDP in 2023?
Fernando: Consumption has a multiplier effect and its decline will be the crucial factor. How soon we can obtain an IMF board-level approval will be crucial to determine if the economy will shrink by one per cent or four.
What is your expectation? Assuming, we have an IMF board-level agreement on support in the first quarter of 2023?
Fernando: A 3% contraction I think.
What do you anticipate will happen with interest rates? This will have a bearing on asset prices across the board?
Fernando: We had interest rates rise by 20% in 2022, AWPLR and 12-month t-bill. The risk premium attributable to Sri Lanka will fall dramatically when we secure an IMF agreement. As soon as that happens interest rates will probably fall by 3-4%. After that and the April new year period, inflation will decline due to the base effect impact. In the year interest rates might fall 50% or from the current 30% levels to 15% next year.
What is your interest rate forecast for the end of 2023?
Peries: Whether Sri Lanka’s domestic debt will be restructured or not will be a significant consideration on interest rates. On what is supposed to be a risk-free investment, there is currently a 10-12% premium for the possible impact of the domestic debt restructuring.
If and when there is certainty and confidence, that market holdings of domestic debt, the treasury bills and bonds, are not going to be restructured; that can significantly lower interest rates. Rates may fall by 20% immediately and by year-end, I would expect market rates to be between 15-20%
People and companies are constrained by interest rates? Is this enough to spark more consumption?
Peries: I don’t think it will change it very significantly. In a consumer’s mind 30% versus 20%, isn’t that different. The recency bias for single-digit interest rates that consumers were used to will prevail.
A domestic debt restructuring will shock the market. We have seen markets freezing after such an event is announced elsewhere in the world. However, once that risk premium is then removed from the interest rates, you see interest rates coming off. Overall, whether there’s a restructure or not, interest rates are going to be lower, but how much lower is going to be dependent on what happens with the restructure.
Do you anticipate a far steeper fall in interest rates?
Mathew: We have to consider the time horizons. The two that matter are post-IMF board-level agreement and post-domestic debt restructuring. Post IMF board approval, we are forecasting Treasury yields to fall below 25% and post domestic debt restructuring we forecast interest rates falling below 20%.
You talk of domestic debt restructuring as if it’s a foregone conclusion. We’ll leave out the T-bills, I don’t suppose that is going to face a restructuring. So we are talking about the Treasurybond stock, which is the larger part of the government’s domestic debt. Is restructuring the T-bonds, a reprofiling or haircut, a foregone conclusion? Can you discuss this?
Mathew: There’s only like a 20% probability that there’s going to be domestic debt restructuring because there are significant issues in doing so. In Sri Lanka the exposure of the banking sector to domestic debt is high. There are IMF white papers and research that advise against domestic debt restructuring. The IMF cites several countries where recent domestic debt restructuring has led to banking crises.
The markets do not agree with that view of a 20% probability of domestic debt restructuring. Market interest rates have spiked since the speculation of the domestic debt restructuring surfaced. Our discussion here takes place in mid-December 2022, and yesterday’s four-year bond auction saw yields at 33%. Why are your views different to how the market is pricing government debt?
Peries: There’s so much uncertainty right now and that’s how we can explain the pricing. There’s radio silence from the central bank. No one knows whether domestic debt restructuring is on the table in our discussions with external creditors. IMF’s research papers suggest the costs of domestic debt restructuring should not outweigh the benefits if that leads to financial system instability that impedes debt service down the line.
Over the last six to eight months there’s been an increase of Rs2.5 trillion in the government’s debt stock, which is being financed at 25-30%. If this continues the likelihood of it needing to be restructured grows. Consider that, with the depreciation, the share of foreign debt is now 55% of Sri Lanka’s total debt versus 45% in early 2022. But this balance can change if the government keeps increasing the local debt at the same pace. From December 2022 onwards, there are around a trillion rupees worth of local debt maturities which need to be refinanced and that is happening at 30%. So Sri Lanka is adding Rs300 billion of high-cost debt every month to replace maturing debt. How long can this be sustained?
A domestic debt restructuring will shock the market. We have seen markets freezing after such an event is announced elsewhere in the world. However, once that risk premium is then removed from the interest rates, you see interest rates coming off
Isn’t this enough reason for a domestic debt restructuring?
Peries: The reason not to restructure is purely due to its impact on financial system stability. Otherwise, if your debtto-GDP ratio needs to be on a downward trend, you can achieve that with an external debt restructure. Our gross financing needs are the challenge. We are raising so much high-cost debt now.
Can Sri Lanka adjust interest rates fast enough to avoid a domestic debt restructuring? Is that the choice it’s facing?
Fernando: The government is already repaying Sri Lanka Development Bonds (or SLDBs, a foreign currency-denominated debt security issued under Sri Lankan law and classified as domestic debt) to banks, by printing rupees.
The banking system has made a 20% provision on their outstanding SLDBs, except for one or two banks which have made high single-digit provisions for possible losses. Since April 2022, the government has been honouring SLDBs in rupee payments.
When it comes to international sovereign bonds, most of the top big banks have provisioned around 30%, and some mid-sized banks have made 25% provisions. Just to give you another perspective, a Pakistani bank that had invested in Sri Lanka’s international sovereign bonds has provisioned 40% already.
I think our sovereign bonds are trading at some 30 cents to the dollar. So there is a disconnect, both in domestic debt and in Sri Lanka’s foreign commercial debt, about what the market thinks will happen?
Fernando: We cannot do a haircut on the principal outstanding on domestic debt, without sending the banking system into a deep five to seven-year crisis. Then you have maturity extensions and coupon reductions, as options. A maturity extension would be the only feasible option for the banks, but from the converse view, we add on to your debt.
The President indicated in July 2023, that he will print a trillion rupees. By now (mid-December 2022) we have printed around half that. So there is another half to go. The government must be clear about the possible paths available.
My understanding is, there are four areas in the economy that are going to be reformed; trade, and fiscal reforms, which include tax reforms, state-owned enterprises and the overall efficiency of the economy. These reforms could unlock significant benefits. These reforms have always been featured in our programmes with the IMF. We have had 16 IMF programmes and if you look at the last four, reforming the CPC, our higher than the emerging market average para tariffs etcetera, have all figured in those. So, are we going to do things differently this time?
Can anyone explain why the markets think differently as far as pricing Sri Lanka’s foreign commercial debt or the rupee debt is concerned?
Mathew: There is a straightforward explanation. Three or four months ago, market interest rates were settled at 20-21%. Then the President indicated that in the debt restructuring process, they are considering the local debt as well. At that time, this statement was a clear disconnect from what the central bank governor had been saying. As soon as you have policy uncertainty in any capital market, equity or debt, you see negative repercussions.
In equity between 2015 to 2019, there was a lot of political uncertainty, and despite the market earnings rising stock prices didn’t move appreciably. Here too, we saw interest rates significantly adjusting upwards as soon as those comments were made.
Let’s talk about the big asset class that you all analyze in that equity. Let’s talk about the impact on that asset class of interest rates and what is happening in the economy, and the demand situation. Shall we start with what you anticipate will happen with earnings in 2022? The results of the first three-quarters of earnings are known. What do you think will happen in 2022 and 23 with earnings?
Peries: Fourth quarter 2022/23 earnings are going to be quite negative if you compare it year on year. In 2021 earnings were rising and that rise continued to the first quarter of 2022. Overall in 2022 companies have been on a negative footing which will continue into the first quarter of 2023. In nominal terms, due to inflation, we’ve seen companies reporting rising earnings. But margins are being squeezed, including by higher finance costs and higher taxation. They’ve all revised prices, although there have been volume reductions across many segments. Nevertheless, they’ve been able to report positive results, particularly on an operating profit level. In 2023, we forecast an earnings growth of five to 10% year on year, but there’s going to be tremendous bottomline pressure.
The reason not to restructure is purely due to its impact on financial system stability. Otherwise, if your debt-to-GDP ratio needs to be on a downward trend, you can achieve that with an external debt restructure. Our gross financing needs are the challenge. We are raising so much high-cost debt now
Fernando: December 2022 quarter earnings growth will be relatively low, but overall growth will be 66% in the year. Because the first three quarters are good with inflation coming in and no earnings being inflated with money printing. In 2021 earnings growth was also 96%, that’s our forecast adding a slight growth for the fourth quarter. I’m forecasting around 23% for 2023 because some money printing is going to continue as indicated so far. In this year’s 66% rise, exchange gains played a role.
Not many companies would be exposed to exchange rate gains because there are not many export firms listed.
Fernando: I don’t agree. Banks made massive gains. But most of those gains were used up in provisioning. Of course, the companies carrying dollar debt reported exchange losses.
These earnings gains have been achieved mostly on the back of higher prices, versus greater volume. If somebody suggests that companies have weathered this crisis well because earnings are rising; is that a fair assessment?
Fernando: Look at the amount of money printed, since the onset of Covid, from March 2020 to date, it’s close to 2.5 trillion rupees. Where did all that money go? It has to go to some asset class. We have three asset classes, fixed-income, equity, and real estate.
If you think your fixed income was not giving you any return, and I’m talking about the Covid period when returns were 5%. During that time, all that printed money had to be invested in some asset and that asset was real estate. Companies also benefited, obviously.
When it comes to international sovereign bonds, most of the top big banks have provisioned around 30%, and some mid-sized banks have made 25% provisions. Just to give you another perspective, a Pakistani bank that had invested in Sri Lanka’s international sovereign bonds has provisioned 40% already
Dimantha, your earnings forecasts?
Mathew: We are more pessimistic. In 2022, we are forecasting 45% earnings growth and the bulk of that comes from the first couple of quarters with the exchange gain for companies like LOLC Group, and banks. The fourth quarter of ‘22 is going to be bad.
In 2023 we forecast earnings will be impacted by higher taxes. We’re forecasting earnings will shrink by 18% in 2023 and recover in 2024 with 20% growth. This is broadly in line with what we anticipate with GDP in 2023, where we forecast a contraction.
Inflation has resulted in a massive revenue escalation which contributed to higher profits and there were exchange gains for some companies on top of that. Trade volumes were declining only gradually. A significant portion of the money is now invested in fixedincome assets, and due to higher taxation disposable income is going to fall. The impact of that is going to be manifest in the first half of 2023 resulting in shrinking earnings, overall, for listed companies.
Our bonds give fantastic yields. Even though all over the world interest rates are high, our bond yields are through the roof. Equity valuations too look attractive, considering they are trading at five times historical earnings. Once we have an IMF board-level agreement, will foreign investors be looking at Sri Lanka differently you think?
Peries: I think foreign investors are looking at Sri Lanka a lot now, we’ve seen the interest building recently. A lot of them see Sri Lanka as being cheap. Of course, among them are vulture funds too that seek out crisis-ridden places. But serious money is looking at Sri Lanka for being cheap. They’re not ready to deploy money yet. There are a couple of reasons. They’re waiting for an IMF board-level agreement or some assurances on that front and they are anticipating that capital controls will be lifted so that they can move their money in and out. But foreigners are viewing Sri Lanka a lot more positively now.
The exchange rate risk is no longer there. You see this in countries that are restructuring their debt, the portfolio inflow starts flowing in the year of restructuring or during the year immediately after. Sri Lanka will see that trend as well. This foreign investment and portfolio flow too will contribute to GDP growth maybe towards the end of 2023 and the beginning of 2024.
Are you also that optimistic about foreign investment? What about fixed income?
Mathew: Yes. We’ve already seen foreign money coming into equity and debt. In the beginning, it will not flow in as FDI, but it’ll be hot money flowing into the capital markets; debt and equity capital market, starting in 2023. More money will probably flow into the fixed-income market because the interest rates at 30% are attractive.
Fernando: Other equity markets are trading at price-to-earnings ratios of 10 to 15 times while ours is at 4.9 times. It was trading at 13.6 times last year. There is a bargain here. You can buy a bank at 30% of its book value right now. During the peak in 2011, banks were trading at 2.8 times their book value. Even if banks can recover to trade at 1.5 times their book value, that’s a 500% gain.
Banks hold around 30% of outstanding treasury bonds. Does the pricing reflect that?
Fernando: Bank stock prices are down significantly, by maybe 50%.
Even before the crisis, banks were trading at 1x or lower than their book value.
Fernando: They traded at 2.5 to 2.8 times of book value in February 2011. That was the peak. Theoretically, economic books suggest you cannot sustain three times price-to-book for a balance sheet-based company. Even if you think of the average as 1.5x, we are at 0.3 times to book, now. So 1.5x is a 500% gain and even returning to 1x book is a 300% gain.
You all talked about a scenario where consumption is low in 2023, because of high taxation, inflation, and all other pressures. Potential investors too will feel this, not just consumers. The valuations are great. What do you think will play out in the market in 2023?
Mathew: Once an IMF programme is firmly in place there will be a re-rating of the market to a higher confidence level; for both fixed income and equity. We expect the All Share Index to reach 12,000 by the end of next year. Currently, it’s at about 8,800 (mid-December 2022). The second half of the year will see a faster rise than we expect in the first half of 2023.
It’s not going to be straight through Bull Run. Every now and again you’ll see a significant market decline. We think it’s going to be a volatile uptrend up to 12,000 ASPI. An IMF deal too will drive the market. But then it can come down again because of debt restructuring and its impact on banks.
Peries: Volatility is going to be the name of the game in 2023 too, similar to 2022. As much as everyone’s waiting for or looking for certainty, that’s not going to be available in this climate. It’s not simply that an IMF board-level agreement will offer certainty. There is an entire process, of negotiating the terms, and how is it going to hit the books of the banks and who else is exposed to it as well. That entire process typically takes one and a half years if you’re restructuring external as well as domestic debt restructuring. We are just beginning this.
December 2022 quarter earnings growth will be relatively low, but overall growth will be 66% in the year. Because the first three quarters are good with inflation coming in and no earnings being inflated with money printing. In 2021 earnings growth was also 96%, that’s our forecast adding a slight growth for the fourth quarter
It’s going to be a very volatile market, similar to what other countries have also experienced. In terms of investing, right now is a good time for long-term investment, because the market has possibly hit a bottom.
If you’re looking at equity allocations, you should allocate part of it to the long term, even including some banks, at these very cheap valuations. You see a lot of foreign investor favourites, trading at very cheap valuations.
Foreign investors’ favourites, like banks or JKH, are trading at very low multiples currently.
Fernando: You have to buy good companies with strict shareholders.
That hasn’t always worked in this market, right?
Fernando: When it’s dirt cheap, like this, you go for strategic stakes. You have lots of companies in this blue-chip segment that have converted their EBITDA into cash consistently. Be it JKH, Spence, CTC, Nestle, even Dialog, and plantations like Watawala. Those have continuously converted EBITDA into cash and during tough times you tend to prefer companies like that.
In 2023 we forecast earnings will be impacted by higher taxes. We’re forecasting earnings will shrink by 18% in 2023 and recover in 2024 with 20% growth. This is broadly in line with what we anticipate with GDP in 2023, where we forecast a contraction
You are making the point that equity is cheap right now. Help somebody understand this in terms of PE, and price to book. You’re forecasting earnings will dip in 2023 Dimantha. Are companies still cheap?
Mathew: Yes, on current multiples. We believe the market trades one year ahead. This means for next year’s consumption and taxes are priced in the market. Already the market is priced for next year’s dip, basically, the declines that are going to happen.
If you look at the 2023 end, what we are looking at is for the market to be trading for the growth that they are anticipating in 2024. That’s the primary reason why we are forecasting an ASPI level of 12,000. If you look at the longer term, most companies have raised prices and now with the tight monetary policy volumes will decline.
Now, what’s going to happen in the future? We think the economy has bottomed out. We think we are going into the recovery phase probably from the first quarter of 2023 onwards. Over the next two to three years, we are going to have buying power coming back into the consumer
In the future, a company selling the same set of goods will be earning double the profit. As we restore consumers’ buying power, the market can also double in a reasonable period of time because of the overall re-rating
They say the stock market is a good hedge against inflation. Why do they say that? Because everything re-prices: revenues double, costs double and technically profits double. A company’s market capitalisation should also double with that.
Dimantha talks about the market pricing in a dip in earnings in 2023. You forecast earnings growth in 2023. We’ll assume that the market has priced that in. What do you think will happen towards the end of the year in the market?
Fernando: In 2021, the market went up by 80%. Around 70% of that gain was centred around five companies. LOLC Group and Expo. When you have those kinds of runs, that fundamental analysts are reluctant to promote, it’s very difficult to give a number. We might as well start throwing darts to guess.
None of you is in the business of giving investment advice directly. But assume you’re talking to somebody with a portfolio. How do you strategize between these two asset classes?
Mathew: Fixed-income investments are significantly attractive because you can invest, not do anything, to earn 30%. We think that’s where the bulk of your money needs to go. In three and a half years you double your money. Even in spite of the risk of rupee debt restructuring, we think that an investor should take that risk. You can take out 10% for debt restructuring, yet you still have 20% plus return. We haven’t seen such high interest rates in the history of this country barring a period in 2008. That’s also 20%, not 30%.
We think 80% of your portfolio should be fixed-income, and maybe 20% of the portfolio should be equity. As an asset class equity will struggle in the face of such high interest rates when companies are struggling to grow profitability.
In equity, your portfolio needs to be in defensive stocks. We are very positive about the energy sector and hotel sector. With the recovery expected next year, the food, beverage and tobacco sector should do well. Once debt restructuring is done probably invest in the banking sector.
I think foreign investors are looking at Sri Lanka a lot now, we’ve seen the interest building recently. A lot of them see Sri Lanka as being cheap. Of course, among them are vulture funds too that seek out crisis-ridden places. But serious money is looking at Sri Lanka for being cheap. They’re not ready to deploy money yet
Peries: I would allocate 60% of the portfolio to fixed income mostly to treasury bills. There are several global examples where in the event of domestic debt restructuring, short-term treasuries have not been restructured. So that’s a safe bet, given their 30% return right now. So 40% on bills and 20% on longterm bonds. There is the risk of debt restructuring impacting long-term bonds. Even in the event of haircuts, there are many examples where individuals have been excluded from being restructured. So that you could still get 30% for a 10-year bond. That’s an amazing return to sit on for the next 10 years.
The rest of your portfolio would go into equities. In equity allocate 30% to long-term strategic stakes, and 10% to trading plays. There is money to be made in trading due to the volatility. That’s the overall allocation.
In terms of sectors, the ones that have stood the test of time, the defensive stocks, the big conglomerates, and the favourites of foreign investors are options. The next run is going to be driven by foreign investments into the market, so you want to be positioned for that. I think some dollar revenue-exposed companies are cheap due to the prospect of a global recession. But there is recovery at the end of it. So I think you buy them now and hold them for the global recovery that we’d hopefully see in two to three years. That’s where I would position myself.
Fernando: Let’s go 50-50: fixed income and equity. In equity, the beneficiaries will be companies that trade in fixed income; they will start gaining, and banks and fixed-income companies who are listed in the market will benefit. In consumption focused companies, margins will decline due to higher taxes and the reduction in disposable income, but their volumes will continue to grow. People are getting used to shopping at supermarkets and that benefits these companies.
Construction will face difficulties going forward whether that be aluminium, cement or tiles. But the leisure segment will be a beneficiary, although they have legacy issues, like debt. We are looking at occupancy reaching 45% for the December quarter, and hitting 55% by the end of 2023. So the growth will be encouraging. With this growth selling a strategic stake would be an easy thing.
The other aspect is resilient companies, companies that can convert EBITDA into cash regularly. Then you will have companies able to get a breather. Highly leveraged companies having a difficult time in 2022 getting a breather. Some of these companies have not even reported results because of the losses due to high leverage. Obviously, property companies operating on short-term borrowings, they too will stabilise and maybe takeoff, after some time.