WILL EQUITY’S RECOVERY HAVE WINGS?
Excerpts of the discussion are as follows:
What’s the macroeconomic outlook for 2020 heading into elections?
Samarasinghe: We are bullish on the economy. Growth will be around 5% in 2020; of course, this from a low base of about 2.5% estimated for 2019. It’s too early to for economic indicators to show an uptick. Neither are corporates investing in new projects right now. But, sentiment has changed for the positive.
The economy heads into 2020 after a slow down over the past three and a half years. It’s an election year with increased government spending, especially on state-sector salaries. This spending cycle could be offset by increased economic activity from the proposed tax cuts. There will be a wave of new investments from FDIs and heightened entrepreneurial activity.
I expect interest rates to remain at low levels; they are already at a 24-month low. This will generate demand for other asset classes like equity and property.
The positive sentiment prevailing throughout the year will depend on how the currency behaves. The economy can even weather a 100-200 basis points increase in interest rates due to improving sentiment and a pickup in growth. If the currency falls, then it would result in uncertainty and put pressure on inflation, interest rates and the Balance of Payments.
The rupee is stable for now but a lot will depend on how the government deficit will pan out given the tax cuts and increased spending. Will the government install spending cuts and collect enough revenue to offset the new tax breaks? That’s a critical question in my mind. The rupee is likely to depreciate leading up to the elections. The exchange rate is unlikely to cross the Rs200 per US dollar mark; that would be unwarranted.
Pressure will also come from a stable dollar and strengthening pound. The US Fed is not easing rates anymore and political stability is returning in the UK. If the government increases spending without restructuring or rescheduling debt, the rupee could weaken. If this happens, authorities will let interest rates increase to stabilise the rupee.
Gunawardane: 2020 will be a good year. I’m of the view that the government will be able to contain the budget deficit. The revenue loss from the new tax cuts will not be as bad as many believed at first glance. This is because there are some clawbacks within that restructure itself. Everyone’s focused on the revenue side of the fiscal equation, but the government has indicated a need to contain spending in achieving fiscal consolidation. There seems to be an effort led by the president to cut unnecessary expenditure so I have a feeling that they would take a long hard look at the cost side of the equation as well.
Sanderatne: The economy has a positive outlook, particularly from an equity investment perspective. There will be much better consumer demand conditions and a significant improvement in business confidence. I am less optimistic about the fiscal deficit. We will have to watch how foreign investors react to fiscal policies going forward because they had bought the story of fiscal consolidation. The government may claw back some of the tax cuts. There’s also a public sector wage hike which is positive, boosting consumption. What we have is a classic Sri Lankan economic cycle. There’s going to be an election and fiscal stimulus which one should consider as normal as far as economic cycles go in Sri Lanka. Just as it did in 2015, we will then see pressure building on interest rates and the currency; more on interest rates because there may be a political bias towards keeping the rupee stable. So, interest rates will remain steady in the first half of the year but will increase during the second half leading to 2021.
Jayatilake: The fiscal stimulus is probably the best choice in the current environment. The economy needs a jump-start. GDP growth reached an all-time low in 2019. The agriculture sector met forecasted growth while the industrial sector was down. The construction sub sector had a lacklustre period. The services sector took a huge hit after the Easter bombings. We expect the economy to rebound in 2020 to historically average levels of around 5.5%. Consumer spending will drive economic activity and businesses will see revenues improve. Indonesia recently moved to remove a deficit ceiling of 3.3% of GDP to stimulate its economy, so Sri Lanka is doing the right thing. The fiscal deficit will widen in the short term due to the new tax cuts, but it’s important to tighten fiscal policy once the stimulus has achieved its goal of reviving the economy. It’s important to keep interest rates at low levels but we will have to watch where business cycles, unemployment, inflation, fiscal deficits and balance of payments lead us. In the short term, positive sentiment and political stability will have a significant positive impact.
Abeyasinghe: The Central Bank has very clearly communicated its intent to keep interest rates low. This combined with the stimulus will give the economy a much-needed impetus, placing it on a growth trajectory over the next 12 months. The government needs to intelligibly communicate its strategy to manage the deficit, and make a compelling case. This will further uplift investor sentiment and augment foreign investor participation in the equities market. For me, it’s critical to keep an eye on supply-side factors so that the economy is not limited to consumption-driven growth but sustained in the long term with FDI. I believe the government is focusing on these areas if you look at the presidential election manifesto; there’s some attention to tech and the Fourth Industrial Revolution and what that means for the economy. Pushing those mandates through the medium term is key in terms of realising the country’s potential over the next three to five years. But in the short term, the next 12 months will be very positive.
What will asset allocations look like in 2020?
Abeyasinghe: We are at the beginning of an expansionary cycle of the economy which will feed into earnings of most listed companies. Equities will gain and now’s the right time to invest. Here’s an interesting fact. If you look at the market in ten-year blocks, there has never been a block since 1993 where equities were overall negative – the market has always had a positive return. The market will give you good returns and the cycle is now at a point of time primed to move. The consumer sector will take off. Banking valuations suggest a potential for much value creation. There are other sectors that will benefit from greater disposable incomes and spending power which will have a positive impact on earnings, which will feed into better returns on the equity market. Hence, equity allocations should pick up heading into 2020. On fixed-income assets, I would rather be short, only taking a position when rates pick up.
Sanderatne: Equity is in a much better position than it has been the previous year. We already see equities gaining some momentum so that’s an asset class we are more positive on. In Sri Lanka, listed stocks are not something we believe you should invest in for the very the long term; in other words, buy and hold for a long time. This is because of the sharp economic cycles that lead to sharp equity cycles. It is better to time asset allocation to buy into equity for a two to three-year view. You should also be willing and able to take risks. I say this because even though the outlook is good right now, sudden unexpected events tend to occur too often. This makes it difficult to predict how the economy and markets will play out. It’s critically important to understand investors’ risk tolerance, profiles and investment horizons before making any investment decisions. Right now, equities are attractive and poised for gains in the year ahead. The recommendation for fixed income assets is to stay short until rates pick up later in the year. But again, it depends on where the tax policy is heading. Very high net income individuals are now taxed at 18% on fixed income returns, compared to 5% final withholding tax earlier. We are relatively negative on property.
Gunawardane: I have to agree on equities’ outlook. We are bullish on stocks. If you look at some of the sectors, consumer-related companies have seen an earnings contraction of 25-30% over the last couple of years. Sri Lanka has a very sharp consumer cycle tied to our interest rates and election cycles. This time the consumer cycle was worse than before because of the drought situation a couple of years ago. We did see a turnaround with some of the consumer related companies reporting volume growth in early 2019. Then the Easter attacks reversed all that. We now see a natural pickup in consumption because of easing interest rates and of course, the tax stimulus. The Central Bank has had a very accommodative monetary policy stance. All these point to a sharp pick up in consumer activity in the early part of 2020. Banking sector valuations are still at 2009 levels. There are questions about the impact of the debt moratoriums for SMEs. Banks tend to go through NPL cycles. We saw this in 2014 where non-performing loans (NPLs) peaked in the first two quarters. There were also structural changes which impacted the performance of the banks from the new IFRS-9 based impairments and Basel III capital raises which are now done. When it comes to allocating assets for the long term one must keep in mind that Sri Lanka has very high real and nominal interest rates. When you are thinking of asset allocations for individuals that’s something to keep in mind.
Samarasinghe: Equity valuations have underperformed for far too long. Sri Lanka’s equity market valuations are attractive compared to most frontier markets. During the past 20 months, foreigners were investing in stocks. There’s been some foreign selling in recent weeks. This is only because they are booking profits. Foreign investor interest is robust given that valuations are still very attractive. We will likely see a wave of foreign inflows into equities after the elections. Corporate earnings’ growth prospects are strong. The equities market recovered in the third quarter ahead of expectations. Property is another growth asset. It’s only a matter of time before the Colombo Port City transforms the property market. On a broad perspective, listed corporate earnings we estimate will grow 14%. Companies in FMCGs, banking & finance and construction will drive the stock market up. Tourism will recover and boom, but the market may not reflect this. What we have listed are traditional hotels, for the most part. Unlisted boutique hotels and experienced-based tourism companies are the ones performing well. Looking at specific stocks, Access Engineering and Lanka Tiles will enjoy a construction boom. Tokyo Cement has already rallied, limiting upside potential. John Keells (JKH), Softlogic and Hemas will realize gains from considerable exposure to consumption. Nestle, the Renuka group and Ceylon Cold Stores are also attractive. JKH has significant property exposure. These aren’t performing well, but it’s a matter of time until its flagship Cinnamon Life project starts recognising revenue.
What are some of the opportunities institutional investors are looking at right now? Jayatilake: Sri Lanka needs to have everything in place to build business confidence. This is critical for local or foreign investors to invest in new businesses, expand or re-engineer existing models. Confidence will provide the initial boost to the economy. Thereafter, the ecosystem must remain conducive to continue the growth momentum. What I mean by the ecosystem is this: easy access to capital, manpower and technology. Post-elections we’re achieving the confidence factor. The rest is up to the entrepreneurs and corporates to work on. Corporates turned to fixed income assets to park excess cash during uncertain times. They will look beyond low-risk fixed income asset classes. Going forward, businesses will start to divert funds to business ventures to create more value and jobs. They will also look for new opportunities in mergers and acquisitions. They may even look at listed companies because multiples are very attractive now.
Does anyone have a view on real estate and property?
Samarasinghe: Property has always been a safe asset. Right now, there is an oversupply of apartments, but that could change. Colombo Port City, the outer circular highway and light rail will be a game-changer. The city will attract high-skilled migrants to live and work in Sri Lanka. There is foreign interest building up, notably from India and China. There will be a wave of Sri Lankan expats returning to the country. A growing middle-income segment is also investing in apartments and homes. The land bank’s limited size means that high rise living is the obvious next evolutionary step. There is a gamut of condominium properties outside the city because Colombo is too expensive.
Jayatilake: Real estate is an undervalued asset class, but rapid urbanisation will drive value. Businesses will begin to invest in property for industrial or commercial purposes; less so on apartments. Having said that, there are emerging opportunities for vertical living spaces both in and outside Colombo.
What are some of the risks that could dampen the favourable outlook for the economy and equities?
Sanderatne: External risks will be significant. We are increasingly dependent on global markets to finance deficits or raise capital. For instance, if the U.S. economy gets into a much more positive cycle, its interest rates could rise. Then, funds could exit emerging and frontier bonds and equity markets. This will also make it expensive to raise debt capital. At the same time, there are risks from unforeseen events in Sri Lanka.
Abeyasinghe: I believe 2019 was a case in point. The economy and business activity were picking up and then we all got blindsided by unfortunate events at Easter. The previous year there was the constitutional crisis no one saw coming.
Gunawardane: We are susceptible to fund flows for both debt and equities markets. Right now, emerging and frontier markets are looking good for the early part of 2020. This is partly driven by US bond yields easing. Funds are moving money away from negative yields in Europe. There’s been a reallocation by exchange-traded funds from US treasuries into US corporates. This indicates a risk-on environment at the moment. These funds could feed into emerging and frontier markets. At the moment, prospects look good for emerging and frontier markets. There is a favourable outlook for global trade but one tweet from President Trump could change all that!
Sanderatne: The negative interest rate cycle and pressure on the currency could rock equity’s boat. We also need to avoid any negative statements from the IMF or further downgrades from rating agencies. The government will need to effectively communicate its fiscal plans. Local investors might be confident that the government will manage things well and get things done. On the other hand, foreign investors don’t know that, nor can they understand that confidence. So it’s important to see how the leading actors of the economy, like the Central Bank Governor, for instance, will articulate Sri Lanka’s vision and purpose. Now that we have the political confidence and fiscal kick-start, the government shouldn’t attempt a monetary kick-start by lowering interest rates and pumping money into the system. This was what governments did in the past. Most people may want it, but that is exactly what will give us a bad report card from the IMF, or a cautious to negative rating outlook.
Samarasinghe: The frontier market selloff is not over, it’s still happening. The US is holding rates and the UK will get its act together, that is the expectation. Trump seems to have a stronger footing heading into elections. All this could exert some pressure on the currency. Foreigners have already booked profits in the recent equities rally. They will likely wait on the sidelines until the elections are over and a clear economic policy framework is in place. I agree, if the IMF makes a negative statement or one of the global rating agency makes a cautious call, it would place Sri Lanka in a tight corner.
Jayatilake: Any correlations between Sri Lanka and other emerging and frontier markets are weak. When these markets were doing well in 2017/18, Sri Lanka was stagnant. We were nowhere compared to emerging markets that returned 18-22%. Our equities market was in negative territory. However, I believe this will change. In the past, foreign investors drove the market but this time around it will be local investors who will come in at the top. Local institutional investors especially state-sector funds will return to the market.
Does anyone have a forecast for the exchange rate?
Sanderatne: In the second half of the year there will be more pressure on the currency. The cycle we have every five years will repeat but we hope it will be better managed unlike the recent sharp depreciation of the rupee which came out of the blue. Because of the fiscal stimulus and the fact we are in the expansionary cycle, the currency at a depreciation stage. We’re not going to have a stable currency. Later in the year, we expect interest rates to also pick up so it will be interesting to see how the new governor looks at all this.
Sri Lanka graduated to upper-middle-income status, its GDP crossed the $4,000 threshold in 2018. What evidence of this is manifest in the real world?
Gunawardane: I prefer to look at household income/expenditure rather than GDP per capita. We need to wait for the next survey results to come out get a sense of how this has changed over the last few years. A proxy for this may be to look at the modern trade versus general trade mix. Over the last 3-4 years, there’s been a massive growth in the number of supermarkets. Despite that growth, the general trade to modern trade mix hasn’t changed. This tells you that general trade has been growing at a much faster rate to keep up with the additional supermarkets that have come up. So this gives you an idea of how consumption has grown.
Jayatilake: Consumer and retail sectors have been stagnant and challenged over the past few years with household income enough to meet essentials. However, with economic growth household spending will improve. However, retail and consumer-related businesses cannot continue to depend on the local market. We keep staring at the same market size over and over again. The solution is to attract external consumers like expats and tourists to the island or take our businesses beyond borders. Bali attracts 10 million tourists and if we can attract those numbers it will uplift the entire economy. It makes business sense to look beyond 20 million people. This number will always be a limitation to the growth of any industry locally. We must look for bigger and untapped or underpenetrated markets to replicate our successful business models. We have done that in the garment industry, renewable energy and microfinance.
Abeyasinghe: Over the years there has been a definite change in lifestyles, be it how people get from one location to another, how we communicate with each other, the healthcare standards that we can experience or how and what we eat. I would say that a greater part of this change has been positive and is a direct result of the growth in per capita income. However, an aspect that requires greater focus and policy guidance in solving is the problem of inequitable distribution of income so that the benefits of economic growth filters down throughout society.
What excites you when you try to envision Sri Lanka three to five years from now?
Samarasinghe: Sri Lanka will take off if all goes well. Infrastructure will develop and FDIs will flow in, provided the government manages things well. There’s an immense opportunity from being at the doorstep of India which could become the second-largest economy in the world in a few decades.
Sanderatne: Sri Lanka will be more than a tourist hotspot but a lifestyle destination. With the existing infrastructure and offerings, tourism could grow 15-20% annually. However, a lifestyle destination is something high-potential that can elevate the entire economy. It doesn’t need a lot to establish. Existing infrastructure standards are a lot better than earlier and what we need is a focus on delivering services. I also believe Colombo can be more than a financial services hub. It can be a place to base operations from, to live and work. The elevated expressway and easy airport access will transform the city.
Jayatilake: There will be new opportunities for Sri Lanka. There are opportunities in healthcare medical tourism, if hospitals can acquire recognised accreditations. Elderly care is another growth sector with Sri Lanka’s population ageing rapidly. Health insurance penetration will increase from its current low levels. On-demand services on mobile apps are already gaining momentum with PickMe and Uber. Other businesses like banks can explore opportunities for themselves in this space. Artificial intelligence and big data analytics will transform industries and revolutionise customer experiences. Let’s not overlook the maritime sector. We have an exclusive maritime economic zone that’s ten times the country’s land area. There are opportunities in sustainable fishing, shipping and a host of other maritime related industries. I’d like to see a change in mindset when it comes to consistent policy. There are major policy changes every three years or so. This must change if we are serious about attracting FDIs and encouraging local industries to invest in expansion and create new jobs. The biggest problem businesses have is this: we need stable policies. If we can achieve policy certainty, now that would be a game changer. Sri Lanka also needs a change in attitude regarding talent. We need to encourage the world’s best talent to live and work here to realise growth potential. Investing in physical infrastructure alone is not going to get us where we want to go. We have to open up to the global talent. There aren’t enough graduates to fill vacancies in the tech industry so we need to attract the best talent from India, Taiwan or anywhere.
Sanderatne: This is where the mandate matters at the elections because the government can then push these reforms.
Gunawardane: The international financial centre slated for the Colombo Port City will be a game changer. We need to get that going with the appropriate legislation. We don’t have to reinvent the wheel but take a look at what Dubai or Singapore did. Singapore has legislation in place to make it easier for companies providing financial services to set up and operate. If we can get that going, and not just for financial services companies but other MNC to set up regional offices. Realising the financial centre’s potential will require structural changes. We need to make it easier for foreigners to live and work here and companies must be able to attract the talent they need. This would also lead to a reverse brain drain. I am also a big fan of the IT/BPO industry, having worked in the industry. The biggest problem we had was not the talent, which was of superior quality, but the numbers were lacking. There has to be a structural change in the education system to develop enough people with the appropriate skill set. Data scientists are in high demand, but the country does not produce enough statisticians at the moment. We could invite global educational institutes to set up here to develop the talent much like how CIMA and ACCA developed the accounting profession. The tech sector can offer better salaries and household incomes will rise. These are some of the long term structural needs over the next 5-10 years.
Abeyasinghe: Apart from tourism and the international financial centre in the Port City I believe tech is another exciting prospect for Sri Lanka, but we need to unlock that potential. Colombo is emerging as an attractive place for expats to live and work, so attracting the best talent to the tech industry shouldn’t be a problem. Coming back to investment opportunities, there’s an opportunity in the private equity side, especially in the tech-enabled space. I alluded to the Fourth Industrial Revolution, which will have a transformational impact on businesses from manufacturing, banking, retail and a host of others. Several startups and businesses are focusing on tech to enable growth and if institutions can find gems there to invest in there is potential for strong mid to long term returns. The more near term opportunity, however, is listed stocks.