With yields declining and stocks  going up, does it still make sense to invest?

For three years, much of what investors saw were ‘negative’ headlines about Pakistan’s stock market. Words such as steep decline, bloodbath etc weren’t as rare as one would hope. However, in the last year, tides have turned, and despite reaching record highs, the PSX is expected to continue its stride upwards.

There is now an ongoing shift from fixed income to equities, driven by declining yields and a favorable macroeconomic environment, which is shaping up to be a defining trend in Pakistan’s investment landscape. With robust inflows into the stock market, the outlook for equities remains positive.

What has happened to yields over 12 months?

Over the past year, yields on fixed-income securities have nearly halved. The 12-month yield on Pakistan government securities has dropped to 13% from 23% a year ago.

The significant decline in fixed-income yields over the past 12 months — and the likelihood of further interest rate cuts — could continue to drive investors toward equities. As yields remain low and inflation eases, equities may become an even more attractive option for those seeking better returns.

If the central bank’s Monetary Policy Committee cuts rates further in December, the shift from fixed income to equities may accelerate.

In the month leading up to the November 4 central bank meeting, yields saw a sharp drop of 350 basis points (bps). Market participants had expected a 200-250bps cut in the discount rate, but money market yields were signaling a more aggressive reduction. Additionally, the State Bank of Pakistan’s decision to buy back Market Treasury Bills (MTBs) further depressed secondary market yields.

How will they fare in the future?

The decline in yields is likely to continue. With inflation trending lower and a more favorable external economic outlook, yields could move even further down. Nukta projects November inflation to clock in at 4.6%, with the average inflation for fiscal year 2024-25 (FY25) forecasted to be 7.8%.

The State Bank of Pakistan, which is set to meet again on December 16, is expected to lower the discount rate by another 100-150bps, bringing the rate to 13.5% or 14%. Nukta expects another 200bps cut in the second half of the current fiscal year (January to June 2025).

If the forecasted rate cut materializes on Dec 16, the interest rate will be at a 28-month low and would likely keep fixed-income yields low, making them less attractive to investors. This could lead to additional shifts from fixed income to equities as investors seek higher returns in the stock market.

Interest in the Pakistan Stock Exchange is already high. Data from October indicates a significant increase in net buying of equities by mutual funds, with a total of $68.5 million in net inflows — marking the highest level since April 2018, when net buying reached $72.9 million.

On the sectoral front, oil and gas exploration and marketing companies have been key contributors to this surge in equity investment. Stocks of oil and gas exploration companies alone accounted for $18.7 million of the total equity net buying, while oil marketing companies contributed $10.2 million.

This sectoral shift can be attributed to a combination of attractive valuations and a favorable government stance towards the energy sector, which includes a focus on structural reforms aimed at boosting energy production and distribution efficiency.

Notably, this trend has continued into November, with equity purchases of $24 million in just the first 12 days of the month. If this pace continues, November’s net buying could reach $60 million, bringing the total net buying over the last three months, including November, to a significant $170 million, which would be the highest in many years.

The influx of funds into equities is driven by both fresh equity flows and the conversion of fixed income investments into equities.

PSX — the star of the show

Equities have significantly outpaced other asset classes, delivering 19% returns during the first five months of the current fiscal year 2024-25 (FY25) and 50% returns since January. This strong performance has helped to solidify investor confidence and fueled the ongoing equity buying spree.

What's driving this upward trajectory?

Several factors have contributed to the rising investor enthusiasm for equities. These same factors will also continue to drive the KSE-100’s performance in the upcoming months.

• Declining inflation: A sustained decrease in inflation is improving purchasing power and creating a more favorable environment for growth.
• Sharp reduction in rates: Interest rates have been significantly reduced, and further cuts are expected, which would lower borrowing costs and encourage investment.
• Real interest rates in double digits: Despite falling nominal rates, real interest rates were in double digits for two months and are expected to again be in that range in the coming months, making equities more attractive compared to fixed-income instruments.
• Declining yields: Yields on one-year government securities in the secondary market have fallen to 13%, while yields on the one year Islamic bond (Sukuk) have fallen to around 11%, signaling reduced risk and more favorable conditions for investing in stocks.
• High dividend yields: Strong companies in the KSE-100 are still offering dividend yields of 14-15%, providing a steady income stream for investors.
• Consistent earnings growth: Corporate earnings have been resilient and shown promising growth of average 24% annually over the last five years, while surging by 43% in 2023, providing solid support for stock valuations.
• Attractive valuations: Price-to-earnings (P/E) ratios are still below 2008 levels, suggesting that stocks remain undervalued relative to their historical performance.

However, despite the KSE-100 being such an attractive option, mutual funds' equity assets under management (AUMs) have been stalled for years.

Equity assets stalled at 2016 levels

The mutual fund industry’s assets under management (AUM) surpassed PKR 3.1 trillion in September this year, up from PKR 2.8 trillion in August. However, equity assets remain a small portion of the total AUM, accounting for just 8%, or PKR 215 billion, as of September. This marks a significant decline from 48% of total AUM, or PKR 275 billion, in December 2016.

While total AUM has grown significantly over the past eight years — from PKR 576 billion in 2016 to PKR 3.1 trillion in 2024 — equity assets have essentially stalled, even declining slightly over the period. In fact, despite the overall growth in the mutual fund industry, equity assets have not kept pace and remain at levels similar to 2016.

Assuming total AUM remained flat at PKR 3.1 trillion through October, equity assets have increased to PKR 235 billion, or about 8% of total AUM. Despite this modest increase, equity assets remain a relatively small share of the mutual fund industry’s total assets, highlighting the continued limited appetite for equities in Pakistan’s mutual fund market.

Top 5 asset management companies' investment in equities

Equity funds managed by the top five asset management companies in Pakistan grew by more than 75% year-on-year, reaching PKR 128 billion in September. This increase reflects a significant shift toward equities among the country’s leading asset managers.

Is the stocks euphoria over?

The PSX’s benchmark KSE-100 index has recently crossed the 94,000 level, marking a notable return of over 100% since the start of the year CY23TD. The PSX has delivered a 54.5% return in CY23 and 50% in CY24 till date, prompting some to question whether the index has become too high to invest in at this point.

Rather than focusing solely on the index level, it’s more useful to assess the market from a valuation perspective. Despite the impressive gains, there are still strong reasons to believe that the market has further room for growth, such as the drivers that propelled the index to this level in the first place, which were mentioned earlier.

Room for further valuation upside

One of the key factors supporting this outlook is the significant valuation gap between the earnings yield and the 12-month PKR yield, which currently stands at 11%. Historically, this gap has ranged from 2% to 4%.

The sizable divergence suggests that there is still substantial room for the market to appreciate as this gap closes. If earnings yields were to decline even by 20%, the KSE-100 index could rise to 112,000. Additionally, if the valuation gap reverts to its historical range, the index could potentially top 150,000.

Given the current valuation metrics, the stock market still has considerable upside potential, even at current levels. Investors should look beyond the index level itself and focus on the underlying valuations, which suggest that the market could continue to rise in the coming months.

Focus on drivers instead of index itself

The true potential of the stock market is better understood through a broader view of its underlying fundamentals, not just the index level. It’s high time for analysts and investors to shift their attention from the index to the key economic drivers that are sustaining market growth.

By focusing on these solid fundamentals, investors can avoid creating unnecessary concerns and more accurately gauge the market’s future potential. The market’s future is shaped by these underlying economic factors such as declining inflation, low interest rates, strong dividend yields, and consistent earnings growth and not merely by where the index stands today.

The easy ride in the stock market has largely been realized, and investors must now be more selective. While the “free ride” may be over, all is not lost.

There are still opportunities in undervalued stocks with strong fundamentals, but careful analysis and a more discerning approach will be key going forward.

As Warren Buffet said, don’t rent stock, invest in business. Additionally, the stock market is a device of transferring wealth from the impatient to patient, so investors should put their money into the right stocks and be patient.

Disclaimer:This article in no way represents investment advice from Nukta. Readers are encouraged to do their own research to form an opinion.