Escalation of the Middle East conflict may spell fresh macro concerns for Pakistan

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Iran’s unprecedented drone/missile attacks on Israel on Saturday (13 April) may have raised the risk of a wider regional conflict in the Middle East. The attacks, however, were reportedly telegraphed by Iran and largely intercepted by Israel (limited damage). Still, any further retaliatory exchanges between the two countries would worsen the disruption of shipping routes through the region and thus lift global freights – in turn leading to higher commodity prices in the coming months.

Any further escalation will check the rally in Pakistan market nonetheless

From the Pakistan market’s standpoint, we think that an escalated conflict will test two key expectations that have driven the YTD rally (KSE-100 up 13%): the start of monetary easing by April/June 2024, and optimism about Pakistan negotiating with the IMF for another program. On the flipside, the market will draw comfort from the prospect of fresh bilateral assistance and investments from Saudi Arabia (a Saudi delegation is due to visit Pakistan on 15-16 April) and the receipt of final tranche of the SBA program (c.US$1.1bn) by end-April. We advocate overweighing large caps with high dividend yields. Our top picks are UBL, HBL, OGDC, POL, FFC, HUBC, SYS, LUCK, INDU and ILP.

Global shipping costs and commodity prices are likely to rise

Even in case of a de-escalation of the conflict, it threatens to worsen the disruption of shipping routes through the region (similar to that through the Red Sea). There is an increased risk of the following in the near term. 

§ Surge in global oil prices toward US$100/bbl. The Red Sea disruption since November 2023, along with the extension of OPEC+ supply cuts, has lifted Brent from US$78/bbl at the start of 2024 to US$90/bbl presently, despite a weak global economic recovery.

§ Surge in the global shipping costs, through elevated insurance premiums on shipments through the region.

§ Global food prices could also rise, because of the rise in shipping costs and higher fertilizer prices, which the region exports. Food exports from South Asia (such as rice from India and Pakistan) to the rest of the world could be disrupted as well.

§ Potential delay in the start of interest rate cuts by the US Fed could lead to a resurgence in borrowing costs in the global credit market.

Inflation and CA balance could be at risk

An escalated conflict will have negative implications for Pakistan’s CA balance and inflation. In a scenario where global prices of crude oil, chemicals and food commodities rise by 10% in the coming months, Pakistan’s trade and CA deficit could expand by USD200-300mn per month. It is also likely that, in an escalated conflict, Pakistan’s exports and remittances may shrink, due to a disruption in shipping routes and economic concerns in the GCC, respectively. Together these could spell a reversal in the PKR-USD exchange rate which has been stable around 280 since the start of year. Note that, as per the SBP, Pakistan has a funding gap of around US$3bn until June 2024, excluding the US$1bn Eurobond repaid on 12 April.

Our base-case (Scenario A) for average CPI for May-Dec 2024, based on PKR-USD of 295-300 by end-December 2024, is 16%. Scenario B: if commodity prices rise by 10% and remain elevated and PKR-USD stands around 315 by end of 2024, our estimate of average CPI over May-Dec 2024 rises by 1ppt to 17%. In both cases, real interest rates on a forward 12mth basis remain positive. In Scenario B, the SBP is likely to delay the start of monetary easing to 2H2024. 

Favor large caps with high dividend yields

The KSE-100 index has risen c.13% CY24TD, which has been backed by optimism about monetary easing and Pakistan’s entry into another IMF program. In light of elevated geopolitical risks and a potential rebound in inflation in Pakistan, we advise overweighing large cap sectors (banks, energy and fertilizers) against the cyclical ones (cement, steel, pharma and autos). Our top picks are UBL, HBL, OGDC, POL, FFC, HUBC, SYS, LUCK, INDU and ILP.

Courtesy – IMS Research

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