PAK: Pakistan May Be Pulling Off A Monetary Miracle

Summary
The PAK Pakistan ETF is primarily tied to the volatile Pakistani rupee and secondarily to the country's equity market.

The equities in the fund remain extremely cheap and have boosted the ETF considerably in recent months.

For now, it appears that the Pakistan Central Bank's effort to keep interest rates far above inflation have been successful.

If rates are kept high, it is likely that the PKR/USD exchange rate will rise, which will reward ETF investors.

However, the country continues to take on external debt and is unable to raise appropriate tax revenue, which calls for active management on behalf of investors.

Back in August, I wrote "PAK: It May Be Cheap, But Cheap Can't Fix The Currency," which explained how the companies in the Global X Pakistan ETF (PAK) are extremely cheap but that the country's fiscal mismanagement created an extremely risky environment for the Pakistani rupee.

As explained in the previous article, a bet on PAK is more of a bet on the PKR than on the country's stock market, due to the extreme volatility of the currency and its many recent devaluations.

Take a look at how the currency has been the primary negative driver of the ETF since 2017:




(Source: Trading View)

You can also see that the recent gains in PAK are due not to currency appreciation but to a rise in the stock market. This begs the question: Is the currency going to follow the market higher and boost PAK? Or, is this yet another fakeout before a currency devaluation that pulls PAK back down. It is not certain, but recent data indicates the first option may be the most likely.

Fundamental Overview of PAK
I must confess that I was wrong about PAK in August. My thesis was that the ETF had strong deep-value fundamentals and sector positioning, but that the country's chronic inability to raise taxes would continue to spur currency devaluations. I still generally hold this belief. PAK has strong fundamentals, but now the currency makes for only an existential risk. If inflation continues to fall, currency risk will likely become currency rewards.


PAK is one of the cheapest ETFs available today with a weighted average P/E ratio of 7.25X and a weighted average P/B ratio of 1.01X. The typical stock in the fund is only $588 million, and being the largest public companies in the 200-million person country, they have a ton of growth potential. The ETF's 7.5% dividend yield is also a plus.

Take a look at the select fundamentals for the fund:



(Data Source: Uncle Stock)

As you can see, the typical company in the ETF has a slightly higher P/E because the bank stocks in the fund have higher valuations, which stem from higher revenue growth rates.

These companies are cheap, to say the least. They trade below their sales per share and very close to their book value. The median company is trading at a 50% price-to-sales discount. They also have low debt given how capital-intensive these industries are.

Speaking of which, here is the fund's sector breakdown by percent of total assets under management:



(Data Source: Global X)

As you can see, the fund has very high commodity exposure due to its large holdings in the petroleum and cement industries. The cement business is highly dependent on construction in Pakistan and India, which is likely to slow due to falling GDP growth in the region. That said, prices are low and long-run fundamentals are intact.

Regarding oil, I believe that now is a reasonable time to be bullish on energy. Oil is historically cheap today, and it appears that U.S. production growth is finally slowing, which should eventually get prices out of their current run.


Zooming Out

Importantly, cement and oil make up a very small portion of Pakistan's exports, which are dominated by linens and clothing. Global industrial manufacturing is slowing down, but retail spending is rising in the U.S. and most major importers. If the U.S. continues to place tariffs on China (which I expect more to come not less), Pakistan clothing exports are likely to see further boosts and ideally continue to close the country's poor balance of trade and possibly the PKR.

As you can see below, the falling balance of trade has been the primary culprit causing a current account deficit in the country:



(Source: Trading Economics)

Of course, the current account deficit has a direct negative impact on the exchange rate and promotes inflation, both of which are bad for PAK's price. However, since the trade war began in mid-2018, Pakistan's balance of trade is rising, and its current account is likely to reach positive territory by mid-2020 if it continues to rise at the current pace.

The currency will also almost certainly rise if the Central Bank of Pakistan keeps the discount rate at its current level. The large current account deficit, poor FX reserves, and chronic fiscal deficit spurred a large spike in inflation, which has been the primary negative driver of the PKR. However, the bank has raised rates to a staggering 13.5% to combat the current 11% inflation rate:

Note, inflation is shown on the left axis and interest rate on the right.



(Source: Trading Economics)

This large real interest rate gives the currency huge carry trade potential, particularly considering today's negative real interest rates.

The current central bank positioning is akin to Paul Volcker's in 1979 during the last period of high inflation in the U.S.: raise interest rates as high as possible to keep inflation and protect the currency. Importantly, this policy helped cause the U.S. dollar index to double in value from 1979 to 1986. A similar result could occur in Pakistan.

That said, the Pakistani government is in a difficult situation. They run a deadly fiscal deficit of about 5-7% of GDP, backed mostly by external debt from the U.S. and now China, that cannot be inflated away.

Due to structural inefficiencies, the Pakistani government is unable to collect the true amount of tax revenue it's owed, though, after nearly running out of FX reserves earlier this year, it is taking more aggressive measures to raise cash. Given how tax increases in emerging markets have been causing mass protests lately, I have my doubts this effort will succeed as much as the IMF wants to believe.

Bottom Line
Despite the recent 30% rise in the Pakistani stock market, the monetary situation in the country remains precarious. If the government cannot collect enough revenue, it will struggle to make external debt payments, which would likely result in further declines to the currency.

This is a major risk, but I actually believe the worst may now be behind Pakistan. If they maintain their high interest rate policy, the currency will likely raise and lower the real value of the country's external debt. Of course, doing so will stifle economic growth temporarily, but seigniorage is an indirect way the government can return to fiscal stability while it looks to increase tax revenue. This would also be great for investors in PAK, as they would likely gain from both currency and equity appreciation simultaneously.

I give PAK a "Buy" rating, but caution that active management is still necessary. If the country's FX reserves begin to trend lower or if its central bank makes large rate cuts, it is probably best to sell PAK, as a currency devaluation could follow.


The country also has high geopolitical risk. They have made an effort to grow economic ties to Western countries, but are now moving closer to China. If they get wrapped into the U.S.-China trade dispute, it could be dangerous for the country's economy. Investors also need to monitor the growing tensions between India and Pakistan.

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