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Fundamentals strengthening, growth remains key – First Capital Research

Daily Mirror | 16.07.2018

Recap of recommendations of January 2018 and review of 1H2018

First Capital Research expected the yield curve to be upward trending 1Q-3Q2018 with an acceleration in the uptrend towards 3Q amidst bunching of debt maturities during 3Q2018.

The unexpected election results in Feb, saw an early surge in yields across the curve in Mar 2018 with lower investor confidence levels. Following the USD 2.5Bn sovereign bond some stability was seen during Apr 2018. However, business confidence dropped to a 70-month low in Apr 2018.

Investor confidence affected by political uncertainty

More elections on the cards: upcoming Provincial Council elections and Presidential polls are likely to be major deterrents for mid to long term investments as investors would be concerned about long term policy consistency.

Economic outlook to slowly improve

GDP growth for 2018E downgraded to 4.5%: 1Q2018 GDP growth of 3.2% was below expectations. Similarly, 2Q is also likely to be slow amidst business confidence levels falling to a 70-month low. However, we expect a gradual pickup in business activity and consumer demand during 2H2018 with an accelerated GDP growth towards 4Q2018. First Capital Research downgraded 2018E GDP growth to 4.5% (previous 5.1%) but remains positive on uptick in growth specifically during 2H2018. A further acceleration is expected in 2019E with a GDP growth target of 5.0%.

Foreign Reserves jumps back up, but so does imports: The USD 2.5Bn Sovereign Bond resulted in reserves convalescing to USD 9.2Bn by Jun 2018. Despite large outflows, final payment of USD 0.5Bn for Hambantota Port deal and syndicated loan of USD 1.0Bn are likely to assist reserves to remain above USD 9.0Bn by end 2018. However, growing imports resulted in an increased minimum reserve amount required (4 months of imports) to USD 8.0Bn. Further foreign reserve accumulation need to continue amidst the continuous rise in foreign debt payments (large sovereign bond repayment 1Q & 2Q 2019) & BoT deficit.

Debt repayment cover improves: Rise in Foreign Reserves further lowered the foreign currency debt repayment cover to 1.3x of Foreign Reserves. The strengthening of reserves improved the foreign currency repayment cover at a time, when the next 12 months is having the highest level of foreign debt payments before overall debt levels start to ease off.

High level of maturities coming up in 3Q2018 and 1Q2019

Beyond 1H2019 overall debt payments to ease off with less bunching off of debt while debt to GDP levels are likely to be on a downtrend: CBSL has so far been successful in rolling over most of the debt and spreading them over a period to prevent any bunching of debt in the future and also reducing the cost of debt at the same time. We expect Debt to GDP to reduce to 76.5% in 2018E while any SoE selloffs (such as Hyatt or Hilton) and PPPs for Mattala Airport works off the ratio is likely further dip below 76.0%.

Liquidity may improve towards 4Q: In line with our expectations in Jan 2018 through “First Capital Strategy Report 2018”, we experience a liquidity shortage towards 3Q and ease off towards 4Q2018, but low level of liquidity of LKR 20-50Bn is likely during 1H2019.

Higher base effect in 2017 may result in low point to point inflation in 2H2018: Due to higher base effect, point to point Inflation may illustrate a drastic reduction from Oct 2018 – Jan 2019 amidst heavy food shortages witnessed last year. Overall the index is expected to be between 3.2%-6.6% during the next 12 months. The average annual rate for 2018E is likely to be 4.0% while it’s expected to increase to 5.3% in 2019E

Credit to remain steady at 15%: First Capital Research expects private sector credit growth to pick up towards 2H2018 signifying a steady growth of 15% while a moderate 16% in 2019E.

External environment

Global Growth and South Asia Growth is positive: IMF upgraded its Global growth forecast in Jan 2018 to 3.9% for 2018 & 2019. Emerging and developing Asia will grow strongly at around 6.5% over 2018–19, broadly at the same pace as in 2017.

Funds flows are towards US is negative for Sri Lanka: Higher growth across the world is likely to create significant competition for capital and investments which is negative for Sri Lanka. Further the rising global yields supported by further Fed rate hikes have resulted in global funds flowing towards the US.

Overall impact is Neutral: Despite rising global yields the improving macro conditions neutralizes the overall outlook for Sri Lanka unless reform agenda is reversed.

First Capital recommendations Bond market: Bullish

We expect the yield curve in Government securities to peak during 3Q2018, followed by a slow downtrend. Thereby, from bearishness at the start of 2018, we are now bullish on bonds beyond 3Q2018. We believe 1Y, 5Y & 10Y trade within the bands of 9.0%-10.0%, 10.0%-11.0% & 10.5%-11.5%.

Banking rates: AWPLR may decline to 10.0%

Banking rates which has a 6-month lag effect to 5 Year Bond is likely experience less volatility over the next 12 months while a further slow dip in AWPLR to 10.0% is expected. In a more broader sense during the next 12 months (Jul 2018-Jun 2019), we expect AWPLR to broadly stay within the band of 10.0% – 11.0%.

Exchange rate: 2018E Exchange Rate target downgraded to LKR161.0 while 2Q2019E is likely to reach LKR164.5

With 4 fed rate hikes on the cards over next 12 months, a stronger dollar is more likely, thereby we downgrade our exchange rate target from Rs. 159 to Rs. 161 : 1USD for end 2018 and target Rs. 164.5 : 1USD over next 12 months upto Jun 2019. Dollar index is expected to remain strong over the next 12 months while with continued reforms inflows into Sri Lanka debt and equity capital markets are likely with the attractive yields. Further Sri Lanka moves into the peak season of exports Sep-Mar. We expect more stability in the rupee in 2H2018, but downgrade our target to LKR161.

Equity Market: Bullish

We expect market returns to be stronger despite slower earnings growth outlook of 5-7%. Healthy valuations may warrant a rerating of the market providing returns of 13% market return over the next 6 months while targeting 15% return for 2019E supported by accelerating earnings growth to 10-12%

Business confidence and consumer demand to normalise in 2H2018

With stable interest rates and low inflation, we expect the stability of the economy to further improve during 2018. The stable environment is expected to slowly improve business confidence and consumer demand towards 2H2018.

We believe business confidence and consumer demand are currently below average and they are expected to normalize during the period. However, the prevailing policy uncertainty created through the political uncertainty is a major deterrent which may slow down the gradual improvement.