Discount rate in focus as CPI dips to multi-year low

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Inflation statistics for FY13 are off to a positive start, with CPI for July 2012 clocking in at a belowexpected 9.6%YoY (two and a half year low and Pakistan’s first single digit inflation figure since December 2011). Benign CPI figure (a manifestation of lower gas and petroleum product prices) coupled with tangible improvement in Pak-US relations (post opening of the NATO supply route) and disbursement of US$1.1bn CSF flows has strengthened the market’s conviction on a potential discount rate (DR) cut when the SBP announces its Monetary Policy Statement on August 10, 2012. While expectations range from a 50-100bp cut in the policy rate from current level of 12%, we believe the KSE is factoring in at least a 50bp cut as the new base case. July 2012 CPI at two & half year low of 9.6% CPI for July 2012 clocked in at a below-expected 9.6%YoY; a two and a half year low and Pakistan’s first single digit inflation figure since December 2011 (c. 9.7%).

 

The number stands out positively vis-à-vis 11.3% CPI recorded in June 2012 and consensus outlook for a July reading of ~10.5%YoY. The benign CPI figure is a manifestation of (1) cut in domestic gas prices (to the tune of 4-52% where CPI statistic appears to lean more towards domestic gas price cut of 43% rather than overall gas price reduction of ~18%); (2) reduction in petroleum product prices (by 1-4%) in July 2012. With lower energy prices contributing the bulk of the softening of CPI, note that Non-Food Non- Energy (NFNE) inflation remains relatively unchanged; at 11.3% in July 2012 vs. 11.4% in June.

Setting the stage for a policy rate cut?

While July inflation was broadly expected to soften, (1) belowconsensus inflation number, coupled with (2) visible improvement in Pak-US relations (post opening of NATO supply route) and (3) disbursement of US$1.1bn CSF flows has strengthened the market’s conviction on a potential cut in the discount rate when the SBP announces its Monetary Policy Statement on August 10. Money market reaction points to the same conclusion, with PIB yields dipping by ~25bp and 6-mth T-bill down ~20bp yesterday. The same elicited a positive response from the KSE yesterday, with the index gaining ~140 pts (+0.96%). While expectations range from a 50-100bp cut in the policy rate from current 12%, we believe the KSE is factoring in at least a 50bp cut as the new base case.

Single-digit CPI appears tough to sustain

While July reading was benign, we believe single-digit CPI is unlikely to be sustainable, given (1) full extent of seasonal Ramadan food price hike does not likely reflect in the July statistics; (2) domestic petroleum product prices are ticking back up (raised 5-9% yesterday); and (3) early indications of a weak monsoon cross border (70-80% of normal) raise the risk of a drought-like situation where a weak harvest could manifest in higher food prices. It also suggests lower hydropower share in the electricity generation mix, impact of which would be an uptick in electricity tariff (Housing, Water, Electricity, Gas & Fuel have combined 29.41% CPI weight).

Bottom-line on Monetary Policy

We do not rule out a 50bp cut in the policy rate in the August 10 Monetary Policy Review. We flag persistent high government borrowing from the Central Bank (SBP) as the key risk factor which could be the policy rate party pooper.

Recall in its June 2012 MPS, State Bank flagged that: “Impact of SBP’s monetary policy…is less effective. The economy basically needs fundamental reforms to engineer a turnaround in economic performance….Inflation expectations cannot be effectively anchored around single digit targets without limiting fiscal borrowings from the banking system, particularly the SBP”

 KSE reaction to events

Judging from yesterday’s jubilation, a potential 50bp DR cut is all but in the bag as far as the KSE stands. From our vantage point, cause for further market excitement would likely only surface if the SBP pushes the boat all the way out with a 100bp cut. While the same may be a short term fix, we highlight (1) rate sensitive companies, including highly leveraged cements (top pick DGKC with 13% upside to our Rs53.6 Target Price); and Fatima Fertilizer (33% upside to our Rs33 Target Price) and (2) Yield plays like the quasi-bond IPPs (top pick Hubco with 15.9% FY13 D/Y and Rs48 Target Price) and FFC (2012E D/Y at 13.1% and Rs133 Target Price) have the most to gain. Meanwhile, banks will have to bear the 2-way brunt of spread contraction (potential lower yields coupled with recent hike in minimum saving by 1ppt to 6%).

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