Rating bonanza and need for disposable income boost

29 April 2014 05:09 am - 0     - {{hitsCtrl.values.hits}}

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By Danushka Samarasinghe
The holiday shortened month of April has been merry thus far for the Colombo Stock Exchange (CSE) with the index gaining 3.1 percent (and by 185 points) during the first three weeks of the month.

Also average daily turnover levels picked up from last month and was recorded at nearly Rs. 1.3 billion which was rather encouraging since index movement was backed by strong activity rather than thin trading patterns.

Bulk of the trading was triggered by local High Net-Worth Investors (HNWI’s), local institutions and foreign funds. However during the first three quarters of April, foreigners were net sellers to the tune of Rs. 1 billion while most of the selling was absorbed by local HNWI’s. Despite the foreign investors selling around Rs. 7 billion worth of stocks during the said period, they also accumulated Rs. 6 billion of stock which gave clear indication that foreign trading activity would most likely continue and it would be a two way flow.


 Frontier markets
Foreign investments in to the so called frontier markets (in which Sri Lanka is also included) are likely to continue with investors’ preference shifting from larger emerging markets to the smaller and fragmented markets with higher growth possibilities.

Global investors would screen the frontier space for countries which has stable macro underpinning with low level of external vulnerability, willingness to expedite economic reform and strong domestic consumption.

Sri Lanka features well in this screening process though domestic demand is still weak and more liberal trade / business legislation is still needed. However many of the global investment funds are positive on Sri Lanka and therefore we could expect more money inflow to the equity markets. Also my experience is that the global investors visiting Sri Lanka are positive on the infrastructure development taking place in the country especially in the Western Province and the countrywide road linkages which they believe would foster sustainable economic growth in the coming years. Albeit professional global investors mind set is found to be rather fickle and a minor reversals in the macro economic stability and liberal economic reform process could be sufficient to turn them the other way.



 Compelling story
Having reported stable macro economic indicators (which are much more positive than 6-7 years ago) Sri Lanka’s story is compelling in the eyes of the foreign investor with strong 7 percent plus GDP growth, mid-single digit inflation, bank lending rates falling to low double digit figures and stable currency position.

Also albeit still running a twin deficit and the currency likely to depreciate 3-4 percent per annum over the medium term, does not scare the investors as long as corporate earnings growth remains at high teens or above. Hence in my opinion, maintaining strong corporate earnings growth remains a challenge not only for the corporate sector but for the CSE as well, since market price growth is likely to ride the net profit growth wave. Despite a reduction in corporate taxation rates few years back, the corporate sector is still burdened by a gamut of various taxes at the top line which affects their overall sales volumes and concurrently the margins and profits.
Therefore the cost of doing business remains high and encouragement for entrepreneurship and R&D is still lacking. Also what was visible during the last few months were that despite the favourable macro indicators, consumer’s real purchasing power was weak.



GDP growth numbers
It is true that this is an anomaly which attracts much skepticism and goes to the extent of questioning the economic indicators. However in my view GDP growth numbers depict the actual growth of the national economy which was largely driven by the state-sponsored infrastructure investments and questioning the accuracy of the reported economic growth figures seems baseless. While the reasoning for the weak purchasing power of the citizens are due to lowering disposable income levels especially among the urban population despite a growth in both per capita GDP and GNP. Employed middle class is a key segment which drives domestic consumption and the disposable incomes of this segment has been heading south. And this is the challenge I see for the corporate profit growth. Disposable incomes of this segment are narrowing mainly because of limited job creation in the private sector, stagnation of private sector salaries and a sharp rise in cost of urban consumer’s basket of goods.



 Retail investor confidence
Despite other alternate investment avenues such as bank deposits also offering rather low returns, the squeeze in disposable incomes is a factor which keeps retail investor participation at the CSE rather lackluster. Also the losses endured by the retail investors investing in speculative stocks in 2011 and 2012 is not assisting a revival while few listed companies facing bankruptcy and charges of financial misappropriation at present is further damaging retail investor confidence. If these charges can be investigated swiftly and provided with a decision in either way it would help boost confidence levels rather than dragging the process.

However it seems likely that we are going to have a low interest rate environment for some time and the banks are unlikely to up their deposit rates. Therefore we could see a gradual flow of retail money back to the equity market, maybe in small chunks initially but with the ability to gather momentum if market vibrancy continues.
Both local HNWI’s and foreign participation would continue shouldering bulk of the CSE turnover levels. Local institutional activity which had been erratic thus far YTD 2014, if sustainable would boost liquidity levels attracting more interest to the market.

Furthermore I believe that Sri Lanka’s probability of obtaining a sovereign rating upgrade is rather high given the positive strides made on the macro economic stability and if this materializes there would be a stepped increase in both foreign money inflow to the equity and bond markets while this could create a fresh wave of activity within the CSE.
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