Higher interest rates ahead can stall Market rerating

Driven by higher GST, higher food prices and increase in petroleum product prices, CPI has jumped by 2.0%MoM to 8.3% in Jul'13. This is the highest increase in headline inflation since Sep'12 (+8.8%YoY). At the same time, core (trimmed) inflation has also jumped to 7.8%YoY in Ju'13 vs. 6.8%YoY in the previous month. 
Considering real interest rates, going by Jun'13 headline CPI, are only  +ve 0.75% and that price pressures are expected to pick pace across the course of the fiscal year, we believe the SBP will likely find itself initiating a round of monetary tightening before end-Dec'13. In this regard, while press reports indicate that monetary tightening could be part of the pre-conditions for the new loan package (IMF's Executive Board meets in early Sep'13), we believe that interest rates will remain unchanged in this month's MPS but may start to inch up from the Oct'13 MPS onwards. While this will likely spell positives for banking sector scrips, the broader market's valuation rerating (forward P/E is at a 5yr high of 8.2x) may now stall.      

CPI Review: Headline CPI has jumped by 2%MoM to 8.3% YoY in Jul'13 where food inflation (35% weight in CPI basket) has increased by 3%MoM to 9.2%YoY. In addition, price pressures have been propelled by a 1ppt increase in GST, a 1.9% -3.5% increase in petroleum product prices and the periodic assessment of rental inflation. In this regard, core (trimmed) inflation has also increased by 1.2%MoM to 7.8%YoY in Jul'13. Headline Jul'13 CPI now implies that real interest rates are only +0.75%.

CPI Outlook: Considering that 1) petroleum product prices have again been raised by more than 2.7%+ on Aug 1'13, 2) the PkR/US$ parity continues to weaken and 3) the GoP plans to significantly raise power tariffs starting from this month, it is likely that price pressures will continue to remain elevated going forward where we project that CPI will average 9.5% across FY14. From a forward looking perspective, this implies that real interest rates may not remain in +ve territory before too long considering that the DR is at 9%. 

MPS Outlook: Pakistan has reached a Staff-level agreement on a new loan program with the IMF's Executive Board scheduled to formally consider Pakistan's request in early Sep'13. In this regard, various press reports have indicated that monetary tightening could be part of pre-conditions. Considering that the DR was reduced by 50bps to 9% in the last MPS, we believe the central bank will likely persist with this level of interest rates in the Aug'13 MPS. That said, we expect interest rates to start inching up from subsequent policy meets with the DR anticipated to increase to early double-digits across the next year or so. 

Investment Perspective: The T-bill/earnings yield differential presently stands at 3.0% vs. an average differential of 2.4% since FY06. Anticipated increase in interest rates will likely compress this differential further, thereby potentially impeding the valuation re-rating process considering the forward P/E multiple of 8.2x is already at a 5yr high. That said, banking sector scrips can emerge as relative winners where we foresee a second-round rally post 1HCY13 results.