Frontier markets vs. ASI’s performance

Frontier markets are a subset of emerging markets. Key features of the frontier markets are: lower market capitalisation and less liquidity compared to more developed emerging markets, and lower correlation with mature markets.

Frontier markets are being sought after by investors seeking high risk and return, long term investments and looking for diversification. It is believed that investments in frontier assets would diversify and reduce risk of their portfolios due to lower correlation with other markets.

In this regard, it is important to analyse the performance of the overall frontier markets and the correlation between frontier market indices and the Sri Lankan equity markets.

It was witnessed that correlation between the ASI and the MSCI World index has come down during 2012 to a coefficient of 0.35 from a previous high coefficient of 0.68 recorded historically in 2011. Sri Lanka’s low correlation with developed markets together with the strong growth potential compared with regional peers would remain attractive to foreign investors who seek to diversify their risk.

The foreign investor’s involvement during 2012 recording the highest ever net foreign inflow of Rs. 38 b to date emphasises the relative attractiveness of the equity market in the country, which can be compared with high net portfolio equity outflows prevailed during 2005-2010.

Future outlook

It has been the case that investors who are seeking diversification from matured markets moving towards frontier markets seeking opportunities to benefit from these growing economies. Sri Lanka is expected to benefit as well, backed by the Government’s intention to create an “investor friendly” climate enshrined in its 2011, 2012, and 2013 Budget proposals.

However, it is important to note that these benefits involve its own risks such as currency risk, less liquidity in the markets and regulatory and trading execution risk.

2013 outlook: Towards a rebound…

The phenomenal performance of the Colombo Bourse witnessed in the immediate post war environment had garnered heightened interest by both the Government and the general public. However the over exuberance and irrational behaviour of market participants has in more recent times led to a reassessment by both the Government and the general public of the role played by the capital markets in the development of the economy.

The Government has correctly identified that a well functioning capital market plays an essential role in economic development. To this end, the Government has made the further development of the financial markets one of its top priorities for 2013 encompassed in its ‘Capital Market Development Master Plan’.

The prospects of equity trade in Sri Lanka are likely to revive from 1Q2013 onwards on the back of higher flow of liquidity into equities owing to two main causes. The removal of the credit ceiling imposed on banks by monetary authorities will take effect from January 2013 onwards. Hence, in this light market interest rates could dip further on the back of higher availability of savings for lending purposes. This would further mean that dip in interest rates is likely to exceed the 25 basis points policy rate cut made in December 2012.

Furthermore, we expect the interest rates to remain stable compared to the sharp volatility seen in 2012 once a particular level of equilibrium range is achieved through the free play of market forces. In this back drop we believe that the flow of liquidity into Sri Lanka’s equities is likely to increase.

Further, given that effective demand in the economy’s real sector is likely to moderate during the year due to factors discussed earlier, we expect that a relatively higher volume of surplus liquidity that is currently lying idle among the corporate sector would enter into equity trade, causing a shift of corporate savings towards equities.

The trend would be further assisted by the fact that high yielding spheres for large scale real investments is moderating in the face of tight monetary and tax policy environments as well as weak demand from export destinations. Large scale conglomerates would hence tend to concentrate more on mergers and acquisitions of smaller firms with the aim of concentration of supply and capacity. It is likely that this change in the general corporate approach towards investments would occur through large scale equity transactions.

This is to say that large scale institutional trades (crossings) would tend to contribute more to the average daily turnover of the Colombo Stock Exchange in 2013. Therefore, intermittent large scale buying from local conglomerates can be expected.

In the Government’s Budget proposals for 2013, a number of policy measures pertaining to capital markets were implemented with the intention of increasing investor participation in equities markets as well as to promote underdeveloped financial instruments such as corporate bonds and debentures.

A number of policies involving the granting of tax exemptions for newly-listed firms subject to a minimum float may be an attempt to encourage more company listings in the CSE, particularly in sectors which are currently underrepresented in the equities market. This may have been partly as a response to the dip in the number of new IPO listings observed in 2011.

While at the time of the Budget proposal, the Government made no plans to list minority positions in any of the State-Owned Enterprises, the Deputy Finance Minister had subsequently announced that such listings may in the future become a reality. Hence overall we expect to see a spike in the number of new listings.

We believe that the All Share Index will stabilise above current levels and reach equilibrium in a better turnover regime. Hence, it’s our view that the investors should take position in the fundamentally strong counters as we expect large and medium scale activity levels to rise in 1Q2013.

We believe that sectors such as Banking, Leisure, Construction (especially firms with a focus on government projects), Power and Energy and Healthcare are likely to outperform in terms of future earnings potential. However we are less certain whether the policy measures implemented by the authorities in order to increase investor participation would be adequate to rekindle interest amongst retail investors in the Colombo Bourse.

All in all we continue to stress the fact that the multiples of ‘blue chips’ and other fundamentally-sound counters remain attractive owing to prolonged bearish movement, and are thus fully geared towards meeting the fresh flow of cash due to the transfer of liquid resources to the financial sphere of the economy.