The KSE-100 index, which is the benchmark index of the Pakistan Stock Exchange (PSX), has increased by roughly 18,000 points or 37 per cent over the last 10 weeks. The earlier high in the range of 52,000 points that was set in 2017 has been far exceeded by the recent run-up in prices. The performance of the KSE-100 index had been lacklustre for the last five years as it was not able to exceed its peak despite a run-up in equity markets globally.

A mix of policy uncertainty, political volatility, never-ending circular debt crisis and an economic model largely dependent on borrowing to fuel consumption were various factors that led to lacklustre performance of the equity market. More importantly, a pivot of earlier governments towards propping up real estate schemes also led to a redirection of liquidity towards real estate as an asset class.

Macroeconomic instability also had a key role to play in a largely flat performance of the market. During the last five years, the volatility in the rupee-dollar parity has been much more pronounced than in the last 20 years, resulting in a sharp depreciation of the rupee. The absence of a coherent policy that charts out the direction of the rupee-dollar parity, or at least instils stability, further eroded confidence of foreign portfolio investors in Pakistan.

The market capitalisation-to-GDP ratio for Pakistan has averaged in the range of 23pc in the last 20 years. But over the last five years, it continued to decline as the value kept on eroding even though GDP kept on growing albeit in a volatile manner.

The run-up in the KSE-100 index is largely the market playing catch-up after staying relatively flat, or choppy, for the last five years

The recent run-up in the KSE-100 index is largely the market playing catch-up after staying relatively flat, or choppy, for the last five years. Compounded inflation during the last five years has been more than 100pc. Despite such a run-up in index values and stock prices, the recent growth has not even covered inflation that occurred during the last five years.

Another key metric that provides signals regarding the relative value of equity markets is the price-to-earnings ratio. This ratio demonstrates how much the price of a particular stock can be relative to its earnings. A higher ratio relative to the historic average, or any other timeframe, shows a market is overvalued. A lower ratio relative to the average of the same time period indicates a market is undervalued. Over the long term, the average price-to-earnings ratio for the KSE-100 index has been in the range of nine times (which is still low for an emerging or frontier market). But during the last five years, it remained considerably depressed, in the range of four to five times. Even right now, despite the considerable movement in prices, the price-to-earnings ratio is around 5.4 times.

Whenever there is a sharp movement in prices, chatter generally gravitates towards calling such inflation in asset prices a bubble. But can it really be a bubble when asset prices have not been able to even moderately match inflation, while earnings across the board continue to grow? It may be too early to call the recent movement in prices a bubble, particularly when prices are just catching up to historic means in terms of relative valuation.

Similarly, whether the same run-up in prices is sustainable is also anyone’s guess. Interest rates play a key role in determining the allocation of capital in any market. Pakistan continues to maintain historically high interest rates, which makes investment in other riskier asset classes unattractive, particularly when the interest rate at which the government borrows remains considerably elevated.

As the government continues to rely heavily on borrowed funds to run its operations and plug its deficits, any sustained maintenance, or even increase in interest rates, will take out steam from the recent sharp movement in equity markets. A semblance of stability did allow the market to reach new highs. But sustenance of the same needs to be grounded in structural reforms across the economy, whether that requires a lower reliance of the government on borrowed funds to square its fiscal position or reorienting the economy in a way that we are able to maintain a stable foreign exchange rate by enabling greater inflows of foreign currency relative to outflows.

The equity market has remained depressed and undervalued for the last many years largely due to a mix of factors pertaining to political and macroeconomic instability. In the absence of any stability in the near-to-midterm, any gains that the market has acquired over the last few weeks may be eroded. If there are any reasonable structural reforms in the offing that can reorient the nature of the economy, then the bull run may continue.

However, if we continue to hold on to a dysfunctional economy and a lethargic policy framework, then it will only be a matter of time before the market reverts to its dysfunctional and depressed ways. Reducing risk in the economy and being fiscally responsible, whether that is through coherent economic policies or political stability, are the most critical elements in providing a strong base for equity markets and, inadvertently, private sector growth. In the absence of a focus on risk, the risk premium associated with an economy continues to increase, which keeps equity prices depressed.

Published in Dawn, The Business and Finance Weekly, December 18th, 2023