MSCI announced in June that it will upgrade Pakistan from Frontier Markets (FM) to Emerging Markets (EM), effective May 2017 during MSCI’s Semi-Annual Index Review.
- Pakistan, at 8.4% of the FM Index, will account for only 0.2% or the EM Index.
- The upgrades creates a meaningful opportunity for capital appreciation, as passive index followers add exposure and active investors recognize the improving market conditions and stability acknowledged by MSCI in the reclassification
Emerging Markets classification is not new territory for Pakistan; the country was previously a member of the index prior to being downgraded in 2008 following a period of market turmoil that halted trading for months in the local Karachi exchange.
Pakistan held “standalone” status until markets began to function more normally in 2009 at which time MSCI added the country to the Frontier Markets Index. Since that time, Pakistan has recovered to be one of the strongest performing markets across frontier countries. Recent growth and improving liquidity in the Pakistani equity market have allowed the country to meet the requirements for a return to emerging market status, which will happen next year.
Although the announcement did not come as a major surprise given the positive feedback to MSCI from investors and the liquidity-driven nature of such reclassifications, we believe that Pakistani stocks may benefit from increased demand resulting from a move to a more benchmarked index.
Pakistan is a relatively large and liquid market compared to other frontier countries, but will be overshadowed by the major constituents of the Emerging Markets Index. The country currently represents 8.4% of the MSCI Frontier Markets Index, yet it will have the smallest representation of any country in MSCI’s Emerging Markets index with a 0.2% weight.
In Figure 1, we provide a list of companies MSCI indicates are provisional Pakistan index constituents as it moves to EM. Post-implementation, liquidity may tail off once investors have gained needed exposure. This was the case in Qatar, where liquidity fell to near 10-year lows after joining the EM index, although other countries such as Morocco have seen liquidity trend higher despite having been downgraded from EM to FM in 2013.
MSCI UPGRADE DECISION
Pakistan was broadly expected to be upgraded, as it meets almost all of MSCI’s emerging market criteria. Ultimately liquidity tends to be an important driver of MSCI’s decisions, and Pakistan’s relatively broad, liquid profile was a meaningful consideration. In addition to investor response to the proposed upgrade, there was a subjective element that added uncertainty to the upgrade: political risk. While this risk has been limited since the peaceful transition of power to Prime Minister Nawaz Sharif in 2013’s democratic elections, and the current regime’s demonstration of strong support for the private sector has further helped to improve Pakistan’s standing.
The country has a long history of political volatility and its market remains susceptible to event-related selloffs. The recent period of relative calm has helped to stabilize the market, but Pakistan remains a market that is highly influenced by political events both at home and throughout the region.
WHAT HISTORY SHOWS
There are only two precedents of countries being upgraded from frontier to emerging market status: Qatar and the UAE which were upgraded together in 2014. MSCI’s upgrade announcement created a material return appreciation catalyst, as the Qatar and the UAE returned 54% and 98%, respectively, from the time that MSCI announced the upgrade to the time that the upgrade was implemented.
We believe there is significant opportunity for appreciation for Pakistan as it heads into its upgrade, given the need for passive emerging market investors to rebalance significant capital into this country. As described in our 2015 paper “Transition Strategies Around MSCI Reclassifications” there is evidence of price appreciation in the period from announcement date to implementation date for countries moving into indexes with a higher percentage of assets owned by index tracking strategies. There is also evidence of price appreciation pre-implementation for countries being “upgraded” to an index reflecting higher levels of market development. Both are true in Pakistan’s case and Figure 2 shows that Pakistan has begun to outperform both EM and FM Indexes since May. Index-transition considerations aside, the country’s structural growth story as well as its discount relative to emerging markets today are additional reasons to expect potential price appreciation. Specifically, Pakistan currently trades at a P/E multiple of 10.1x earnings; a discount to both the Frontier Markets Index (10.5x) and Emerging Markets (14.3x).
While UAE and Qatar enjoyed significant rallies in the period between announcement and implementation of the re-classification, the countries retreated after the upgrade. As shown in Figure 3, UAE and Qatar have declined approximately 40% in the two years following their upgrade to EM. Liquidity has also tailed off, with trading volumes for the first five months of 2016 less than half of those registered in the first five months of 2014 leading up to the reclassification. There have been many potential drivers for the selling in the UAE and Qatar including governance concerns at the corporate and country level, their relatively low weight in emerging markets, the drop in oil prices, and sensitivity to emerging markets.
FRONTIER PORTFOLIO IMPACT
Our Frontier Market strategy has a significant overweight in Pakistan and hence if further appreciation occurs, we expect to be well-positioned. Further, existing frontier assets may rotate into other regions as their weights are increased in the reformulated index, boosting the opportunity for price appreciation across frontier countries.
The Karachi Stock Exchange is a fairly liquid market, so the upgrade of the country in next year will represents a loss of asset class liquidity for frontier markets. However, our portfolios are attuned to the low liquidity nature of this asset class and will be able to rebalance our 17% Pakistan portfolio exposure across other frontier countries. Further, we believe there are other sources of liquidity to offset the impact this upgrade. For example, other Asian markets are similarly liquid, including Bangladesh and Vietnam, and there may be an improving liquidity profiles in other countries with improving fundamentals, including Argentina and Romania.
In Acadian’s frontier market portfolios, our policy is to largely follow the S&P Frontier index, so we will continue to actively invest unless S&P also upgrades the country. Pakistan is on the S&P watchlist, and we expect an announcement in late August. Should S&P also upgrade, we would halt further buying of Pakistani securities in our FM portfolios upon implementation. Existing positions would be sold in a transaction-cost sensitive manner rather than being forced out of the portfolio in a single day.
As Pakistan moves from frontier to emerging market status, MSCI’s Frontier Markets Index will lose a relatively large and liquid market; however, we anticipate improving liquidity from other Asian markets, as well as Romania and Argentina, will fill this gap as these markets mature and evolve. While impacts to emerging market investors may be minor given Pakistan’s small share of the MSCI Emerging Markets Index, the reclassification may present an opportunity stemming from increased benchmarking demand. The recent experience of UAE and Qatar gaining emerging market status showed a pattern of price appreciation leading into the implementation date. From the perspective of Acadian’s Frontier Markets strategy, our overweight to Pakistan leaves our portfolios in position to benefit from potential market-wide price appreciation that may occur leading into the implementation date.
Asha Mehta is director of Responsible Investing and lead portfolio manager of the Frontier Markets strategy at Acadian Asset Management.