Pakistan just barely avoided demotion on the FTSE Russell watchlist. What is the list and how does it impact you?

It seems like Pakistan is alway teetering on the cusp of the worst from happening. Whether it is facing a default or being demoted on different indexes and lists, the cliffhanger suspense never seems to end. And just when there is a chance that the fingers will slip, the country is saved miraculously. With the deadline on the Iran Gas pipeline looming, it seems the roller coaster is not going to end anytime soon.

On an optimistic note, on 28th of March 2024, news broke that Pakistan had avoided being demoted in the FTSE Russell watchlist. The decision meant that Pakistan would stay as part of its Secondary Emerging classification and could be included in different indexes. What even is the FTSE Russell watchlist and what impact does this decision have on the stock market? Profit explains. 

What is an index?

Now when one hears the word index, the most common one that comes to our mind might be the KSE-100 (Karachi Stock Exchange) index, NASDAQ or Dow Jones Industrial. The goal of an index is to track performance of an asset. Let’s say a person wants to track the performance of 100 of the top companies trading in the Pakistan Stock Exchange. In order to have that, 100 companies will be selected based on performance and they will be indexed at a starting date. 

When the KSE-100 index was initiated in 1991, 100 stocks were chosen and a date was set which was the starting point for the index itself. Now as time goes on, the price of the companies change and the index reflects those changes. After 10 years, just by looking at the index, a person can determine how the index, and conversely the companies themselves, have performed. 

Indexes help in providing a snapshot of performance to the participants of the capital markets. In November 1991, the index was initiated at 1,000 points. From then till now, the index has surpassed 67,000 points over a period of 33 years. An annual average of 2,000 points have been added to the index which shows that the market has fared very well compared to where it started.

Just like the movement in the index is dynamic, so is the composition of the index itself. The initial index is made based on certain criterias that the stocks need to meet. Over time, certain companies might see that they have fallen below the criteria while other companies might have met the criteria which they were not able to previously. Due to the liquid nature of the stocks and market, the index is revised twice a year and companies are added and deleted periodically.

Similar to the likes of KSE 100 index that tracks the performance of the top 100 companies, PSX also manages other indexes like KSE all share which tracks the whole stock market, KSE 30 which is made up of 30 top companies and KMI 30 index which tracks the 30 most liquid Shariah Compliant companies. Indexes are also made for certain sectors like the Oil and Gas Tracking Index (OGTI) and Banking Tradeable Index (BKTI) which track only a sector of the stock market. This allows investors to gauge how a sector is performing and gives them a comprehensive view on the sector alone.

So now that we know what an index is, what is FTSE Russell?

FTSE Russell

Financial Times Stock Exchange (FTSE) is a subsidiary of the London Stock Exchange group which is involved in producing, licensing and marketing of stock market indices. FTSE Russell was constituted in 2015 when FTSE integrated its indexing services with the Russell index series. The main operation of FTSE Group is to operate 250,000 indices that are calculated across 80 countries and earn a subscription fee based on providing access to this data to its users. In addition to that, the company also licenses index based products which it sells to its clients.

The KSE 100 index which has been talked about would fall into the first category of indices that FTSE tracks for its clients. In the case of Pakistan, the data is readily available and disseminated by the stock market itself. In the case of FTSE, they can provide this data at the fee and ask for subscription in return for provision of this data. The other part of the service provided by FTSE is that it creates index based products which the investor can invest in based on their requirements.

Consider an example to understand the difference between the two services. Let’s say a person wants to find out how the top 3,000 US companies are performing. In order to provide that information, they can get access to the data of the Russell 3000 index which tracks 3,000 companies in the US which represent 96% of the US market. Similarly, they can get information about the Russell Top 50 Mega Cap Index which tracks the performance of companies with the highest market capitalization all over the world. 

This data will be provided at a cost and that cost will be paid for by the clients. The data comes at a premium as it will give all the details on the companies that are part of the index and the returns they have made. Fund managers, brokerage houses and traders value this data as it has been sourced from thousands of sources and rely on it. Due to the depth and breadth of the data provided, FTSE charges a fee.

On the other hand, FTSE Russell also creates index based products which can be invested in. Let’s say an investor wants to invest in Shariah Compliant companies that are operating around the world. Rather than opening accounts in different jurisdictions and countries, the investor can invest directly with the FTSE Russell indexed product and get a share in the investment in all the companies that are a part of the index related product. As these companies will perform, the index will rise and so the investor can end up making a gain on his investment.

Even though they may sound familiar, in reality they are very much different. In one case, the index is only tracking the price changes and telling that to the clients. In the other one FTSE Russell is actually investing in the shariah compliant companies based on their own investing guidelines. FTSE Russell will actually use funds to buy stocks of companies which meet the criteria that they have set out and then earn a return on those investments.

So how does this impact an investor in a stock market?

The dollar impact

Consider the case of the U.S. Executive Order 13959. Under the executive order, investment in Chinese companies was prohibited based on the security threat which was posed by Chinese technology companies to the US. As investment was limited, the FTSE Russell index had to strip its indexes of Eight Chinese companies which it was covering. Similarly, after the invasion of Ukraine, FTSE had to remove all the Russian securities from all its indexes in response to that.

As these companies are removed from the indexes, they are also removed from the index related products that the company is marketing. What does it mean? They liquidate these positions or sell them off which causes the share price to fall. 

When a stock or a company is added to an index, it means that not only will FTSE start covering its performance, they will also start to invest in these stocks in order to make them a part of their product portfolio. As they start to buy shares of these companies, the share price starts to increase. A decision and a stroke of a pen by an investment committee has real world implications and the stock price moves accordingly.

With a kitty size of $ 15.9 trillion, the stroke of pen has a lot of heft to it.

The investment products that these companies promote are not only for individuals. These products are bought by fund managers, asset management companies and large corporations based on their performance and their attractiveness. Being included by FTSE also increases the visibility of these companies to the broader investment ecosystem who become aware of these companies and are able to provide free publicity to these stocks as well.

In order to make the companies part of the index, there are different criterias that are used in order to make sure that the stocks being selected have passed a threshold that has been set. The index sets the criteria and then periodically reclassifies its index to make sure that all companies are meeting the merit that has been set out. All throughout the year, the performance of the whole universe of capital markets is considered and then at the end of the period, new stocks are added and old ones are deleted.

Other than stocks being evaluated, the FTSE also considers different countries and classifies them as either developed, advanced emerging, secondary emerging and frontier. These go from the most developed markets to the ones which still have some maturing to do. 

The Sword of Democles

The Watchlist is a service provided by FTSE where it gives out a list of countries it sees either getting demoted down the scale or being promoted. In September 2023, the review added Egypt and Pakistan as two countries which were going to be added to the Watch List. Pakistan was added as a possible demotion from secondary emerging to frontier market status.

The decision was based on the market failing to meet the minimum investable market capitalization exit level threshold which was required to maintain the secondary emerging market status. As the country was seeing a deterioration in its capital markets, there was a risk that the country could be removed. The September review is based on June end data which showed that the country had $ 3.01 billion in terms of its investable market capitalization in the FTSE Emerging All Cap Index while the minimum threshold set was $3.49 billion. The decision to formally demote the country would be carried out in the March 2024 review.

With the sword of Democles hanging over the country, there were reports that the country had to show an economic turnaround in its results in order to avoid the demotion. Pakistan saw a massive rebound in its equity markets from July to December with the index increasing by 50% while the bond markets also saw an increase due to IMF disbursements. With capital controls being reduced and liquidity being improved, the country did see considerable recovery from June 2023. The market saw an addition of $11 billion in market capitalization from July and FTSE had to decide whether this was ample enough to save the country.

When the results for the latest review were announced, they were nothing short of underwhelming. Just like a child passing with the bare minimum, the report stated that the country marginally passed the Minimum Investable Market Capitalisation exit level which needed to be maintained. A report card of D in other words.

There will be another review which will be carried out in June 2024 whose results will be announced in July 2024. Based on these results, the review will be carried out in September 2024 which will decide whether the failing child needs to be demoted once and for all. The name will remain on the Watchlist till then.

What can be expected in the future?

To try to predict the future at this point would seem premature but it seems that early signs are promising. At December end, the KSE-100 index was trading at 62,451 which is currently at 66,593 as on 2nd April 2024. This is an increase of 6.6% which is a step in the right direction. Similarly, bond prices were trading at 93.53 in December and have increased to 98.39. This is due to the convergence of bond prices towards 100 as it reaches maturity and due to macroeconomic indicators getting some support due to the IMF review being successful.

As per a report by bloomberg, “Pakistan’s biggest problem since 2017 has been a steady erosion in market size. However, a rebound has been underway since September, with the market adding almost $11 billion of shareholder wealth.”

“The country’s stocks have rallied 5.7% this year, outperforming EM peers. Dollar bonds have returned 28%, the third-best performance in the asset class,” read the report. 

The optimism is also shared by experts in the capital markets who feel that the latest review being successful and going towards a new IMF program will provide some much needed relief to the markets. The multiples in the market are still seen to be cheap and with reforms being implemented in the economy, the multiples will move towards a fairer value stimulating the markets. The core issue right now is inflationary pressures which are expected to fall which will lead to an ease in the monetary policy. As interest rates are expected to be cut, the market will get another boost in terms of funds flowing into the capital markets.

“We expect Pakistan will remain engaged with the IMF and will request for a longer and larger size of fresh bailout package under the Extended Fund Facility (EFF). The new program will come with its tough conditions but given recent resolve shown by the government and limited options, we expect the government to implement the tough conditions.” states Mohammed Sohail, CEO at Topline Securities.

Around the end of last year, when the index was trading at 62,000 points, there were brokerage houses which were bullish and were expecting the index to settle above the 100,000 mark in a year’s time. Topline Securities also released a report stating that the market recovery had just begun back in November of 2023 and expected the index to reach 75,000. With recent statements by the Finance Minister of a longer and larger package being sought from the IMF, there is potential that the mark will be hit sooner than expected.

Sohail further adds that “given the new IMF program on the cards market capitalization will increase and Pakistan will manage to retain its position in FTSE Secondary Emerging Market.”

Whatever will end up happening, time will tell. Join us again for the next thrilling installment of “Pakistan and the (almost) impending Doom” *echoes*