The 2025 Mid Year Recap

If, in early 2024, one were to correctly predict a landslide victory by the left wing NPP, a massive Trade War started by America (particularly singling out little Sri Lanka) and a kinetic war between Israel and Iran, such a forecaster would not have concluded that the right course of action would be to go all in on Sri Lankan equities. This is a good example of why sometimes it is better to be agnostic of macroeconomic factors and focus on valuation. Valuations were attractive, and hence buying and holding regardless of the noise would have been the prudent thing to do.

As we approach the middle of the year, it felt like a good time to recap what has been a remarkably strong market, helped no doubt by a remarkably strong local economy. Below we will talk (in brief) about the key events and observations from the last six months and our outlook going forward. We also discuss (to a limited extent) how we are positioning for this. As always, this is not investment advice. 

A Recap of Global Events

As expected, a second Trump administration plunged the world into his signature brand of chaos. The “Liberation Day” tariff announcement was particularly meaningful for Sri Lanka. While our markets initially reacted negatively, the shock appears to have been shrugged off. We think the risks of the tariff plan are far more significant than priced in by the market, and do not think we are out of the woods by a long shot. We discuss more about it here.

We also had continued uncertainty and war in the middle east. A “hot” war between Israel and Iran created another bout of uncertainty, which as of today appears to have cooled off. We do not believe this event is as significant a risk to the Sri Lankan economy, except for its indirect impact via higher oil prices and freight rates. It is, of course, one to continue monitoring carefully but we have not made any material portfolio adjustments due to it. 

In a rather unusual twist of fate, Sri Lanka appears to be a stable haven, in a global economy filled with uncertainty and volatility. The biggest visible risks we see to Sri Lanka appear to be global in nature at this moment, such as oil price shocks and a sharp drop in exports caused by tariffs and/or a weaker economy. 

A Recap of the Local Economy

Sri Lanka’s painful but necessary structural economic reforms continued to pay dividends. Twin surpluses in the fiscal and current accounts, which were previously unheard of, are now predicted for a third year. These very positive surpluses have had multiple positive effects:

1. Low interest rates, as government borrowing needs are lower and inflation is contained.

2. Strong credit expansion, fueling investment and consumer expenditure, helped by lower interest rates and less government crowding out.

3. A strong currency due to the current account surplus

4. Low inflation due to the stronger currency, and the end of money printing.

The local consumer is still recovering from a once in a generation economic shock, and we think this consumer recovery will continue to be a strong support for the economy, with companies catering to the local economy continuing to see strong earnings. 

A well performing tourism sector and record remittances helped to mitigate the expected headwinds of rising imports and the resumption of external debt servicing, leading to the currency being more stable than expected. 

We also expect the tax intake to remain strong, helped by recovering consumer expenditure and the wave of vehicle imports. (A special thanks to those Rolls Royce importers for their tax contribution to the Sri Lankan economy!).

All these green shoots in the economy are combined with a stable political environment making us hopeful that the next six months will be a continuation, or even an acceleration of all the positive trends we have seen over the last six months.

Sri Lanka has a history of shooting itself in the foot and grabbing defeat from the jaws of victory. However, we are tempted to whisper the most dangerous words in finance. “This time might be different”. This is probably a consensus view however and hence the real question is how much of this is already priced in, and how will the market react to a shock? 

A Recap of the Colombo Stock Exchange

We saw a mild correction in mid February after one of the strongest sustained market movements we had ever seen, before the market continued its broad based, steady march up. For the last six months, the CSE returned 17.5% (including dividends) while for the 12 month period it returned 56%. Both exceptionally strong figures.

The market move was broad based, although export oriented firms did lag behind, understandable given the global headwinds they faced. The banking and finance sector, along with firms focused on the local economy performed the strongest. Turnover remained very strong and the trend of market activity being driven primarily by local investors continued.

One of our biggest surprises has been the low levels of foreign interest in the Colombo Stock Exchange. Given the strong datapoints coming from the country, we expected significantly more foreign buying, which has not yet materialised in any notable way. If these do arrive, it could herald a second wave of market strength. However given the weak global environment and the fact that most EM funds are facing outflows (in favour of tech funds), we are not banking on these foreign investors as a certainty.

The above moves suggest that the “floodgates” we hypothesized in an earlier article may have now been opened. We now focus on trying to figure out when these huge capital flows will stop. This is hard to answer, but we think we have further to go, albeit with ebbs and flows in the market, as always. 

We have also observed strong earnings growth, particularly in the banking and finance sector as well as in companies exposed to the local consumer. This makes sense, and given the strong economic background and it is reasonable to expect it to continue

Is TINA in Sri Lanka

The 2010s saw a period of sustained rising global equity markets. Many investors took profit too early, basing their judgement on the historical market ebbs and flows, and expecting the opportunity to buy back cheaper. However, these opportunities never really came, with the market steadily marching upwards, often achieving valuation metrics that in the past would have been considered bubble territory. 

This steady rise was caused by "Tina" (There Is No Alternative). Persistently low interest rates meant that even at high values, equity markets provided more attractive returns than alternatives, leading to global capital to continue to flow into equity markets. We think such a concept may now be happening in Sri Lanka. Traditional savings options such as bank deposits are paying extremely low rates, made worse by their unfavourable tax treatment. We think that this current sustained market rally has been driven by significant capital flows of local savers into equity markets. As long as macroeconomic stability is sustained, interest rates can remain low, if not go even lower. Hence we think markets may continue to grind up, simply because “There Is No Alternative”. 

What Are We Doing

Our approach is to invest with valuation as our north star, regardless of whether we expect near term moves up or down. The sharp move up in share prices mean valuations are significantly less attractive than they were a year ago. However, this has also been accompanied by a significant de-risking of the market, and in particular the political environment. 

As mentioned, we are more nervous about the external environment than Sri Lanka in specific. We also reflect this with a relatively low allocation to the export sector, preferring companies insulated from global chaos, and able to benefit from a recovering local consumer.

We have also slowly increased our cash balance to around 7%. This is high for us, but is generally still considered a bullish position. While we think valuations are still attractive, the optionality of having spare cash is valuable. Hence we have been collecting dividends and no longer reinvesting in the market, along with some small portfolio rebalances and profit taking. We do however remain significantly long, and are willing to tolerate anticipated near term volatility in the expectation of more significant longer term gains.