HSBC is turning positive on Sri Lanka as a frontier market pick, but it's lowering exposure to Vietnam after the recent rally.
HSBC's upgrade of Sri Lanka's upgrade to "positive" from "negative" may surprise some. The country only reached an agreement with the International Monetary Fund for a $1.5 billion bailout last month after foreign exchange reserves dwindled amid a slump in exports.
While HSBC acknowledges Sri Lanka's rising fiscal and external vulnerabilities, it believes all the negative news is now priced in.
"The deal is a good opportunity for the government to replenish its forex reserves, ease the debt burden and pursue long-term fiscal and macro reforms," HSBC said.
And for stock investors, HSBC noted that the last time Sri Lanka received a tranche of a loan from the IMF, in 2012, the local stock market rose 42 percent over the next six months.
HSBC also expects company earnings have bottomed and will see some improvement, while the market's high dividend yield of over 3 percent should attract yield-seeking investors.
Among market sectors, it expects Sri Lanka's construction and building materials industries will benefit from the restarting of several stalled infrastructure projects. Tourism is also a focus, it said.
Tourist arrivals in 2015 climbed nearly 18 percent from 2014, reaching more than 1.8 million arrivals, nearly quadruple the level a decade ago, according to government data.
When it comes to economic growth, HSBC expects that will depend on whether infrastructure projects restart, forecasting gross domestic product (GDP) expansion will slow to 4.7 percent, compared with a previous forecast for 6.3 percent.
The Colombo Stock Exchange All-Share index is down more than 4 percent so far this year after tacking on more than 8 percent so far this quarter.
But while it is turning more positive on Sri Lanka, HSBC has downgraded Vietnam, another frontier market to "neutral" from "positive."
"We continue to regard Vietnam as one of the better-managed frontier market economies in the world and remain positive about its long-term story," it said. "However, following the recent rally we think the market is now relatively expensive compared to its peers and also lacks any near-term catalyst."
It noted that the VN Index is up more than 15 percent since it hit a trough in mid-January after the U.S. Federal Reserve hiked interest rates in December.
Additionally, HSBC said it has cut its full-year gross domestic product (GDP) growth forecast to 6.3 percent for this year from 6.7 percent previously as government funding constraints are likely to slow public investment.
The pace of reforms in the country has also been slower than expected, and with a new government "settling in," not much progress is expected near term, HSBC said.