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While we were not necessarily surprised by the Central Bank of Kenya (CBK) decision last week to keep its policy rate unchanged at 18 percent given the current and forward looking dynamics (short-end yields have narrowed sharply since January) to both inflation (Headline CPI 15.6 percent y/y in March from a cyclical peak of 19.7 last November, with food inflation—36 percent of the total basket—down to 22.1 from 26.2 and transport inflation moderating from 28 to 15.9 over that same period) and exchange rate appreciation (KES/USD up ~29 percent since mid-October partially on the back of timeframe restrictive currency restrictions relating to currency borrowing by offshore banks as well as final round policy rate hikes) we still find the overall tight monetary policy current to be subtly shifting underneath the surface as officials seem to be just as, if not more concerned with export (i.e. manufacturing) competitiveness than with underlying price pressures and currency stability (factoring in a weaker than expected Q4 2011, we expect overall economic growth rate of roughly 4 percent in 2011 versus 5.6 in the previous year as net exports act as a drag on consumer driven output). That said while our target rate per a Taylor’s rule analysis indicates the CBK could reasonably slash some 400bp from its benchmark rate through 2012 in order to buoy growth, we acknowledge the MPC continues to see potential upside risks to inflation given a deteriorating current account deficit (~12 percent of GDP in 2011 versus 7.8 in 2010) as well as sticky core figures—11.2 percent y/y compared with the government’s short-term target of 9 percent, a testament to rising crude prices (~20 percent of the country’s imports) given food’s previously stated disinflation—as well as above-target credit extension that taken together keep its policy mindset circumspect, especially given lingering La Niña effects as well as unusual tropical cyclone activity in the Indian Ocean that will likely delay long rains, impacting electricity generation and agricultural production and further underpinning food and fuel prices.[i]
Additionally, on a technical front USD/KES rests gingerly atop its 200dma support line and appears to have made a sort of rounding bottom or saucer pattern typically indicative of a reversal in price behavior. The pair now trades again roughly in line with the reaction highs of February, a level which also served as support one year ago while preceding an ultimately rapid ascent to the 106 level. Simply put, therefore, the pair is at a critical zone of truth whereby a definitive break one way or the other would likely be more than transitory, a view corroborated by historical volatility (HV), i.e. the standard deviation of day-to-day log price changes expressed as an annualized percent. For example, we examined a 5-day moving average of the ratio between the pair’s short term and long term HV, looking for spots whereby the relationship dipped below and then traded above .5, implying reversion to the mean volatility (we cite Professor Turan G. Bali’s 2006 study in particular regarding the mean-reverting behavior of stochastic volatility)[ii] and an impending price break. Interestingly the recent potential bottom in USD/KES coincided with an approximate 6-week stretch of low (<.5) relative volatility, and given that the average has again receded we would suspect a similar, albeit more sustained breakout looms. While given its recent history of protracted consolidation periods (see 2008-2009 and 2010-2011) we target a near term run to 84 in the coming month.
Trade recommendation: While mindful of said currency dynamics rising real rates (i.e. policy rate less headline inflation), which have now shifted into positive territory, should offset technical movements enough such that the sharp decline in the short-end (-157bp in March from the previous auction) is likely to give way to a more tempered rate of decline such that in the near term we see enough near-term downside, rather than upside risk to inflation as well as an adequately supportive currency environment (assuming authorities maintain current restrictions) to continue to recommend un-hedged local bonds.
[i] Bali, Turan G. and Demirtas, Ozgur K. Testing Mean Reversion in Stock Market Volatility. September 2006. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=936647
From Alterio’s SSA report last week:
Countering relative disinflationary trends across SSA are diverging currency dynamics which can be swayed by both fundamental and technical reasons. The Central Bank of Kenya’s somewhat surprising decision this week to keep its policy rate unchanged at 18 percent, for instance, is otherwise shilling supportive in both the near and medium-term as it comes despite higher-than-anticipated declines in both headline CPI (16.7 percent y/y in February from an 18.6 annual average over the preceding two months) as well as private sector credit growth (28% y/y in January versus 30.9% in December 2011) and against a backdrop of lower food inflation and impending base effects which should further reduce price pressures despite hitherto sticky core inflation (ex food and fuel) that detracts from the country’s balance of payments. Technically the shilling has returned to levels not realized since last April at which point it began a fairly hasty plummet of over 20 percent against the dollar (characterized by a nasty feedback loop whereby negative real rates on short term [91/182-day] debt—which ultimately rose over seven-fold over the course of just a few months—initiated ever strident dollar demand as the central bank furiously tried to maintain its import cover ratio) while finally peaking in October. Given our subdued outlook for inflation as well as the central bank’s hitherto ‘ahead of the curve’ hawkishness over the past year (+1200bp overall since January 2011) other things being equal (they never are) present levels (i.e. 82-84 consolidation) should support a USD/KES bottom and ultimately provide an impetus to the upside past 83.6 and through the 84 level. That said even if the shilling ultimately retraces some of its near-term rally, macro conditions are such that 2011’s volatility can be comfortably set aside for the appreciable future, a plus for both public and private equity risk sentiment.
That said, though credit growth has subsided Kenya’s MPC remains unsatisfied, we feel, by demand-related pressures on both imports and consumer goods. As a percentage of output Kenya’s private sector lending still outpaces M2 money supply, a relationship authorities would prefer to invert. Therefore KES weakness may also be dependent on the pace of further private sector deleveraging. Looking to Nigeria, on the other hand, one may find a potential USD/NGN bottoming that could signal perceived transitory inflation dynamics are extensively capped to the downside as well given an ongoing secular trend of dollar demand for imports continuously exceeding supply. Fundamentally the currency has deteriorated for over a year as dollar demand for imports generally exceeded supply while last fall the central bank, failing to meet demand at the official market, lowered the midpoint of its exchange-rate band to 155/dollar from 150. Concurrently, however, from a technical level the pair also looks problematic; indeed a glance at the weekly chart since Q42010 shows both strong support and resistance at 155, while recent hammer patterns indicate that a move back towards 160 is increasingly likely.
Given the increased attention paid to so-called ‘fat tail’ events stemming hitherto largely from developed market credit excess and threatening to impact liquidity as well as asset correlations and volatility across countries and classes, I’ve decided to attempt to quantify or at least shed light on certain factors which may tend to indicate which economies could be perceived as the most or least vulnerable in a comparative sense to contagion stemming from the weaker trade and portfolio flows associated with periods of contracting global growth (in this sense a country’s ‘openness’ to trade may become a liability). The “contagion score” model output, which will debut in this week’s Alterio Research report (and whereby proposed contagion propensity is inverse) is thus a function of a given economy’s exposure to trade and commodity prices (expressed as the sum of exports and imports as a percentage of output), its exposure to portfolio flows (shown by either its current account surplus or deficit, the latter of which must be financed either by foreign direct investment or more fickle portfolio flows) and finally the diversity of the makeup of its commodity export basket (and by extension its sources of foreign exchange).
As will be seen, Kenya rates comparatively high per our metrics—a credit plus in light of the various fiscal and monetary headwinds it stands to face in the coming year (this week Finance Minister Uhuru Kenyatta revised real GDP growth down to an expected 5.3 percent in 2012 from the earlier 5.7 projection) including chronically high inflation which, policy rate normalization notwithstanding has perpetuated a marked deterioration in the country’s terms of trade (i.e. export against import value) amplifying a negative net contribution to GDP due to a higher import bill. To this point, however, we indicated last month the possibility of “a cyclical peak in both rates and inflation” which last week the Central Bank of Kenya’s (CBK) MPC validated, at least for the near term, by keeping its policy rate unchanged at 18 percent while citing a decline in inflation in December (18.9 percent y/y from the previous month’s 19.7) on the back of falling food and fuel prices as well as a contraction in private sector credit demand in November. Today this thesis was further supported when January’s year-on-year rate slowed to 18.31 percent, though it must be noted that with the smallest Reserves-to-GDP ratio among our SSA coverage, the central bank’s shilling-shoring policy of liquidity sterilization may be tempered enough in the coming months to keep it in a definite wait-and-see policy approach.
Moreover any perceived inflection point in inflation also may be a harbinger of stalling growth. Hawkish monetary policy certainly played a central role in the shilling’s dramatic year-end turnaround; however as a report this month from HassConsult (which maintains and publishes the country’s sole property price index) demonstrates, higher policy rates concentrated in the final months of the year also influenced a corresponding rise in commercial lending costs, fueling in turn an ensuing glut of delinquent or non-performing loans that are likely to dramatically impede bank balance sheets (from both an asset and loss reserve standpoint) going forward (Kenya’s mortgage industry grew from Sh19bn in 2006 to Sh61bn in 2010 per a joint CBK/World Bank report) and thereby temper a construction boom labeled last July by the Kenya National Bureau of Statistics (KNBS) as one of Kenya’s top performing sectors having grown by over 10 percent y/y.
As hinted here earlier, sub-Saharan frontier markets may be distinguished in part by their monetary prudence and overall macro policies. While foreseeing an impending rise in Eurozone related global market volatility earlier this fall (and by extension the SSA region’s near-term growth prospects), for instance, we theorized that commodity exporters such as Ghana would enjoy enhanced terms of trade, augmenting FX reserves as well as tempering price stickiness such that capital costs remained controlled while the option to ease interest rates remained relatively viable–all in contrast with net importers such as Kenya and Uganda (a notable exception to this ongoing thesis remains South Africa, for reasons outlined here, while Nigeria’s disappointing reserves accumulation YTD and hitherto pesky inflation have in turn brought about six different attempts to normalize rates during the year). That said, a tipping point does exist even in the most price sensitive of countries such that once inflation pressures lessen (a function, it should be pointed out, not only of supply side factors but also demand side ones such as private sector credit expansion) monetary policy can remain static or even perhaps loosen such that local bonds look a bit more palatable. Absa Capital noted yesterday, for instance, that following the deceleration in November’s headline inflation to 29% from the previous 30.6%, the Bank of Uganda’s (BoU’s) MPC left its central bank rate (CBR) unchanged at 23% (up 300 basis points from the last hike in October) at its policy meeting‘last Friday while observing that “prospects for lower annual inflation rates have strengthened”. At the same time, Bank Governor Emmanuel Tumusiime Mutebile pointed out commercial bank lending to the private sector declined by 20.9 per cent between September and October, a trend he expects to continue as “the slowing down of bank credit growth will help to ameliorate inflationary pressures over the coming months”. All this bodes well for fixed income, though an always mindful eye on domestic food prices wouldn’t be for naught.
The FT‘s Kenya oriented pullout from late October underscored the contextual dichotomy present between those investors [rightfully] weary of the country’s NSE Index, down 44.6 percent YTD at the time compared with the benchmark MSCI Frontier Markets Index’s -20.1 showing (though it was SSA’s best performer in 2010, up 28.3 percent), versus an ever burgeoning brigade of “public money, alternative asset managers, funds of funds, family offices [and] public and private pension funds coming onstream almost every month” into private equity, a phenomenon whose efficiency will only be enhanced, per Edward Burbidge, a Nairobi-based corporate finance advisor, by both an SME exchange (geared towards smaller-to-medium sized firms in lieu of the generally not practical costs and regulations associated with public listing) as well as a proposal to raise capital limits allowed to be invested (currently only 5 percent) by domestic institutional investors such as pension funds and collective investment schemes. While long-term investors such as Templeton’s Mark Mobius continue to correctly emphasize the economy’s inherent potential, we noted this summer that the Central Bank of Kenya’s (CBK) dovish dithering in the face of increasingly entrenched inflation (core inflation more than doubled to roughly 13% from March-September) left it continuously behind the curve, perpetuating a vicious spiral whereby declining fundamentals exacerbated a deterioration of the balance of payments (analysts estimate the country’s CA deficit in H1 2011 doubled y/y to approximately 12% of GDP), eroded by an ever-wobbly schilling (KES, down 23% YTD against the USD to mid-October and now at ~97/dollar). Lo and behold, headline inflation printed 18.9% y/y in October-the highest rate in three years-driven chiefly per the CBK by food inflation fueled in part by over-zealous domestic credit expansion. Finally, however, the response seems apropos: Tuesday’s 550bp hike by the monetary policy committee to 16.5% (following a 400bp bump in early October) surpassed consensus expectations and may help temper yields (Tuesday’s 91-day treasury yield was at 15.31% versus 9.71% at end-August and 3% at end-March 2011, per Absa Capital) and schilling weakness alike, especially if the government’s request to further tap the IMF’s Extended Credit Facility (ECF) is obliged (Kenya has hitherto withdrawn USD170mm from the USD509mm, 3y program agreed to with the Fund last January). Regardless, however, the underlying macro-theme to remember about Kenya remains the growing, negative net export contribution to growth, which will counteract whatever monetary policy exists to try to stabilize the schilling–stability that should ultimately be of interest to public and private investors alike.
The Economist somewhat glumly opined this week that for all its recent progress (the economy has hitherto rebounded close to pre-crisis levels, up 5.6% y/y in 2010, the strongest expansion in the past three years) “Kenya still often feels like a country running to stand still.” Indeed the near-term future continues to look bearish for both policy rates (the monetary backdrop leans towards tightening despite the central bank’s (CBK) latest 180 on its late June 175bp overnight rate hike) and the currency (USD/KES closed last week at 90.90, -1.0% w/w) as sharply surging headline inflation (+14.5% y/y in June from negligible levels at the end of 2010) on the back of food inflation (+22.5%) caused chiefly by East Africa’s worst drought in over 50 years will likely dampen growth (last week Absa Capital lowered Kenya’s overall GDP projection for 2011 from well above 5% to 4.8% while noting that Kenya Power, the country’s sole electricity distributor announced rationing measures) while also causing a marked deterioration in C/A balances (above 9% of GDP in 2011 projected from 7.4% in 2010) as high import demand for both food and fuel are exacerbated by weaker rates (buoyed additionally by CBK reserve replenishment)–creating a negative feedback loop of sorts for the country’s fundamentals in which the output gap widens despite increased fiscal expenditures as reduced or removed import duties help cushion price rises on one hand but also dent progress being made on the very infrastructure projects needed to sustain growth (and woo foreign capital investment) on the other, bloating fiscal deficits (7% of GDP projected, now 2x that seen in 2008) in the process and returning us to square one. Meanwhile Kenya’s 20-share index is down nearly 25% YTD while the 91-day t-bill yield remained 9% at the latest auction compared with 3% at the end of Q1, a symptom of entrenched negative real rates. If only such clouds contained rain.
Kenya’s downward spiraling currency (USD/KES and EUR/KES are up 12% and 18% respectively since last November) coincides with soaring inflation (CPI inflation increased to 14.5% in June from 13% y/y in May) on the back of a hitherto rise in international fuel and food prices, the latter of which has been especially potent given poor domestic rainfall. That recently enacted, targeted subsidies failed to mollify the trend, while core inflation (7.9 versus 7.3 in May) ticked up as well–suggesting some entrenchment of expectations–should only stoke pessimism; indeed analysts with Absa Capital target further year-end rise to at-or-above 15% and a current-account (CA) deficit gap of nearly 9% of GDP from 7.4% end-last year. Indeed the recent hawkish flailing from the MPC ahead of its July meeting (a 175bp hike to 8% after only 50bp in cumulative hikes YTD) is hardly reassuring, much like its dogmatically stubborn maintenance of a 4 month FX/import cover ratio, a tactic which has had the not-so-curious effect of requiring perpetual replenishment given the bulk of import inflation is priced in dollars, while providing a telltale telegraph to speculators (whom the central bank now has in its crosshair; note the now-banned use of funds borrowed from the overnight window for interbank market or foreign exchange trading in an effort to curb volatility) that now-deeply negative real short-term rates are indeed for real while GDP growth (5.6% in 2010) will likely fall under 5% in 2011 (one reason why the 20-share index, down ~20.4% trails only Uganda YTD across SSA equities). Overseas remittances, meanwhile, are up a third from last year, meaning that if the state continues to suffer in its bid to borrow it may wish to try a more targeted approach. Yields won’t be topping for awhile.
Analysts with Nairobi-based Sterling Investment bank wrote to clients this month that “the opening up of the East African region” per last year’s EAC Common Market Protocol “[should] provide dilution to the monopolistic position of East African Breweries Ltd. (EABL:KN) in Kenya”, majority owned by industry heavyweight Diaego Plc, which along with SABMiller and Heineken has been aggressively building up [its] presence in emerging and frontier markets to drive future growth. SABMiller, for instance, recently beat its forecast by reporting a 3% rise in beer volumes in the first 3 month of 2011, a performance predominantly led by Africa and Asia, and is set to re-enter the Kenyan market after Diaego bought out its 20 percent stake in Kenya Breweries Ltd., EABL’s primary subsidiary, as part of an agreement to end cross-shareholdings in each other’s operations. Yet those sounding EABL’s death knell may wish to hold off: the firm’s EBITDA margin and ROE (33.1 and 36.89%) compare favorably to SABMiller (16.25 and 10.35%, respectively) and given its 90% Kenyan market share, an 8% growth in volumes last year and the fact that the country is still in the early stages of convergence vis a vis its per capita consumption (12 liters compared to South Africa, Nigeria and Botswana with 59, 53 and 40 respectively), the long run looks, shall we say, rather tasty.
Moreover in addition to increased competition EABL looks set to counter oft-cited near-term headwinds (i.e. an inflation-fueled consumer shift into low-end brands such as now legal, “traditional” brews, as well as the rising global cost of barley) comparatively favorably: Sterling notes, for instance, that the firm is “implementing a raw material substitution strategy that aims to reduce the barley reliance to 60% and increases sorghum (which is more cost effective) input to 40%”, a strategy which in turn will help augment production of its lower-end brand, Senator Keg, and also help cushion overall operating profits. To this end the firm has been contracting more sorghum famers to boost production since it estimates its demand for sorghum (currently 12 tons this year) to rise 4x by 2014″, while the Kenya Agricultural Research Institute has concurrently come up with “a variety of sorghum which is drought resistant and fast maturing which EABL has confirmed to have ideal carbohydrates for brewing.” Finally, while market share will be eroded somewhat in Kenya, EABL continues to look outward to fuel growth: its majority stake in Tanzania’s Serengeti Breweries, increased capacity in Uganda and planned capex in Sudan and acquisition in Ethiopia (where the government now seems set on further state-owned brewery privatization) is part of an overall vision to “increase its regional footprint from 7 to 13 countries” and underpinned by hitherto cash flow growth, which stood at Ksh7.99bn in cash and cash equivalents end-FY2010 with zero debt. On the downside, Sterling writes (its SELL recommendation in late May stated a Ksh154 price target versus 189 currently), remains soaring inflation, higher excise taxes and the Alcohol Control Act which “continue to undoubtedly pose a downside risk to volumes in its main market.” Duly noted, but keep this one in mind once the dust settles.
Analysts note that S&P’s recent [B to B+] upgrade and Fitch’s August [B+] affirmation of Kenya’s credit was largely a function of the East African country’s stable economic (real GDP growth of 5.1% y/y in H110, driven principally by the agricultural, manufacturing, and trading sectors) and political outlook. On the latter point, the country’s new constitution became law in August and leaders point to it as the pillar underpinning an ambitious “Vision 2030” program that seeks in essence to modernize and grow the economy with the help of international investment. Yet as The Economist pointed out immediately following the referendum, “differences between the country’s leading ethnic groups [are] huge, illustrating a persistently worrying ethnic polarisation of politics” that calls into question the viability of the stability sought.
Moreover, Barclays Capital opined this month that while the country’s current account deficit “improved significantly in the year to July, falling to USD1.7bn from USD2.2bn last year,” the trade deficit deteriorated marginally (import growth rose on the back of an increase in oil imports–23% of total imports) in that period and can be expected to further widen going forward “should global prices of oil and food increase in 2011” and/or the recovery in Europe stalls since it is “the destination of 20% of the country’s export goods and is the origination port for more than 20% of Kenya’s tourist arrivals.” Additionally, the government’s infrastructure program “is likely to be stepped up next year” and will also push up spending for investment goods (28% of total imports). Said fiscal expansion pushed the state’s deficit to roughly 7% of GDP this year, up from 4.4% in 2009, but should temper going forward thanks in part to the country’s USD500mn Eurobond, postponed in 2007 but now planned for 2011.
Mumias Sugar Co., Kenya’s biggest sugar producer and the stock of which has risen 99 percent this year (almost triple the 35 percent advance in the country’s benchmark stock index) is in the midst of diversifying its revenue sources by reducing its reliance on its core business of sugar production as final selling prices of the commodity will be negatively impacted beginning this December by the expiry of regional trade concessions that will give way to a flood of duty free, imported stocks that sell at a discount due to their lower production costs. In addition to increasing the amount of branded sugar to 70 percent from 30 percent, the company will launch a 120 million litre per year ethanol manufacturing plant in December 2011 (in late August it secured debt-financing amounting to $20 million (Sh1.6 billion) from a consortium of banks led by Ecobank Kenya to fund the plant), produce bottled drinking water from co-generation, a process whereby plants generate electricity from industrial waste or by-products such as gases, and refine its own sugar. The newfound stable electricity supply from the co-generation project would already boost output of its sweetener by 15 percent this year, management touted back in April.
JGW
Frontier Markets 