ICEA Asset Management - Mid Year Investment Review

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Mid Year Investment Review

As we near the half way mark in 2008 it is time to take stock and chart the way forward for the second half of the year.2007 was a disappointing year for long term investors, mainly because the four year rally on the NSE ran out of steam and offshore investments lost value as a result of the combined effects of falling global markets and a strong Shilling.

The fixed income markets fared no better as the CBK maintained low and stable interest rates in the face of increasing inflationary pressures. The monetary authorities stuck to their belief that interest rates should be pegged to underlying inflation, which excludes food and fuel costs, as opposed to the CPI. This resulted in increasingly negative real interest rates as inflationary pressure intensified on the back of rising fuel and food prices. The average return for retirement benefit schemes for the year was 8.7%, below the average annual CPI inflation rate of 9.8% as well as the long term average for inflation of 12%.

Towards the closing months of 2007 investors looked towards 2008 with hope and belief that the accelerating economic growth in Kenya and the region would restore the Bull Run on the NSE. What was most needed was a return to a position where returns on long term portfolios would be high enough to counter the effects of inflation and preserve savings and capital in real terms. Unfortunately the political crisis in the early part of the year, coupled with a severe drought and rising oil prices changed the outlook dramatically and dashed all hopes of a continuation of the better than 6% GDP growth rates experienced in recent years. Forecasts for economic growth for 2008 have since been downgraded to around 4% and inflation is rising sharply as interest rates remain substantially negative in real terms. The CBK has decided not to change the key Central Bank Rate and has maintained it at 8.75%, thus signalling that it believes that, despite runaway inflation, a rise in interest rates is not appropriate in a rapidly slowing economy. Working against this is the sharp acceleration in inflation to 26.6% and a surge in money supply growth to 23% y-o-y in February , indicating that inflationary pressure may not be entirely import and traded goods related, in an environment where banking sector liquidity remains consistently high. Inflation may be harder to tame than previously believed and we should all prepare for another round of rising prices and increased wage demands. The dilemma facing the monetary authorities arises as result of a phenomenon known as stagflation. This is a term used to describe a period of inflation combined with stagnation. In other words, slowing economic growth and rising prices and unemployment. In these circumstances the policies usually used to stimulate economic growth, such as cutting interest rates, will further increase inflation. On the other hand policies usually employed to arrest inflation, such as tightening monetary policy and increasing interest rates, will further the decline of an already declining economy.

Stagflation is typically caused by a severe supply side shock, such as a food shortage or a sharp rise in oil prices. Both of which apply to this economy. The problem is more difficult to tackle when it is more focused in one sector than another. For example the rising food prices have a significantly worse impact on consumers at the lower end of the economic chain who spend more of their disposable income on food than higher earning consumers.

If it is accepted that we are in a period of stagflation then there is little that the monetary authorities can do to influence the problem. It falls on Government to rapidly address the supply side problem by ensuring that food becomes more readily available so that prices can fall. Importing is a short term but expensive solution. The medium term solution is to get the farmers back on the land with affordable inputs, adequate finance and viable price structures. Long term a national policy of reducing reliance on rainfall by increasing water storage and irrigation capacity will help to moderate the huge volatility in food prices arising from seasonal factors as well as erratic rainfall Very little can be done about imported fuel costs other than to wait for inflation to adjust to the recent price shocks and consumption to slow as a reaction to rising costs. The market has been overshadowed by the massive Safaricom IPO which has distracted investors and caused a severe liquidity dislocation in the money market as IPO funds flow to the receiving banks, at the expense of all of the other banks. CBK has taken steps to maintain market liquidity and stability but several banks have been under pressure and short term deposit rates have spiked upwards by two to three hundred basis points. Most see this as a temporary phenomenon which will reverse once the IPO is over.

OUTLOOK FOR THE NEXT SIX MONTHS

Once the Safaricom IPO is out of the way and markets settle back to normal what can we expect?

The crisis in the global markets is still far from over as the domino effect spreads; the oil price shows no sign of retreating and several natural disasters have wrought havoc in Asia. On the local scene the fallout from the political crises is still being felt, especially in tourism, and the rains have once again been disappointing. This lack of adequate rainfall will threaten food supply and may even impact on electrical generation capacity later in the year. All of which is not good for prices and inflation and indicates that it may be well into 2009 before investors can expect better conditions for generating inflation beating returns. A return to 6% GDP growth is possible in 2009 provided the politicians can keep it together and can persuade a population that is faced with sharply rising food, transport and energy costs to remain peaceful and productive. Any further disruption to production, distribution and tourism would be extremely damaging.

We expect the next six months to be a challenging period, set against a backdrop of a slowing global economy, sharply higher oil prices, a fragile political accord at home and sub-standard rains. We think that the lag effect of all of this will be felt in the months ahead as consumer spending contracts and inflation rises towards a peak later in the year. The NSE may rebound once refunds from Safaricom filter back to the speculators but subdued fundamentals will not support a sustained rally. Interest rates are likely to remain well below the inflation rate as the CBK waits for the inflationary pressures to abate and the spike in prices to reverse. Once again, long term investors will have to be patient and wait for a recovery in 2009 before anticipating real growth in portfolios. In the meantime, those with an appetite for offshore investment could take advantage of a strong Shilling to take a position in global markets now that prices have fallen in many markets across the world. The prospects for the Shilling look good in the short term but some downward pressure may emerge later in the year. The CBK has sufficient foreign exchange reserves to maintain a relatively stable market and the influx of foreign portfolio funds into Safaricom should ensure continuing currency support in the short term. Deteriorating economic fundamentals could start to exert downward pressure in the last few months of 2008.

In the longer term the challenges of funding a higher budget deficit at a time when tax revenues are stagnating or falling will continue to put pressure on the market. The inflation effect on VAT and some bracket creep may make up some of the shortfall but revenues will likely fall in real terms. The Safaricom IPO will provide Treasury with a temporary respite but funding the budget for the forthcoming fiscal year will take some imaginative structuring if domestic borrowing is to be kept in check. A mix of local and international debt coupled with further privatisation sales is most likely to be the formula used to plug the gap once again. In addition Government may finally come to the market with the much talked about infrastructure bonds and it will be interesting to see what incentives will be offered.

LOOKING AT THE MAJOR SECTORS OF THE ECONOMY

Tourism is slowly recovering as the events surrounding the election fade and peace prevails. Unfortunately the recovery will be slow and protracted as it is dragged back by a strong Shilling and a fall off in global tourism and business travel. The financial crisis and credit crunch, coupled with higher fuel bills for airlines will mean fewer travellers as they tighten their belts and feel decidedly less affluent. Many potential travellers have seen the value of their homes fall along with their savings and their pensions so expenditure on travel and leisure will definitely decline. Tourism and all of its downstream activities are still not out of the woods by any means. Financial Services has been the best performing sector in recent years and it will probably continue to be so. However, the spectacular earnings growth of recent years is unlikely to be sustained as banks grapple with rising bad debts, increasing competition, rising costs and shrinking interest margins. The investment in the region by several banks will begin to pay dividends but will not offset the anticipated decline in the rate of local earnings growth. Never the less, on a relative basis banks will continue to be attractive, despite a plateau in earnings growth for many. Energy and the fuel sector will continue to battle in a difficult market as oil prices reach record levels. Issues over pipeline capacity, pricing, tax and working capital costs are the major challenges. The electricity sector is still bedevilled with lack of decision on tariffs, declining reservoirs for hydro-power generation and rising fuel costs. Despite recommendations for price increases it may be sometime before market driven tariff structures are in place, particularly as consumers are already feeling the pinch. In the background looms the ongoing requirement to raise substantial amounts of capital to expand and maintain the power network. We don’t expect this sector to perform well in the months ahead. ICT should be one of the sectors that are more or less immune to the testing economic conditions. Consumers show little propensity to reduce expenditure on communicating by cell phone so the outlook is positive but growing competition and changing regulations may be the main threat to the listed ICT companies. Infrastructure should continue to prosper if Government presses ahead with its infrastructure refurbishment and development programmes. The cement, paint and cabling companies may once again be negatively affected by power problems, capacity constraints and rising distribution costs but should continue to perform well. Agriculture will continue to be badly affected by the disruptions to production, poor rains, rising costs and the strong currency. Rain fed sugar, tea and coffee producers will be suffering from poor rainfall and rising transport costs as well as the post election period disruptions. Motor Industry is very much a cyclical industry that also relies heavily on public sector programmes. This industry is benefiting from public sector orders and orders placed during the last period of economic growth. Once the lag effect catches up we expect to see this industry slow down in tandem with the economy.

Consumer spending will decline and discretionary spending patterns will alter as consumers spend more on basics and less on luxuries. Consumer companies will see sales decline if they are not able to quickly adjust product mix.Media and advertising STRATEGY We dislike writing reports that appear to be largely doom and gloom so we must make it clear that these economic cycles are typical in an agricultural developing economy. The economy remains robust and the economic reform process is unstoppable as Kenya builds on its role as a regional hub. The cycle will turn if all of the factors needed to fuel growth are restored and we can expect a recovery once the present challenges have been met. Having said that, the only strategy to combat these difficult times is to take a defensive stance and also use the opportunity to accumulate quality assets in anticipation of a recovery in 2009. Locking in yield on bonds and minimising exposure to the money market is the best way to preserve portfolio yields, while we wait for better times ahead. The strong Shilling presents an opportunity to increase offshore exposure where most value can currently be found in emerging market funds that invest in Africa. In due course world markets will stabilise and turn at which time assets will be offering good value and an opportunity to buy in at attractive valuations. We see little hope of portfolios growing significantly in 2008 and will position ourselves in defensive assets that will preserve value and react positively to any early recovery.