Executive Summary

• Fixed Income: Yields on government securities increased for the third week. The U.S Fed increased the target range for the federal funds rate by 25 basis points to 0.25%-0.5%;
• Equities: The market registered mixed performance, with NASI gaining 0.6% while NSE 20 and NSE 25 fell by 0.1% and 0.2%, Kenya banks record the highest return on equity amongst regional banks;
• Private Equity: Increased level of activity in private equity in Sub-Saharan Africa, supported by attractive valuations and better economic growth in the region;
• Real Estate: Fusion Capital launches a large housing project.

Company Updates

• Cytonn continues to be the preferred real estate partner with three significant real estate deals in December (i) a joint venture (?JV?) agreement for a 1,000 acre master-planned development in Athi River that we expect to be in the market by mid-2016 once master-planning is complete, (ii) a second project in Ruaka on a 1 acre JV, and (iii) an agreement for a 100 acre master-planned development in Rongai. The strategy of bringing global capital for partners such as Taaleritehdas of Finland, local land-owners through joint ventures and our development expertise onto one platform continues to receive wide acceptance
• Our Senior Investment Analyst, Duncan Lumwamu discussed the impact of the Fed Rate hike and the WTO 10^th Ministerial Conference. See link on CNBC Africa
• We continue to beef up the team with the ongoing hires

Fixed Income

Treasury bill auctions were oversubscribed during the week, with overall subscription coming in at 122.0%, compared to 92.3% the previous week. The 91- day T-bill received subscriptions of 320%, an indication that investors prefer shorter dated securities. Yields were on an upward trend for the 91-day and 182-day papers, coming in at 10.0% and 11.7% from 9.7% and 11.1%, respectively, with the yield for the 364-day paper remaining relatively stable at 12.5%, from 12.6% the previous week. As indicated in our Cytonn Report #48, the Government recently issued a 9-Year amortized infrastructure bond with a weighted tenor of 7 years to raise Kshs 30 bn for financing infrastructural developments. Since the bond was undersubscribed with overall subscription coming in at 55.3%, the government opted to extend the offer through a Tap Sale, where investors on a first-come-first-serve basis can continue bidding for the bond with the total amounts of the bond on offer at Kshs. 16.0 bn. The yield on the tap-sale bond is the accepted market average when it was first issued, 14.8%. The re-opening of the bond is not good for the secondary market, since investors who had taken positions in expectations to trade cannot do so and realize returns and that explains why the bond has so far not traded in the secondary market. With expectations that yields could spike in the first quarter due to the high amount of maturities in this fiscal year, the government is keen to lock up long-term funds.

The money markets remained fairly liquid with the interbank rate averaging 4.6% during the week, compared to 4.2% the previous week. The Central Bank pumped in Kshs. 6.7 bn through reverse repos in support of small banks compared to maturities of Kshs. 5.4 in the week. Since the month of November, CBK has injected Kshs. 103.4 bn in liquidity.

Despite increased liquidity in the market and the Fed raising the rates, the Kenya Shilling remained relatively stable losing 0.2% against the dollar during the week to close at Kshs 102.4 to the US$. This can be attributed to the continued growth in the forex reserves at 4.5 months of import cover and the fact that Kenya can now access the USD 688 mn facility from the IMF.

The U.S Fed met this week and unanimously decided to increase the Fed?s target range rate by 25 bps to 0.25% - 0.50%, the first increment since the Great Recession. The increment was on account of:

1. Improved labor market conditions: The labor market has been strong, most recently adding 211,000 jobs versus an expectation of 192,000 in November and the unemployment rate dropping to 5.0% from a peak of 10.0% in October 2009,
2. Improved Economic growth: With improved labour markets, economic growth has been on the rise with the second quarter GDP growth rate at 2.1% compared to the average of 1.2% since 2008,
3. Inflation rate at temporary low levels: Inflation, currently at 0.5%, was expected to edge down, further away from the Federal Open Market Committee?s long-term target of 2.0% but in their view the energy prices are expected to correct in the short term leading to a rise in inflation to normal levels

The IMF has again, for the third time now, revised their 2015 GDP projections for Kenya downwards to 5.6% from 6.0%, coming closer to Cytonn?s projection of between 4.7% and 4.9%. This comes after revising their projections twice during the year, from the 6.9% at the beginning of the year to 6.5% in June, and then to 6.0% in October. IMF stated that growth in 2015 was slower than expected due to (i) delays in infrastructural spending, (ii) weaker tourism receipts, and (iii) volatile external capital outflows. IMF also raised concerns about Kenya?s macroeconomic policies, which they state need to be prudent to contain inflation within target and public debt should be sustainable to reduce the current account deficit, which still remains high. In our view the projections at the beginning of the year were ambitious and not achievable. We are currently working on the 2016 growth projections and we shall release them at the beginning of the New Year.

Despite the Government being ahead of target in its domestic borrowing programme, having borrowed Kshs 173.9 bn for the current fiscal year compared to a target of about Kshs 104.9 bn, (assuming a pro-rated borrowing throughout the financial year of the budgeted Kshs. 219bn of total domestic borrowing for this year), the pressure on rates is expected to persist. Most of these borrowings are short-term instruments that mature within the current fiscal year and the Government will face pressure in refinancing the obligations as they mature. As a result, we maintain our view that investors should be biased towards short-term fixed income instruments given the uncertainty in the interest rate environment.

Equities

During the week, the market registered mixed performance, with NASI gaining 0.6% while NSE 20 and NSE 25 fell by 0.1% and 0.2%, respectively. Gains were registered in Safaricom, Standard Chartered and Bamburi which rose by 2.8%, 2.5% and 2.3%, respectively. Since the February peak, NASI and NSE 20 have shed 18.0% and 27.5%, and down 10.6% and 22.0% on an YTD basis, respectively. NSE 25 index is down 0.3% from inception to date.

Equities turnover rose by 36.6% during the week to Kshs 4.8 bn from Kshs 3.5 bn the previous week. Foreign investors were net sellers for the eighth straight week with net outflows of Kshs 214.8 mn, which was a 185.7% increase from net outflows of Kshs 75.2 mn witnessed last week, with Equity bank and KCB experiencing the largest outflows. The sustained foreign investors? net outflow can be linked to a shift in global investor portfolio flows based on the recent rate increase in the US that has reduced their risk appetite for securities in emerging and frontier markets and made the US market more attractive.

The market is currently trading at a price to earnings ratio of 12.8x, versus a historical average of 13.8x, with a dividend yield of 4.0% versus a historical average of 3.3%. In our view, given the challenging operating environment in 2015, which has resulted in low earnings growth, we expect market activity to remain subdued. The charts below indicate the historical PE and dividend yields of the market.

The Bank of Uganda released a financial stability report which indicated that Kenyan banks shareholders? enjoyed the highest returns compared to their East African peers, aided by lower operating costs and wider interest margins. Below is the summary of the report:

1. Kenyan banks had a return on equity of 28.3% as at June 2015, higher than in Uganda (24.6%), Tanzania (15.1%), Rwanda (13.1%) and Burundi (8.1%),
2. Ugandan banks ranked highest with respect to return on assets at 3.8%, with Kenya at 3.3%, Tanzania at 2.9% and Burundi at 1.2%,
3. Kenyan banks benefitted from aggressive lending with loan growth at 21.9%, compared to 19.7% in Uganda,
4. Deposit growth in Kenya was at 19.5% compared to 16.5% in Uganda,
5. As a result of the volatile interest rate environment witnessed in a number of East African countries, especially Kenya and Uganda, the NPL?s to total loans ratio was at 5.7% for Kenya, compared to 4.0% in Uganda and 6.3% in Rwanda,
6. As a result of efficient alternative channels of distribution, Kenyan banks benefited from operation efficiency, as reflected in the favourable cost to income ratio (CIR) at 51.0%, compared to a CIR of 68.7% and 78.6% in Uganda and Rwanda, respectively.

Going forward as Kenyan banks continue to expand into the region, the margins might be lower in the short term but given the East African Community push, the efficiencies being enjoyed in Kenya can easily be adopted in the region.

The new Barclays Bank CEO James Staley, is pushing for the London based bank to divest part or all of the holdings in its African subsidiary, because of ?questions about the strategic fit of the UK-based bank?s large African business with the rest of the group?, a report by Financial Times indicated. In Kenya the multinational holds 42.6% of Barclays Kenya and if the divesture comes to pass, the minority shareholders are likely to get a new partner and this might be a big blow to the Kenyan business given the huge brand equity that the bank has. In our view this shows the effect of the strength and growth of local banks such as Equity and KCB, which have displaced traditionally strong banks such as Standard Chartered, Barclays and Citi from their perch as the key provider of banking solutions.

We remain neutral with a bias to negative on equities given the lower earnings growth prospects for this year. The market is now purely a stock pickers? market, with few pockets of value. We continue to be avid buyers of KCB and Equity while accumulating Standard Chartered guided by our recommendations.

Private Equity

Ethos Private Equity has sold its 7.7% staken Transaction Capital, the Johannesburg-listed commercial finance company. The sale of the 43.8m shares would fetch approximately USD 34mn, noting that Ethos has been invested in Transaction since 2006, for an undisclosed amount. The company has two business divisions: asset-backed lending, which finances the purchase of some 25,000 taxis, and transaction capital risk services, which manages the non-performing loans of 5.7m borrowers - about one in six South African adults.

IFC plans to invest up to USD 22mn in Metier Capital Growth Fund II, South African private equity firm Metier?s latest fund which is looking to raise up to R3 billion or almost USD 200 million. The fund expects to invest controlling or significant stakes in high growth, middle market companies. Metier Capital Growth Fund II will build a portfolio of 8 to 12 sub-Saharan companies in sectors that look likely to benefit from the continent?s growing middle class, the rising investment in infrastructure services and intra-regional trade.

We reiterate our bullish stance on PE as an asset class, driven by:

• The abundance of global capital looking for opportunities in Africa;
• Attractive valuations in private markets compared to public markets, and;
• Better economic growth in Sub Saharan Africa as compared to global markets.

Real Estate

Fusion Capital this week launched a Kshs. 11.5 bn housing project in Nairobi, targeting the high-end and middle class income earners. This property, dubbed ??Galaxy Gardens?? is located on a 100-acre piece of land next to Tatu City. The development shall comprise of 470 housing units of 3, 4 and 5 bedroom units. The project has been selling off-plan with prices ranging from Kshs 12 mn to Kshs 40 mn. Developments such as these are in response to:

1. The housing shortage that has long plagued Nairobi,
2. The growing middle class which are looking to be first time home buyers, and
3. Availability of large tracks of land next to upcoming cities and mega developments, which create value for the neighborhood.

In the coming year, we expect developers to roll out projects of this magnitude or larger in order to curb the housing shortage.