Jan 22, 2017

In our topical “Probable Direction of Equities Market in 2016”, we analyzed the trend in the local equities market and the factors that determine the stock market performance in an effort to forecast the direction of the equities market. The Kenyan Equities market saw a year of poor performance in 2016 with NASI, NSE 20 and NSE 25 losing 8.5%, 21.1% and 15.8%, respectively. So far the market has continued with its downward trend with NASI, NSE 20 and NSE 25 having lost 7.0%, 8.5% and 8.5%, respectively on a year to date.

Since the inception of the all share index in 2008, valuations, as measured by price to earnings ratio (“PE”), have peaked twice; once in August 2010 and the other in February 2015. Since the August 2010 peak of 19.6x, prices went on a downward spiral for 16-months to hit a low of 8.3x in December 2011, registering an annualized loss of 47.5% over the 16-month decline period. The market then picked up with prices rising for a period of 38-months to peak on February 2015 at a valuation of 16.9x, registering an annualized gain of 25.2% over the 38-month increase period.  Since then, the market has steadily declined over the last 23-months, currently at 9.8x, registering an annualized loss of 24.7% over the 23-month decline period. Currently the market valuations are below the historical average, and just 18.1% above the most recent trough of 8.3x, and long-term investors can now access the market at cheap valuations. However, the question still remains, have the markets troughed? Or are we up for a further decline in the future?

Currently, the market is on a bear run, mirroring the decline from the August 2010 peak to the December 2011 trough. A casual glance at the PE chart indicates the PE may be in store for a further decline for a few months before reversing trenHowever, in-order to properly understand what direction the market might take, several key metrics need to be analyzed. These metrics will be compared over the two periods i.e. July 2011, when the market was at the same valuation as the current period and also in a downward trend, to December 2011, when it troughed. Through analyzing and comparing the market conditions during the last 2 periods of persistent decline in market prices, and our outlook for 2017, we can make a judgement as to whether this trend will continue as per the previous cycle due to similar market conditions, or recover due to better market conditions compared to the last cycle. The 6 metrics to be observed include:

GDP Growth

From July 2011 to December 2011, GDP growth averaged 4.2% underpinned by tough macroeconomic conditions such as high inflation, high interest rates and at one point a rapidly depreciating currency. This poor economic performance was also reflected in the stock market, which lost 21.3% in the same period. However, the following year saw the stock market rebound, delivering a return of 38.7%, a positive correlation with the higher GDP growth of 4.6%. Despite a projection of a slower GDP growth for 2017 than 2016 at between 5.4% - 5.7%, we do not expect this to significantly affect the stock market thus we remain neutral.

Interest Rates

The volatility in interest rates as indicated by (i) the 91-day T-bill rising from 9.0% in July 2011 to 18.9% in December 2011, later falling back to 10.1% in June 2012, and (ii) the CBR being increased by 11.0% to 18.0% in June 2012, from 7.0% previously, led to poor performance of the stock market as most debt reliant companies struggled to fund their operations while others preferred to invest in fixed income instruments as opposed to the stock market. The following period witnessed stability of interest rates with the 91-day T-bill averaging at 9.2%, a positive for the stock market. This year we expect some upward pressure on interest rates as the government plugs in the deficit that may arise from foreign borrowing and tax collection from the local borrowing program. We however don’t anticipate the upward pressure to reach the levels in 2011, thus having a neutral effect on the stock market performance.

Inflation

The inflation trend in 2011 was unsettling, averaging at 14.0%, having peaked at 19.7% in November. This affected the stock market negatively. We expect 2017’s inflation to rise slightly but be contained within the government target of 2.5% - 7.5%. This is not likely to trigger any monetary action from the CBK and as a result, we expect the stable inflation levels to provide some levels of support to the local stock market performance. This will have a neutral effect on the equities market.

Exchange Rate

In 2011, the Kenya Shilling hit a low of 105.9 against the dollar in October 2011, a depreciation of 11.6% in one year’s period, resulting in sell-offs in the stock market triggering a downward trend in the market performance. However, the depreciation of the shilling was then as a result of speculation, as opposed to the current expected weakening of the shilling, which is due to structural issues and the recovery of the US economy with the Fed citing a possibility of three rate hikes this year. Additionally, the reliance of dollar denominated foreign debt has increased since 2011 further piling pressure on the shilling when it comes to servicing. This will have a negative effect and add to the downward pressure on the equities market.

Corporate Earnings

2011 witnessed strong corporate earnings with the banking sector recording earnings growth of 20.5% from July 2011 to June 2012. During the year, only 5 listed companies issued profit warnings compared to 4 in 2016. In 2016, earnings growth is expected to be lower at 12.5%, with banks recording earnings growth of 9.3% in Q3’15. We expect earnings growth to remain subdued in 2017, with expectations of an earnings growth of 8.0%, especially given the enactment and operationalization of the Banking (Amendment) Act 2015. Given this corporate earnings growth rate, this gives a forward P/E of 9.6x, relatively cheaper than historical average of 13.6x. As a result of this, we expect a neutral effect the market.

Investor Sentiment

The Eurozone crisis led to poor investor sentiment especially for the risky frontier markets that led to a reduction in foreign investors’ activities at the Nairobi Securities Exchange. The US economy was also on a recovery path and still struggling. Furthermore, the elections to be held this year might have some negative impact as investors take a wait-and-see approach. For the year 2017, the world economy is bound to recover with the Chinese economy stabilizing, commodity prices expected to rebound and the US economy at its strongest level since 2008. We also believe that the impacts of the expected increased rate hike cycle in the US and the general elections is likely to affect foreign participation in the market therefore leading to significant foreign outflow from the market, however, we remain neutral.

Market valuations in 2011 were low bottoming at a PE of 8.3x. Currently, the market is trading at a PE of 10.6x with projected earnings growth of 8.0%, leading to a forward PE of 9.6x indicating the market is trading at the same level compared to where it was in 2011.

These factors have been summarized in the table below: -

Macro-Economic Indicators	July 2011 – December 2011 Experience	2016 Experience	2017 Projections	Effect (2017)
GDP growth	3.7% growth in Q3’11 and 4.6% growth in Q4’11	GDP growth during the year was at: -	GDP growth is expected to come between 5.4% - 5.7% supported by (i) Government continued expenditure on infrastructure, (ii) the recovery of the tourism sector, and (iii) the continued growth of the construction sector	Neutral
		i) 5.2% growth in Q1’16
		ii) 5.6% growth in Q2’16
		iii) 6.3% growth in Q3’16
Interest Rates	The CBR rate was at 6.25% in June 2011 and was increased to 18.0% by December 2011	CBR stood at 11.5% up to April. It then it was reduced by 100 basis points to 10.5%. It was later reduced by 50 points in August to 10% which stood for the remainder of the year	Expected upward pressure on interest rates as government seeks to plug deficit, but not to the levels witnessed in 2011	Neutral
	91 Day T-Bill was at 8.99% in July 2011. It increased to 18.95% by December 2011
Inflation	Inflation stood at 14.5% in June 2011 and increased to 18.93% by December 2011. The inflation rates decreased gradually remaining in double digits to 10.1% by June 2012	Inflation remained within CBK’s expectations of 2.5%-7.5%. The highest inflation was in January which stood at 7.8%	We expect upward inflationary pressure in 2017 but average within the government target driven by (i) drought which will persist until mid-2017 driving food prices up, (ii) currency depreciation as the dollar strengthens globally, and (iii) the expected rise in oil prices	Neutral
Exchange Rate	The Shilling depreciated 25.2% against the USD from an average of 89.3 in June 2011 to highs of 105.96 in Oct 2011. The foreign reserves hit a low of 3.59 months of import cover, but climbed to 3.74 months in December 2011	The Kenya shilling remained stable during the year, depreciating by 0.2% to close at 102.5. Forex reserves hit a high of 5.2 months and closed the year at 4.6 months	We expect the shilling to depreciate against the dollar driven by (i) continued global strengthening of the dollar as the Fed plans to increase their rate hiking cycle in 2017, and (ii) recovery of the global oil prices	Negative
Security & Investor Sentiment	The Euro crisis led to reduced foreign investor activities at the Nairobi Securities Exchange which dampened investor sentiment, setting the NSE on a bear run, losing 29%. The country also faced insecurity due to the rising Al-Shabaab threat	Uncertainties such as Brexit and the US general elections caused concern for investors in the global market. Security remained relatively stable during the year as a result of various security measures implemented during the year	We expect 2017 to register reduced net foreign outflows due to uncertainties regarding political and social risks as Kenya undertakes general elections, and expectations of a more aggressive rate hike cycle by the Fed. We expect security to be maintained in the country supported by government initiatives towards improving internal security	Neutral
Corporate Earnings Growth and Valuation	The banking sector pre-tax profit grew 20.5% from December 2010 to December 2011, with an overall growth of 7.8% for the same period	NASI and NSE 20 Index fell 8.5% and 21.1% respectively	We expect corporate earnings growth of 8.0% in 2017 due to lower earnings for financial companies attributed to the implementation of the Banking Act (Amendment) ,2015	Neutral
	NASI and NSE 20 Index fell 21.3% and 29.0% respectively. 5 listed companies issued profit warnings	4 Listed companies issued profit warnings	Assumption of corporate earnings growth rate of approximately 8.0% gives a forward P/E of 9.6x, relatively cheaper than historical average of 13.6x

Way Forward in 2017:

Following the above comparison, we find that out of the 6 key metrics that we are analyzing, only one is negative while the rest remain neutral. The only metric that is negative is the exchange rate. This is primarily because the shilling will probably weaken due to (i) global strengthening of the dollar as the Fed hikes the fed rate, and (ii) increase in global oil prices. Key to note, there is no metric that favors a positive performance of the stock market. This supports the hypothesis that the equities market will most likely remain flat for 2017, at best or continue to decline given its an election year and the valuations are yet to hit the troughs experienced in December 2011.

We would recommend a gradual increasing of equities allocation during 2017, and even then have a long-term view and pick stocks that are deeply undervalued but with strong earnings prospects.

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted. This publication, which is in compliance with Section 2 of the Capital Markets Authority Act Cap 485A, is meant for general information only, and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.