Egypt Outlook Improving but Underperformance to Persist Near-Term

Egypt appears to be finally on the road to recovery after several years of political uncertainty took a toll on the economy. While many challenges remain, the government of President el-Sisi appears committed to economic reforms that will help boost Egypt’s long-term outlook. The seeds have been planted for an improved economic future, but Egyptian assets are likely to underperform near-term.

POLITICAL OUTLOOK

President el-Sisi took office in 2014 with little opposition. The first round of parliamentary elections was held last month, with the second round scheduled for November 22/23. The new legislature is widely expected to support the executive branch. As such, we remain optimistic that planned structural reforms will proceed, albeit perhaps slowly.

Concerns about terrorist activity have risen after the recent tragedy involving the Russian Metrojet plane. An ISIS affiliate in Egypt has claimed responsibility for the downing, and Russian President Putin recently acknowledged that it was most likely a terrorist act. We note also that with persistent high unemployment, social tensions are likely to remain high and this could be fertile breeding ground for terrorism to take root. The government has wisely signaled that it would like to boost spending on social programs.

 

ECONOMIC OUTLOOK

GDP is forecast to grow around 4% this year. This is an improvement from 2012-2014, when growth was around 2.2% per annum. Much of the recent growth has been driven by consumption, but this should shift more towards investment and exports in the coming years.

The fiscal outlook remains one of Egypt’s weak points. The deficit is forecast at -11% of GDP this year, despite the phasing out of some subsidies. Because of this, the government has committed to further fiscal reforms that would help put public debt on a downward trajectory. The IMF has recommended lower fuel and electricity subsidies, as well as implementation of a VAT. The government has confirmed that the VAT is being studied.

The external accounts improved in 2013 and 2014, but that trend should reverse this year and beyond. The current account gap is expected to rise to near -2.5% of GDP this year and -3.1% next year, up from -0.8% in 2014. Foreign reserves have been falling steadily, and are poised to fall below $15 bln for the first time since June 2013. This has happened despite several infusions of more than $20 bln in aid from Gulf allies Kuwait, Saudi Arabia, and the UAE.

Longer-term, the discovery earlier this year of significant natural gas reserves off-shore could turn Egypt into a significant energy exporter. The West Nile Delta development should come on stream starting in early 2017. BP recently announced that it was accelerating this project, devoting one sixth of its global capital investment over the next two years to Egypt. That means upward potential for FDI, which took a hit during the period of political uncertainty.

CPI rose 9.7% y/y in October, accelerating for the second straight month. This is still below the cycle peak of 13.1% y/y from May, but the rising trend should keep the central bank on hold for now. The last move was a 50 bp cut to 8.75% back in January. Current Governor Amer was just appointed in October, following the resignation of previous Governor Ramez a few weeks before his term was set to expire.

S&P recently moved the outlook on its B- rating on Egypt from positive to stable. The agency cited persistent external imbalances and the potential for less support from GCC countries as factors behind the move. Our own sovereign ratings model has Egypt at B+/B1/B+, which is above actual ratings of B-/B3/B. As such, we disagree with S&P’s move. We note that Egypt returned to the international markets in June with the successful issuance of a $1.5 bln Eurobond.

 

INVESTMENT OUTLOOK

The central bank introduced a new FX mechanism for foreign investors back in March 2013. Investments made under this arrangement are reportedly easy to repatriate, with access to foreign currency granted with little or no delays. However, any investments made outside of this new mechanism, or from prior to the implementation of the new mechanism, typically face delays in excess of a year to repatriate.

The pound is effectively pegged, but has undergone periodic adjustments this year. It is still one of the better performers in EM, -9% YTD against the dollar. This compares to -29% for BRL, -23% for COP, -20% for MYR, and -18% for both TRY and ZAR. However, downward pressure on the pound can be inferred from the steady decline in foreign reserves. This decline cannot be sustained. In addition, the growth of a parallel exchange rate means that the official rate is not market-clearing. After the current period of relative stability, we think USD/EGP will have to be adjusted above the all-time high near 8.05 from earlier this month.

Egyptian equities have underperformed within EM. MSCI Egypt is down -25% YTD, and compares to -13% YTD for MSCI EM. Our EM Equity model has Egypt at a VERY UNDERWEIGHT position, same as the previous quarter. Further improvement in the growth outlook could help in the future, but we’re not quite there yet.

Egyptian bonds have underperformed this year. The yield on 10-year local currency government bonds is up about 50 bp YTD. This is slightly in underperforming camp, and is well behind the worst performers Brazil (+285 bp), Turkey (+181 bp), Peru (+169 bp), and Colombia (+121 bp). With inflation likely to rise, preventing the central bank from resuming rate cuts, we think Egyptian bonds could start underperforming more.