Five Reasons Why Egypt Will Surprise!

Like many emerging markets, Egypt’s economy has been slowing down since the beginning of 2021. However, the country's economic woes accelerated with the breakout of war between Russia and Ukraine last March. Lower tourism proceeds (35% of tourist arrivals in 2021 came from Eastern Europe), coupled with rising grain prices (Egypt is the largest wheat importer globally), left a dent in its current account. The deterioration in the terms of trade, which also coincided with a hawkish Fed, created the perfect storm. The country's sovereign debt faced a sharp derating and domestic equities saw an exodus of foreign investors, to be replaced by GCC institutions and sovereign wealth funds.

We believe that Egypt’s economic fundamentals are stronger that what it is currently perceived by the market. For one reason, Egypt has always been a closed economy. Egypt’s imbalances are mostly rooted domestically, which makes them easier to manage than otherwise. The recent deterioration in the terms of trade was just a catalyst to bring domestic imbalances under the spotlight.

The Eye of the Storm

As a result of the social unrest witnessed between 2010-2013, the government announced several national projects like Suez Canal expansion/New Capital to support the economy, pushing fiscal expenditure as high as 36% of GDP in 2016. Despite the rise in government outlays, tax collection trailed spending, leading to an estimated fiscal deficit that peaked to 12% in 2016. In 2021, the fiscal deficit recorded 7% of GDP.

This chart illustrates how government “crowded out” private investment (capital formation) and led to an FX mismatch on the government balance sheet. When a government's domestic funding requirement exhausts the saving pot of its citizens, it has to seek foreign capital to finance its deficit. Beginning of 2010, the fiscal deficit started to exceed domestic savings and the government had to tap the international debt market to plug the difference (the dark blue line measures the net balance of fiscal deficit minus domestic savings as a percentage of GDP).

In the meantime, Foreign Direct Investment (FDI) as a percentage of GDP was also not sufficient to fund the current account deficit (light blue). The Central Bank of Egypt had to maintain a high real interest rate (2015-2019) to attract foreign capital to finance the twin deficit. The real interest rate led to a historic decline in capital formation (investment) as percentage of GDP (red line). The good news is that the external sector (current account + FDI) is turning into surplus and domestic deficit is narrowing, reducing the need to raise external debt to finance the local government.

The recent statements by the government acknowledge the need for fiscal consolidation which seem to be underway. Unlike many other emerging economies, Egypt’s external deficits are rather manageable in absolute and relative terms. The internal imbalance (fiscal deficit – domestic savings) is more relevant and this is now correcting. In short, Egypt’s imbalances are rooted domestically, and both the internal and external funding gaps are narrowing. The fiscal consolidation will have a negative impact on economic growth in 2022-2023, but this is no inevitable to keep the debt dynamics in check.

Five Reasons Why We Turned Positive!

1) Debt Sustainability

Both internal and external debt to GDP ratios put Egypt in the middle of the pack compared to other Emerging Markets. In terms of debt sustainability, Egypt’s debt profile is not an outlier. The spike in the country CDS and pressure on the Eurobonds are more reflective of i) challenging funding environment for emerging markets because of the Fed policies ii) short-term funding and roll-over pressure at the country level in 2022-2023.

2) Debt Roll-over & Funding Requirements

Stress in the debt market started with the war breakout in February. Egypt is the largest importer of wheat globally. The country imports 13mn tons per annum. Russia and Ukraine amounted to almost 77% of total wheat imports. The run-up in wheat prices from $7/BU to $11/BU could cost the country an extra $2bn in 2022 alone. Today, wheat prices are lower than when the war started $8.4/BU due to a strengthening USD and the grain export agreement signed by both Russia and Ukraine and guaranteed by Turkey.

Source: Bloomberg (See DDIS<GO>). Chart from Bloomberg “Global Insight” column dated July 12.

Overall, the funding requirements seem to peak in 2H of 2022 with 2023 dropping to $25bn. By tapping GCC sovereign wealth funds, Egypt secured $15bn in term deposits/CDs from GCC governments and paid $20bn in interest and instalments for foreign debts from July 2021 to March 2022, $16.6bn of which were instalments and $3.345bn were interest payments.

GCC to the rescue

It is not the first time that the US government sanctions a country and freezes its assets (Iran and North Korea tasted the bitter pill before). However, the US has crossed the Rubicon by sanctioning the reserves of a nuclear power that are worth +$600bn. The whole idea of keeping reserves is to be able to use them in need. Other nations including China are now questioning their exposure to the USD. On the 22nd of April, the Chinese government held a meeting with local banks to design a strategy to protect its assets from US sanctions (FT: China meets banks to discuss protecting assets from US sanctions). One month later, a Chinese delegation flew to NYC to seek guarantees from the US Treasury regarding Chinese reserves, given that China continues to do business with Russia as usual, to be turned away without reaching an agreement (Eurasian Times: “Averting A $3.2 Trillion Loss” — China Holds Emergency Meeting To Protect The Country From Russia-Like Sanction). No wonder GCC countries are looking for ways to diversify away from the USD and secure resources, including food security. A strategic alliance with Egypt is timely and it is more likely that economic integration and foreign investment from the GCC will likely accelerate going forward.

GCC capital inflow will help stabilize the FX rate in the short-term. An agreement with the IMF to extend the current program or increase its quota will introduce the necessary reform to address internal imbalances and provide the necessary catalysts for Egyptian assets to perform.

3) Valuation

As the Fed uses its sledgehammer to slow the economy and fight off inflation, history suggests that a hard landing will be difficult to avoid. J. Powell made it clear that he is willing to sacrifice economic growth for price stability in this cycle. In this scenario, risk assets will continue to come under pressure until the Fed pivots and reverses its hawkish stance once US unemployment starts to pick up. This will likely signal a peak US dollar, paving the way for Emerging Markets assets to outperform. Until then, the narrative for EM equities will remain negative. With the lack of an imminent catalyst, EM Equities will remain depressed; however, some markets including Egypt are pointing to extremely attractive forward return over 3-5 yr period in USD.

The above chart shows Warren Buffet's favourite valuation metric, Market Capitalisation to GDP ratio. Unlike other fundamental factors like sales or earnings, GDP is less cyclical and acts as a valuation anchor in the long term. The ratio tends to have a high explanatory factor (r2) over the long-term and is a good tool to fade any short-term noise. Given the sour sentiment, valuations of Egyptian equities are hitting a historic low. It doesn’t mean they can't get cheaper but if history is any guide, patience will pay off handsomely once the dust settles. The current Market Cap to GDP today is less than 3%. On that metric, Egyptian equities are expected to generate 12%-13% return per annum in USD over the next 5 years (Past performance is not necessarily indicative of future results. Investor’s capital is at risk).

4) Sentiments

The Egyptian stock market has seen relentless selling from foreign investors (ex GCC) since Nov 2021. The intensity of the selling has far exceeded the periods that followed the social unrest in 2010 and the COVID sell-off as per the cumulative net-flow of foreign investors in public equities (including FDI) as published by Cairo Stock Exchange. The net flow is adjusted by the market cap of the Hermes Index. From our experience, foreigners tend to own 40%-50% of the float in most emerging markets. By this measure, the bulk of foreign selling is behind us. Foreign institutions will be likely the marginal buyers from now on.

5) Maxi Deval: A Threat or An Opportunity

The carry trade and emerging currencies have been underwater since 2010. A weaker currency often acts as a hurdle for investor to invest in EM equities, especially if the country is engulfed with debt problems. It is rational that most investors try to time the market and deploy capital after the excesses are cleared however how difficult this may be.

One alternative approach is to rely on the market itself as a signalling agent. This study shows how domestic equities, for a selected number of countries, performed on average 60 days going into a major devaluation and the forward USD returns one year later. A major (maxi) devaluation is defined by the top 0.5% percentile of the FX drawdown. Day 0 marks the day the currency weakness began (day 0 ushers the start of the FX drawdown rather than lowest point in the FX drawdown). As such, it doesn't include any forward-looking information (a prior) regarding how deep the FX movement will be. In most cases, equity investors enjoyed a positive return in USD on 1-yr horizon from the point the currency started to significantly weaken (Past performance is not necessarily indicative of future results. Investor’s capital is at risk).

Three conclusions could be observed: 1) the maximum pain for equities happens around 2-3 months after a major devaluation starts, 2) investors need not to wait for the climax and 3) the odds of positive returns are quite favourable on one year horizon even if the FX continues to weaken in between.

Disclaimer:

Principa Capital LLP (“Principa”) is authorized and regulated by the Financial Conduct Authority (“FCA”) in the UK (Firm Reference Number: 822274). The materials provided are based upon information included in our records, as well as information received from third parties. We do not represent that the Information obtained from third parties is accurate or complete or up-to-date, and it should not be relied upon as such; Principa is not, and shall not agree to be, bound by the Information. Past performance is not necessarily indicative of future results. Investor’s capital is at risk. This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved offering memorandum. This document including any attachments is confidential, is provided for information purposes only and is intended solely for the person(s) to whom it is addressed. It is not intended for you if you are not eligible to receive it without any party breaching legal or regulatory requirements in any relevant jurisdiction. If you are not the intended recipient, you are not allowed to use the Information and you should disregard and/or destroy the Information.