The cheese will be back at the NSE

Last year, the NSE was the best performing bourse in Africa having appreciated by almost 35%, only second to the Ugandan exchange which registered a sterling 62% appreciation.

This year, its fortune tide has reversed direction, moving from the best to the worst performing bourse, except for Egypt, having declined by 22.30% since January. In US dollar terms, the loss has been further magnified to 32.54% by a persistently weakening Kenya Shilling, the worst performing currency in Africa, save for the Ugandan shilling. Indeed, it is a double tragedy for foreign investors who have had to deal with a weakening currency besides the falling value of equities.

Last week, the NSE index touched a new low after breaking the 3,500 mark psychological barrier for the first time in 19 months attributed to stocks constituting the index trending towards their twelve month lows. Safaricom, the largest component of the NSE index, has, for instance, eased by 35% since January and is now trading at its 12 month low of Kes3.00 per share.

The driving force for our stock market has been a gradual deterioration of Kenya’s macro economic conditions rather than performance of individual companies listed at the stock exchange. If you take the performance of KCB, Equity Bank and Cooperative Bank as an example, they recently reported 33%, 57% and 41% earnings improvements respectively, which was impressive judging by the performance of their peers across Africa. Return on equity was also above 20% for the three banks promising a healthy return to their shareholders. Contrary to the expectations of unsophisticated investors, their individual share prices has since retreated stressing the point that institutional investors, the most influential class of investors, are currently concerned about how the local economy is fairing more than anything else.

My personal view is that the Kenyan economy may have just quietly eased into an economic ‘slow down’ phase in the business cycle. The economy is seemingly vulnerable to shocks that could trigger the economy to land into a recession, business confidence is starting to waver, and inflation continues to rise. From a capital market perspective, Treasury bill rates are high and still rising, the yield curve is showing tendencies to want to invert due to decreased activity on the long end and, of course, the stock market is falling. All these are tell tale signs of an economic slowdown.

Having identified where we are on the cycle, two things come to my mind as an investor: will the next phase be a recession or ‘initial recovery’ and when is it likely to kick-in? The government and central bank must intervene to steer this cycle not to transition into a recession. The central bank is in a delicate position of setting short-term rates to levels that will control inflation without inhibiting economic growth rate. Kenya is also in the middle of implementing the ambitious Vision 2030 and a restrictive policy will obviously not be in line with that vision. The Central Bank has appeared reluctant to raise interest rates to curb inflation and weakening shilling because it contradicts its apparent preference for growth policy pursuit. Investors are keenly watching on policy actions and appearance of dilemma will only fuel fear and anxiety in the economy and capital markets posing danger of sliding into recession.

Kenya’s NSE problems have been compounded further by increasing concerns about the US and European economies. Marc Chandler, global head of currency strategy at Brown Brothers Harriman was recently quoted saying that “Global markets have been rattled by a crisis that is fast morphing into a global banking and economic crisis on one side, and a very piecemeal policy approach to contain risks on the other." Global fears and anxiety has sent world markets reeling with global sell-off across the board.

The NSE has not been spared from the brunt of global sell-off as foreign investors flee from stocks to meet redemptions at home or seek shelter in traditional safe havens, including gold. Kenya is one of the most liquid exchanges in Sub-Saharan Africa and hence it is no surprise that it has exhibited a strong correlation with global markets especially in the current global downturn. A slowdown or recession in the United States and European economies could act as an exogenous shock to the Kenyan economy that could prolong the slowdown.

When is all this uncertainty going to end? Relief from the current local and global macroeconomic concerns is not yet in sight and even the most optimistic investor would find it difficult to imagine anything better than equities maintaining at the prevailing prices in the short term. There is also the small matter of next year’s general election to consider.

Kenyan inflation accelerated to 16.7 percent in August, more than triple the central bank’s 5% target, as the worst regional drought in 60 years coupled with a weakening shilling, close to all time low, and high oil prices continue to spike food prices. Analysts are of the view that inflation has not yet peaked and is likely to top out at 18 to 20 percent region.

In an operating environment where inflation is expected to remain above the policy target, fund managers should, by rule of thumb, have a bias for holding cash. Interest rates are likely to continue edging upwards and anyone holding cash is in an enviable bargaining position in an environment where liquidity is only likely to continue tightening. In the last two weeks the discount rate spiraled to over 29% from just 6.25% and the interbank rate to over 26% from 8.3%, creating the appearance of a liquidity crisis within the banking sector. It is no surprise to me that banks are now willing to offer 11 to 12 percent for call deposits, a return that was unimaginable last year and this could still edge further up.

Real estate and other real assets are also likely to do well implying that investors should also increase their asset allocations to this asset class. In a rising inflation environment, asset values and their inherent cash flows and returns are only likely to increase.

Savvy investors who foresaw the inflection point to an economic slowdown are smiling all the way to the bank as they are now invested in the least risky asset class, cash, and yet they are currently outperforming the most risky asset class, equities. Indeed, they have found the cheese.

If you missed the cheese, you must not miss it the next time round. What I know for certain is that the cheese will be back at the bourse and it is only a question of time. Equity investors are hurting from the current downturn but they must not allow fear to blind them to the fact that investment is about the future and the time to position for the next cheese move is now. Investment managers who are currently enjoying the prevailing double digit cash returns saw it coming, and positioned themselves, at least six months ago and will soon be, if not already, positioning themselves for the next kill. The question that is disturbing most investors’ minds is just “how low can the NSE go?” and the moment they start smelling that it is going to be any time soon, there will be a mad rush at the NSE. Unfortunately, that might be too late.

Investors have lost more than Kes230 billion since January for reasons other than the fundamental performance of companies at the NSE and the bourse continues to hit new lows. Everything else remaining the same, it is only rational to expect reversion when macro economic conditions begin to turn. Who will get the most of that Kes230 billion pie, if not more?

Warren Buffet’s popular saying that investors should “be fearful when others are greedy and greedy when others are fearful,” sums up the opportunity we presently face. Global and domestic markets are gripped with fear and anxiety and I sense that the time to be bold and fearless is nigh, if not now. This opportunity may be wrapped in a period of painful waiting but it is almost certain that it will pay off handsomely given the current rock bottom prices. My parting shot to all investors: do not wait to chase the cheese, the magic lies in positioning yourself now and the cheese will surely find you.