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Egypt: Lessons from Brazil FX depreciation

  • Brazilian real is down 10% ytd; Egyptian pound is up 2%. Over 12 months, BRL down 15%, EGP up 12%

  • Policy easing has led to near-zero real interest rate and is a key driver of Brazil devaluation

  • Egypt rate cuts are needed for capex to pick up, but may bring FX risk back into the debate

Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

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Tellimer Research
2 March 2020
Published byTellimer Research

FX risk might re-enter the investment debate later this year

  • Brazilian real is down 10% ytd; Egyptian pound is up 2%. Over 12 months, BRL down 15%, EGP up 12%.
  • Policy easing has led to near-zero real interest rate and is a key driver of Brazil devaluation.
  • Egypt rate cuts are needed for capex to pick up, but may bring FX risk back into the debate.
  • Will inflation fall enough to allow both large enough interest rate cuts to trigger domestic capex and preserve meaningful, positive real interest rate (and stable FX rate)?
  • Will multinationals and the domestic private sector commit to more capex or be dissuaded, even with lower borrowing costs, by an uneven playing with military-related enterprises?

  • We see attractive value in most Egypt equities, but it is not one of our favourite markets.
  • The main risks are not political (military-intelligence deep state is still in charge) but rather:
    • Consensus portfolio manager views are very positive (ie more sensitivity to bad than good news).
    • FX rate depreciation if interest rates are cut aggressively (which may be needed to accelerate capex and GDP growth to match labour force growth) and from a point where REER is back over 100.
    • The continuing uneven playing field for the private sector (versus the military-related enterprises), despite reforms such as the Industrial Licensing (FDI) and Investment (domestic capex) laws.
    • The emphasis of government spending on large-scale projects (with less obvious recurring productivity benefits than healthcare, education and infrastructure in the existing urban centres).

Comparing the FX vulnerability of Brazil and Egypt

  • REER implies undervaluation in Brazil and a slight overvaluation in Egypt.
  • External debt, current account, import cover metrics are comfortable in both Brazil and Egypt.
  • Real interest rate (policy rate minus inflation) near zero in Brazil, but materially positive in Egypt.
  • The only way to make the trade-off between growth (downward pressure on policy rate), inflation control (upward), FX stability (upward) is structural improvements. 

The improvement in security following the start of the Sisi government was a structural improvement. Legal reform to improve the ease with which multinationals and local private sector companies could deploy capex promised a second round of structural improvement. But the results so far have been underwhelming: there have not been many new, large scale multinational projects announced in the Suez Canal Zone, for example. High interest rates may have acted as a constraint on the domestic private sector. As inflation comes down, and negative global shocks such as the US-China trade war or the coronavirus fade, then policy rates should fall and release private sector capex. 

A nagging doubt is that the multinationals and the private sector may be holding back because of the perception of an uneven playing field with military-related enterprises (in terms of access to and treatment of labour, access to and cost of land and raw materials, approval and licensing of new products). If this is the case, then the magnitude of policy rate cuts required to stimulate capex may be greater. And if those cuts erode the real interest rate (without addressing this root cause of sluggish capex), then there may be pressure on the FX rate without a pick-up in capex (or long-term GDP growth).

Egypt equities: Positive consensus, but underperforming ex-COMI

Egypt equities: Top-down stock screen

On trailing valuation multiples, the following screen well:

  • Among the three MSCI Egypt constituents, SWDY (electric utility equipment, cables) and EAST (tobacco) screen better than COMI (banks). Non-COMI banks (CIEB, ADIB, QNBA) screen very attractively, but they have very thin trading liquidity.
  • Industrials generally screen well (eg SWDY, OC in construction, ORWE in carpets, SKPC in petchem, EKHO in conglomerates) and generally have larger export, or non-Egypt, revenues (ie they should be more defensive in a scenario of EGP depreciation) compared to the Consumers (which generally have less compelling valuations with the exception of EAST). 
  • Real estate companies (eg TMGH, EMFD, PHDC, OCDI) screen relatively well although OCDI alone has a meaningful (trailing) dividend yield.