Executive Summary

• Fixed Income: Yields on government securities declined for the seventh consecutive week. The International Monetary Fund approved a USD 1.5 bn precautionary facility for Kenya, to protect against any exogenous shocks;
• Equities: The market was on a mixed trend during the week, with NASI and NSE 25 both gaining 0.5%, while NSE 20 declined 0.3%. During the week, Co-operative Bank, Pan Africa Insurance and KenolKobil reported their FY?2015 results, registering EPS growth of 25.1%, (32.1%) and 84.6%, respectively;
• Private Equity: Increased demand to power Africa and tap into the ever-growing demand for energy has seen private equity investors increase their interests in power and energy infrastructural projects;
• Real Estate: Developers continue showing interest in the attractive Kiambu market, and Sarit Centre launches a major expansion drive in Westlands aimed at increasing revenue growth;
• Focus of the Week: We expect interest rates to stabilize at the current levels, owing to a favourable macroeconomic environment.

Company Updates

• We are launching Cytonn Real Estate Franchise this Wednesday morning at The Sarova Stanley. The initiative enables entrepreneurs to operate real estate businesses under the Cytonn brand, share our execution platform, technology, access to development finance and superior design. In addition to extending our brand, this initiative will accelerate the building of safe neighborhoods for families and create employment opportunities for entrepreneurs in real estate. The franchise application process remains open at: Franchise Application Process.
• Our Senior Investment Analyst, Duncan Lumwamu, discussed the performance of the Kenya Shilling on CNBC Africa. Duncan Lumwamu on CNBC.
• We continue to beef up the team with other on going hires: Careers at Cytonn.

 Fixed Income

T-bill subscriptions remained high this week, with the subscription rate at 269.5%, from 286.1% the previous week. The subscription rate on the 182-day T-bill came in highest at 212.6%, an indication that investors are anticipating an increase in interest rates at the beginning of the new fiscal year. Yields continued on their downward trend, with the 91, 182 and 364-day T-bills coming in at 8.6%, 10.5% and 12.0%, respectively, down from 8.8%, 10.9% and 12.3%, respectively. Liquidity this week was as a result of:

1. High government maturities of Kshs 14.3 bn this week, following maturities of Kshs 15.9 bn last week,
2. Kshs 10.0 bn of Term Auction Deposit maturities, and,
3. Kshs 4.5 bn of Reverse Repo activity, in order to redistribute liquidity across the money market.

This increased liquidity was evidenced by the interbank rates remaining stable, but low, to close the week at 3.8%, from 3.7% last week.

This week, the government re-opened both 10 and 15-year Treasury bonds amounting to Kshs 25.0 bn, with the performance rate for the bonds at 104.7%, with total subscriptions at Kshs 26.2 bn, and the amount accepted at Kshs 17.1 bn. The average yields of accepted bids came in at 14.4% and 15.0% for the re-opened 10 and 15-year bonds, respectively, in line with our upper-bound projections of between 13.5% - 14.3% for the 10-year and 13.8 ? 14.8% for the 15-year. Last month?s bond auction saw a performance rate of 226.1%, and the bonds on offer had shorter duration to maturity of 5 and 7-years, compared to this month, which had durations of 7 and 12-years. The lower performance this month, despite high liquidity in the market, can be attributed to a risk-return trade-off where investors are better off staying short on duration as they stand to gain on a risk-adjusted basis, and hence preferred to participate in the T-bill market.

The shilling remained flat against the dollar to close the week at 101.4 on account of weekly foreign exchange inflows from tea and coffee earnings. The shilling has appreciated 0.9% on a YTD basis and we revise our view on the shilling, from previously being under pressure in 2016, and now expect a relatively stable shilling. This is driven by (i) a reduction in the number of rate hikes by the US Fed from 4-times to 2-times, which will keep the dollar steady against global currencies, (ii) sufficient forex reserves, currently at 4.5 months of import cover, and (iii) the recent approval of a precautionary facility by IMF.

The budget formulation and implementation in Kenya remains a key concern, as the changes are many and difficult for investors to predict and plan on. In February, the Budget Policy Statements that were released indicated less pressure for Government to borrow and fund the budget as a result of a reduction in the budget size for both recurrent and development expenditure. However, this week, the Budgetary Committee indicated a move to increase recurrent expenditure by Kshs 8.0 bn, compared with the initial proposal to cut it by Kshs 23.0 bn, and also cut the development expenditure by Kshs 49.0 bn against the planned Kshs 70.0 bn. In our view, the lack of real time data on the budget outturn is also a key concern on the ability to track the performance of the government and this affects many other sectors of the economy.

The Central Bank of Kenya (CBK) is set to start controlling the interbank rate (the overnight rate at which banks lend to each other) as part of the requirement set by the IMF on the release of the precautionary facility. This comes soon after Governor Dr. Patrick Njoroge indicated that they are looking at having a different rate, Annualized Percentage Rate (APR), to control the banks? lending rates, since the KBRR rate has been ineffective. In our view the intentions are good, however as witnessed in the past, they might prove ineffective given it would be important for the economy to have a free market where prices are determined by market forces. Central Bank should concentrate on ensuring that there is more transparency and information sharing is free, in order to enable people to make informed decisions; we should leave loan pricing to market forces.

The Monetary Policy Committee (MPC) is set to meet on 21^st March 2016 and we expect that they shall maintain the CBR at 11.5% driven by the need to help (i) the effects of the lower interest rates, a stable shilling and lower inflationary pressures to consolidate, and (ii) the economy to be fully anchored against any shocks in the near term. For more details and analysis of the impact of this meeting, please see our MPC Meeting Note.

The International Monetary Fund continues to be very bullish on the outlook of the Kenyan economy, projecting a 6% growth in the economy supported by the ongoing financial services reforms and the spending on infrastructure. In the last meeting, IMF increased its precautionary facility to Kenya to USD 1.5 bn, more than doubling the previous allocation. The facility constitutes a USD 989.8 mn 24-month Standby Arrangement (SBA) and a USD 494.9 bn 24-month Standby Credit Facility (SCF) to mitigate exogenous shocks that would affect the balance of payments position. The shocks could be internal, such as too much importation of capital goods, or external, such as the China slowdown and the rate increases by the Fed. The table below summarizes the size of the current and previous facilities.

The US Fed met this week and maintained the target range for the federal funds rate at 0.25% - 0.50% and reduced the planned number of rates increases from 4 to 2. This decision was based on (i) a weak and uncertain global economic environment which still poses a threat to the US economy, and (ii) weak inflation numbers below the 2% target set by the US government, as a result of the decline in oil prices. The Fed also downgraded the GDP growth forecasts to 2.2% from the earlier 2.4% set in December 2015. The slowdown in the US rate increases is good for emerging markets, and we would see stability in these currencies, including Kenya.

The government is ahead of schedule with its borrowing programme, having borrowed Kshs. 199.8 billion for the current fiscal year compared to a target of Kshs. 159.5 billion (assuming a pro-rated borrowing throughout the financial year of Kshs. 219 billion budgeted for the full financial year). Interest rates have been dropping since the beginning of February due to (i) reduced pressure on government borrowing, and (ii) high liquidity in the market. The government will continue borrowing locally to bridge the external financing deficits to date and the expected shortfall in collection by KRA. With Interest rates coming down, we advise investors to lock in their funds in short to medium-term papers, tenors of between six months and one-year, as the rates are attractive, compared to long-term, on a risk-adjusted basis.

Equities

During the week, the market was on a mixed trend with NASI and NSE 25 gaining 0.5% and 0.5% while NSE 20 declined 0.3%. This was due to gains in large cap stocks including, KCB Group (1.9%), Co-op Bank (1.3%), Safaricom (1.2%), and EABL (0.7%). On an YTD basis, NASI and NSE 20 are down 0.01%, 2.3%, respectively, while NSE 25 is up 0.8%. Since the peak in February 2015, NASI and NSE 20 are down by 17.9% and 28.2%, respectively.

Equities turnover rose by 21.2% during the week to Kshs 4.0 bn from Kshs 3.3 bn last week. Foreign investors were net sellers, recording the highest weekly net outflow in 2016 of Kshs 750 mn, however foreign participation declined to 70.0% from 80.7% last week.

The market is currently trading at a price to earnings (PE) ratio of 12.4x versus an historical average of 13.8x, and with a dividend yield of 4.0% versus an historical average of 3.3%.

There were several earnings and corporate announcements this past week:

Co-operative Bank of Kenya

Co-operative bank reported full-year 2015 results, an impressive EPS growth of 36.7% y/y to Kshs 2.31, from Kshs 1.69 in 2014. However, stripping off the one-off cost of Kshs 1.3 bn in 2014 from early retirement of staff, core EPS growth came in at 25.1% y/y to Kshs 2.31, from Kshs 1.85 in 2014. This is the best core EPS growth reported by a bank, so far, for 2015 and is way ahead of industry average core EPS growth of 7.2% for 2015. Key points to note are:

• Operating revenue increased 13.4% y/y to Kshs 36.4 bn from Kshs 32.1 bn in 2014, outpacing operating expenses growth, which rose by 6.4% y/y to Kshs 21.4 bn from Kshs 20.1 bn in 2014, leading to a decline in the cost to income ratio to 53.2% from 59.0% in 2014. With top line growth of 13.4%, it is clear that expense management was the key driver for the bank?s above average performance
• Growth in operating revenue was driven by a 9.1% y/y increase in net interest income to Kshs 23.2 bn from Kshs 21.3 bn in FY?2014, and non-funded income that rose 22.0% to Kshs 13.2 bn from Kshs 10.8 bn in FY?2014. The higher growth in non-funded income was due to a 125.3% increase in forex income to Kshs 3.2 bn, resulting into a revenue mix of 64%:36% funded to non-funded income, respectively
• Total operating expenses rose by 6.4% y/y to Kshs 21.4 bn, on the back of (i) a slower increase in staff costs, that rose 5.8% y/y to Kshs 8.9 bn from Kshs 8.4 bn in FY?2014, and (ii) improvement of branch efficiency with the implementation of initiatives such as an automated queuing system, which requires less permanent branch staff
• Net Interest Margin declined marginally to 9.0% in FY?2015, from 10.0% recorded in FY?2014, which is attributed to a faster interest expense growth of 68.2% y/y to Kshs 13.6 bn from Kshs 8.1 bn in FY?2014, than interest income growth, which recorded a growth of 25.3% y/y to Kshs 36.8 bn from Kshs 29.4 bn
• The bank reported a 21.9% y/y increase in customer deposits to Kshs 265.4 bn from Kshs 179.5 bn in FY?2014. Bucking the trend of banks that have reported so far, deposit growth outpaced loan growth, which grew 16.2% y/y to Kshs 208.6 bn from Kshs 179.5 bn in FY?2014. This resulted in a decline in the loan to deposit ratio to 78.6% from 82.4%. Coop is the only bank where deposit growth has outpaced loan growth
• Non-performing loans rose a marginal 2.6% to Kshs 8.2 bn, from Kshs 8.0 bn. Following the faster increase in loans at 16.2%, this lead to a reduction in NPL to total loans ratio to 3.9% from 4.4% in FY'2014
• Co-operative bank?s South Sudan subsidiaries achieved profitability of Kshs 849.7 mn in 2015, bouncing from 2014?s losses of Kshs 687.2 mn, despite translation losses from the devaluation of the South Sudan Pound of Kshs 1.9 bn. This was mainly on the back of strong growth in non-funded, income including forex income, from the South Sudan subsidiaries, which contributes to majority of the subsidiaries income
• The bank?s total capital to risk weighted assets ratio came in at 22.4% in 2015 from 22.9% in 2014, 7.9% above the statutory requirement of 14.5%

Co-operative?s results were impressive, and with the continued implementation of the ??Soaring Eagle?? transformation initiatives, revamped ICT infrastructure and profitable operations in the region, the future still looks bright for the bank. For more details on Co-operative, please see our earnings note Cooperative Bank Earnings Note

Of the banks that have reported so far, Coop Bank is the only bank so far to report deposit growth greater than loan growth. The average growth in reported earnings across the banking sector stands at 7.2%, which is weaker than last year?s first quarter core EPS growth of 10.9%, with the slowdown attributed to the tough operating environment in 2015. The core EPS growth for banks will become clearer once National Bank of Kenya, I&M and Standard Chartered release their earnings, with I&M bank releasing their results on Tuesday, 22^nd March, 2016.

Pan Africa Insurance Holdings Limited

Pan Africa Insurance Holdings released their FY?2015 results, recording a decline in EPS by 96.8% to Kshs 0.19 per share from Kshs 6.0 in FY?2014. Core EPS, stripping off the one- off impairment of goodwill amounting to Kshs. 0.6 bn recorded in 2015, declined by 32.1% to Kshs 4.1 in 2015.

Key points to note include:

• Operating revenue declined 9.3% y/y to Kshs 7.2 bn from Kshs 8.0 bn in FY?2014, which was outpaced by an increase in operating expenses that rose 65.4% y/y to Kshs 2.9 bn from Kshs 1.8 bn in FY?2014
• Gross earned premiums declined 1.2% y/y to Kshs 5.2 bn in 2015 from Kshs 5.2 bn in 2014 driven by i) a tough economic environment that led to low uptake of insurance, and ii) challenges faced by the distribution network of the life business
• Net claims and policyholder benefits declined 15.8% to Kshs 4.3 bn from Kshs 5.1 bn, resulting into a decline in loss ratio to 88.7% in 2015 from 101.3% in 2014. Operating expenses increased by 65.4% to Kshs 2.9 bn from Kshs 1.8 bn in 2014, giving an expense ratio of 61.1%, translating to a combined ratio of 149.8%. The growth in expenses is attributed to the one off impairment of goodwill by Kshs. 0.6 bn
• Investment income grew by 19.8% y/y to Kshs 2.4 bn from Kshs 2.0 bn in 2014, with investment income contributing 33.0% for the total income in 2015 compared to 25.0% in 2014. The growth in investment income is attributed to i) the increase in investment assets, which grew by 10.0% in 2015 to Kshs 24.6 bn from Kshs 22.3 bn in 2014, and ii) the favorably high interest income on bank deposits and commercial paper placements during the second and third quarters, which contributed 15.0% of the total investment assets

Moving forward, Pan Africa Insurance Holdings will have to i) improve the efficiency of their distribution network especially on the life segment, as this adversely affected the embedded value for their total life business, and (ii) turn around their recently acquired entity, Gateway Insurance, which has so far underperformed expectations, posting a loss of Kshs 302 mn during the year, and an impairment on goodwill of Kshs 564.1 mn.  For more earnings details on Pan Africa Insurance Holdings earnings, please see our earnings note at:  Pan Africa Insurance Holdings Limited Earning Note

KenolKobil Group Limited

KenolKobil recorded an impressive EPS growth of 84.6% y/y to Kshs 1.37 from Kshs 0.74 in FY?2014. The performance was boosted by an increase in the company?s gross profit margins to 6.7%, from 5.7% in FY?2014, following improved inventory management, and a 46.3% y/y decline in finance costs from Kshs 1.2 bn to Kshs 651.3 mn. Key points to note include:

• Operating revenue increased 21.4% y/y to Kshs 7.2 bn from Kshs 6.0 bn, which was outpaced by growth in operating expenses that increased 25.5% y/y to Kshs 2.2 bn from Kshs 1.8 bn in FY?2014. The high growth in operating expenses was due to an increase in the number of branches by 21 branches and upgrading of their existing service stations
• Earnings before interest, tax, depreciation and amortization (EBITDA) rose 22.6% y/y to Kshs 4.8 bn from Kshs 3.9 bn in FY?2014. This was boosted by a 16.7% increase in other income to Kshs 1.4 bn from Kshs 851.7 mn following the sale of their Tanzania subsidiary, and a 19.5% y/y reduction in exchange losses to Kshs 232.1 mn from Kshs 288.4 mn. This led to an improvement in the EBITDA margin to 5.5% from 4.3% in FY?2014
• Finance costs declined 46.3% y/y to Kshs 651.3 mn from Kshs 1.2 bn in FY?2014, testament to the debt restructuring program the company embarked on in 2013 that has resulted in debt levels reducing significantly to Kshs 4.6 bn from Kshs 10.4 bn as at end of 2014
• The group recorded a loss from discontinued operations of Kshs 464.6 mn as it exited Kobil Tanzania and the Kobil Congo, an inactive depot asset in the DRC (Lubumbashi) due to unfair competition and unprofitability

Moving forward we expect sustained earnings for the oil marketer given the focused expansion of the retail network through addition of new service stations, and the continued reduction of their debt obligations with the aim to be debt free by the end of 2016. 

Trans Century Limited (TCL) has received Kshs. 2.0 bn capital injection from Kuramo Capital, a US based private equity firm, as part of the ongoing fundraising effort to settle its outstanding convertible bond of USD 76.5 mn due March 25, 2016. The company had issued the dollar denominated convertible bond through its Mauritius subsidiary in June 2011 at an interest of 6.0% p.a. and an additional 6.0% premium for units held to maturity. Since the issue of the bond, the dollar has appreciated 17.0%, effectively increasing the cost of financing the USD 76.5 mn instrument.

The firm has the following options:

1. Convertibility Option: The bond has a convertibility option to equity. Exercising this option will result into paper losses of Kshs 44.25 per share considering a conversion price of Kshs 50. It is almost certain that rational bond holders will not exercise this option
2. Cash Call: TCL has the option of issuing a rights issue to repay the debt. Given the few days to maturity of the bond and the logistics in a rights issue, a cash call is not a possibility. The absence of a rights issue to pay debt indicates that existing shareholders are not willing to put in more money into the company. The company?s earlier plans to have a rights issue in March 2015 was rejected by shareholders, as it required them to inject nearly double the market capitalization of the firm at the time, and with those opting not to participate facing a significant dilution
3. Strategic Investors: This is the option that?s most suitable to the company although it will have a dilutive effect on shareholder?s equity. The capital injection by Kuramo Capital, of Kshs. 2.0 bn, translates to a 55.6% stake given the current market value of TCL of Kshs 1.6 bn, and a PE investor in a distressed company will require a controlling stake to enhance strategy
4. Bond Holders proposal: TCL bondholders suggested to the company to have their bond repaid in two tranches with the first payment of Kshs 4.0 bn at maturity on 25^th March, and the other tranche in 2017. They further suggested that the firm undertakes a rights issue to repay the second tranche in which the bondholders would underwrite the cash call.

Our view is that given the few days left to maturity, the firm has limited options and, in our view, most likely will use funds from strategic investors, the Kshs 2 bn from Kuramo plus part of its own capital to settle the first tranche of the bond and then over the next one year, it will then do a rights issue to settle the balance of the bond. This will result in an immediate dilution of close to 55.6% for TransCentury?s current shareholders, with the certainty of further dilution when the rights issue is done over the next one year. The current shareholders are likely to end up with less than 20% of the company when the entire debt is paid. TCL has some valuable assets, such as East African Cables, Avery East Africa Limited, Civicon and Tanelec, which make it attractive for investors such as Kuramo at this time of financial distress.

Given the change in the operating environment that we have witnessed since the start of the year, we carried out an analysis of the various drivers that affect the performance of the equities markets, in order to re-evaluate our view of the listed equities outlook. The table below highlights the various economic drivers and their effect on the stock market performance.

Macro-Economic Indicators	2015 Experience		2016 YTD Experience	Going Forward		Outlook
GDP	Kenya?s GDP for the full year 2015 is expected to average 5.5% as per local, IMF and World Bank projections		With a conducive and stable macroeconomic environment and tea exports improving for the year	We project the 2016 GDP to come in at an average 5.8%
Interest Rates	The CBR increased 300 bps to 11.5% in August 2015 with the 91-day starting the year at a rate of 11.7%		There has been a downward pressure on interest rates in January and February given reduced pressure on government borrowing. The CBR and KBRR rates were maintained by the MPC	Interest rates expected to remain on downward trend that will persist for the better part of the year
Exchange Rate	The shilling depreciated 13.0% against the dollar from 90.70 in Jan to 102.30 in Dec The foreign reserves improved to 4.5months by Dec 2015		The shilling has remained stable supported high forex reserves translating to 4.7 months of import cover as a result of the reducing current a/c deficit. Kenya has received an increased credit facility by IMF to the value of USD 1.5 bn	We expect the Shilling to remain stable given support from a strong dollar reserve and improved forex inflows from remittances and tea exports
Corporate Earnings	The year experienced weak earnings from the banking sector with a growth of 9.3% in Q3'2015. 17 listed and 1 unlisted company issued profit warnings as a result of tough operating environment and high interest		Several companies have released positive FY?2015 results, mainly manufacturing industries Bamburi, BAT, EABL and Kengen and banks KCB, Co-operative and DTB with profits ranging between 10%-20%	To improve due to the relatively improving interest rate environment, stable shilling and improvement in credit growth
Foreign Investor Sentiments	Increased flows out of Kenya owing to the US interest rate hike compared to inflows into equity markets as a result of volatility in interest rates		Investor sentiment has been high with foreign investors being net buyers in January at USD 3.6 mn and net sellers in February at USD 6.1 mn as investors move to Kenya?s attractive market	Chinese economic slowdown and devaluation of their currency may lead to poor performance of most emerging and frontier market indices. However, Kenya?s NSE still remains attractive to foreign investors
Valuations	Stock market was fairly valued in 2015 trading at a P/E of 12.4x compared to a historical average of 13.8x		Market has been trading at an average P/E ratio of 12.4x with prices being low and the market undervalued	Assumption of corporate earnings growth rate of approximately 10% and above gives a forward P/E of 11.3x, relatively cheaper than historical average
Security & Political Environment	Improvement witnessed in levels of security with tourism levels increasing in the month of December compared to the previous year and reduced terrorist attacks		Kenya has received an upgrade in credit rating by Moody?s as a positive indicator that the environment is safe to carry out business operations	Increased spending on security equipment and recruitment of more personnel will enhance the country?s security, however heightened tensions before the National elections next year will weigh on the political environment
Positive			Neutral

From the above analysis, 3 of our indicators are positive, while 4 are neutral. Generally, there are improving conditions for the stock market, however there are a number of risks that remain present that might have a negative effect on the market sentiment.

We hence remain neutral on equities given the low earnings growth prospects for this year. The market is now purely a stock picker?s market, with few pockets of value.

Below is our equities recommendations table. The key changes for the week include:

• We moved Uchumi to its own section as a Speculative Accumulate given the price volatility.
• Britam has moved from ?Accumulate? to ?Buy? given the 7.2% price drop during the week. Given that there was no significant corporate announcement from Britam during the week, this significant price drop is a strong indicator that the upcoming earnings announcement could be bad and some parts of the market could be trading out of the counter ahead of earnings announcement.
• Coop bank shares traded upwards during the week by 1.3% on the back of their positive performance. However, we note that investors are trading out of the stock having anticipated the good EPS growth. We therefore expect price correction downwards in the coming week.

Private Equity

The Abraaj Group announced the acquisition of Themis Energy for an undisclosed amount in a bid to form an energy dedicated project development arm. The move will enhance the energy infrastructure capabilities of the private equity firm that is focused on global growth markets. Themis will leverage on Abraaj?s global network, execution capabilities and existing infrastructure team to originate, develop and manage projects from conception to operationalization, while Abraaj will leverage off Marc Mandaba, Founder of Themis and former private infrastructure investment officer at the African Development Bank, who will join Abraaj as Managing Director and Head of Themis. Themis was launched in 2013, by a team with a strong track record in energy project development with the company having advised several African governments and lending institutions on energy and civil infrastructure related projects. Themis Energy currently has energy infrastructure projects under development in excess of 1,300 MW including a thermal power plant in Rwanda and a hydroelectric power station in Ivory Coast. The deal highlights the existing potential for growth in the energy industry in Africa due to (i) the large power deficit inhibiting economic development, (ii) the lack of well-structured quality and bankable projects, and (iii) the large population of Africa that does not have access to power. Abraaj?s focus is primarily geared towards renewable and energy efficiency projects across several sub-sectors and technologies and its move to acquire Themis is aimed at capturing value throughout the life cycle of projects.

IHS Towers is acquiring over 1,200 towers located in Nigeria from Helios Towers Nigeria (HTN) for an undisclosed amount. Both companies were instrumental in establishing the mobile telecommunications infrastructure in Nigeria in the early 2000s. The deal marks the first consolidation of mobile infrastructure companies in Africa and is expected to close in Q2?2016. Upon regulatory approval, IHS will acquire 100% of HTN?s outstanding share capital from Helios Towers plc, which is owned by Helios Investment Partners, Pembani Group, First City Monument Bank and a number of minority shareholders. Helios has had forays in the telecommunication sector in Kenya, having bought a stake a 70.0% stake in Telkom Kenya, buying out Orange Group late last year. Telecommunication is one of the major sectors that private equity firms have shown significant interest in due to (i) the limited fixed-line infrastructure available in Africa, (ii) the increased demand for voice and data services, and (iii) the high pace of network investment and growth that shows no signs of slowing down. The growing data traffic, increased smartphone use and integration of telecommunications in financial services with growth in financial literacy and inclusion presents investors with exciting market opportunities. With the potential for up to 40,000 more towers required to meet demand, we expect increased interest in Nigeria?s telecommunication sector and the larger African space. We believe that at some point for the Kenyan market, it will not make sense for each service provider (Safaricom, Airtel, Orange) to have their own towers. We expect a towers deal in Kenya in the near future.

Private equity investment in Africa continues to improve, as evidenced by the increase in the number of deals and deal volumes into the region, and the closing of various fund raising activities by funds focused on investing in Africa. Financial services, healthcare, education, and IT continue to be preferred by PE firms, but infrastructure, real estate, and natural resources are gaining ground. We remain bullish on PE as an asset class in Sub Saharan Africa given (i) the abundance of global capital looking for investment opportunities in Africa, (ii) attractive valuations in private sector, and (iii) better economic growth projections compared to global markets.

Real Estate

CIC Group plans to venture into real estate with a planned Ksh.2.8 billion commercial and housing mixed-use development, which shall be composed of high-end, middle income and studio apartments on a 200-acre parcel of land in Kiambu. The development is set to be launched in Q2?2016, with consultants already doing site investigations. Reasons behind the move are to improve and stabilize the firm?s financial given:

1. The volatility in the stock markets and the desire for the high returns in real estate which posted 25% returns through 2015, and,
2. The inflationary hedge that real estate offers compared to the financial markets is also a major reason for CIC?s move, as they seek to safeguard their investor funds against returns in the volatile public markets of fixed income and equities.

The allure for housing in Kiambu has been largely contributed by the increased mobility to the Nairobi CBD, arising from infrastructural improvement on the Northern Bypass that links Kiambu County to Nairobi.  This has attracted many developers to the area. Other developers with projects, or planning to launch projects, in Kiambu include Fusion Capital, Shelter Afrique and Cytonn Real Estate, our development affiliate.

According to the 2014 Shelter Report by Habitat for Humanity, a projected 48% of the population in Africa will be living in urban centers by the year 2030. This figure is expected to increase to 58% in 2050. The rapid urbanization and population growth will increase the housing deficits in line with Habitat for Humanity?s 2012 report, that estimated housing deficit in Kenya, then at 2 million units, a value expected to increase by approximately 200,000 units a year. This creates a huge opportunity for investors looking to provide housing for the low to middle income population.

Sarit Centre, one of the oldest malls in Kenya, is set to expand its premises. The expansion, expected to cost Kshs 4 billion will involve construction of a four-storied building beside the mall, a multi-storied parking silo as well and a general refurbishment of the mall. This expansion will see the mall add an extra 250,000 square feet of retail space to its existing stock. Most of the extra space is to be taken up by a supermarket as an anchor. The reasons cited for the expansion are:

1. An increasing population in Westlands, given its preferred location as a mid to high-income residential area,
2. Increased number of office developments in the area, which alongside the residential, will increase the footfall for the retail section, and,
3. An increase in the middle class population, whose disposable income is also rising.

This move was long overdue considering the attractiveness of the retail sector in Kenya. From Cytonn?s research, high-end malls in suburbs such as Westlands and Kilimani can have high rental yields of up to 10.2% and a high occupancy, averaging at 89%. The owners are hence capitalizing on the high returns being witnessed in the retail sector. The high returns have seen an increase in the number of retail stores in Kenya in the last few years, which has seen retail space in Nairobi growing from 980,000 square feet to 1.8 million square feet. Notable openings in the recent past include Garden City Mall and the Hub in Karen. Two Rivers and Riviera malls along Limuru Road are also to be launched soon, while older malls such as Yaya and Village market are getting refurbished and with international retailers such as Game and Carrefour entering the local market, the retail sector can only grow.

Oxford Business Group ranked the Kenyan retail market as the 2^nd most developed in Africa, with a retail penetration of 30%. This growth is however not limited to Nairobi alone as devolution has helped in increasing urbanization and malls are also relocating to the counties. A good example is Buffalo Mall, which is opening branches in Eldoret after their opening in Naivasha. Kisumu has also seen the opening of three malls, namely West End, Tuffoam and Lake Basin Malls in the last year alone. We expect Kenya?s retail market to remain competitive due to favorable economic conditions, increasing middle class and infrastructural growth continue opening up locations for development. However, we believe that the number of malls that have come up and those in the pipeline are too many even with the competitive ranking of Kenya?s retail market. 

Government agencies continue to embrace automation as a way of efficiently providing the services to Kenyans. The National Construction Authority (NCA) is planning to launch an e-registry system where details of ongoing projects will be uploaded and updated constantly after the land Registry and the Kenya revenue Authority moved most of their operations online. The NCA system will incorporate a Geographic Information System (GIS) and a Construction Site Mapping System (CSMS) to enable the public to locate any site in the registry. This is a move aimed at reducing the high number of building collapses witnessed in recent years with the NCA estimating that approximately 52% of constructed buildings do not meet set standards. The national body sites a shortage in capacity, amid a fast growing construction industry as the biggest hindrance to effecting its mandate. The system will solve the capacity issue as:

1. All the information pertaining a project will be available online, including the list of licenced professionals and approvals given to a developer,
2. System will reduce noncompliance, incidences of false information and increase the enforcement efforts of the Authority as anyone can flag down noncompliance and inform them, and,
3. Other bodies involved in construction are to be linked to the system, including KRA, KNBS, NEMA and County Governments, which will increase transparency and synergy of all statutory bodies involved in the approval process.

We expect improved compliance by contractors and developers and hence an increase in the quality of buildings being delivered to market.

Kenya?s Interest Rate Outlook

In our Cytonn Weekly Report #42 (2015), we analyzed the interest rate environment and what was driving the rapid upward trend that we witnessed in Q3?2015. A lot has transpired since then, and the interest rates have declined to levels witnessed at a similar period last year. The aim of this piece is to first give a background of the challenges witnessed in Q3?2015, review the drivers of the high interest rate environment, understand the underlying factors driving the interest rate environment currently, and finally end with what we believe will transpire in the near future.

2015 Recap
The interest rate environment in Kenya witnessed volatility in the last calendar year, with a sharp increase in rates highlighting the challenging economic environment. This was evidenced by the 91-day Treasury bill rising from 8.6% in December 2014, to peak at 22.5% in October 2015. This high interest rates environment was attributed to

1. Aggressive Government borrowing to fund the budget at the beginning of the fiscal year,
2. Monetary and Fiscal policy disconnect where Government expenditure was high,
3. Low liquidity levels in the money market,
4. A rapidly depreciating currency, and,
5. Uncertainty in the banking sector following the closure of Imperial bank and Dubai Bank.

Of importance is that despite the above factors contributing to high interest rates in Kenya, inflation rates remained relatively low, within the CBK?s target of 2.5% - 7.5%, an indication that the challenges were not inflation driven. In order to curb the shilling depreciation, MPC raised the CBR by 300 bps in two meetings, by 150 bps each meeting, to 11.5%.

As per our Cytonn Weekly Report #42 (2015), we noted that a number of policy issues needed to be addressed. We also noted ?to address the country's rate challenges, we need to be candid about the key issues. A comprehensive and objective analysis points to a need to enhance executive management of public finances before the rate environment causes irreparable damage to our economy?. Now we try to analyze if the issues have been fully addressed, or we may find ourselves in an all too familiar situation:

• Harmonization of Fiscal and Monetary Policy: Last year, there was a disparity between monetary policy and fiscal policy. Central Bank of Kenya, mandated to run the monetary policy side, was on a tightening path, raising CBR to tame a rapidly depreciating shilling, while Treasury, mandated to run the fiscal policy side, was on an expansive mode, and were aggressively borrowing to fund the budget. Currently the two policies are working in tandem, as Government is not aggressively borrowing to fund a budget gap. However, this might change if Government results to financing the Kshs 200 bn foreign borrowing gap in the local domestic market. The risk is still high since the governments is still in a spending mode and we could still see a huge budget for the next financial year,
• Contain Government Expenditure: Devolution, despite its benefits, requires strict monitoring to prevent high and unwarranted government expenditures, both at the county and national level. Currently, Government is increasing allocation on recurrent expenditure by Kshs. 8.0 bn, which is a step in the wrong direction as this will increase expenditure to the core governmental activities and direct funds away from development expenditure,
• Contain Corruption: Corruption remains a key challenge in our system that needs to be addressed, as it leads to a lot of cash leakages. However, despite the ?tough governmental stance on the matter?, even declaring it a ?national crisis?, the government is failing on this front given (i) their slow pace in eradicating graft, (ii) the ever emerging corruption cases, and (iii) lack of will to investigate, and prosecute the current corruption cases,
• Moderate Infrastructural Project:  Government is ambitious with its mega infrastructural projects such as the SGR and the LAPSSET project. However, despite these projects coming with advantages such as opening up the transport corridors for easier movement of goods thus facilitating trade, the financing can be spaced out and at the same time look for cheaper ways of financing them other than reliance on debt. However, the progress of the projects has been slow with the LAPSSET project having stalled due to slow disbursement of funds. In the short-term, this will be beneficial to the interest rate environment as the importation of capital goods that lead to the rapid depreciation of the shilling will be delayed,
• Revenue Collection: The government missed revenue target collection for the first half of fiscal year 2015/16 by Kshs. 46.9 bn. We believe that if Government wants to reduce the overreliance of borrowing from the local market, they need to enhance revenue collections. Government is trying to improve on this by expanding its tax net to include the informal sector. Government is behind on its revenue collection, and projects to miss it by Kshs. 93.8 bn, and will have to finance this gap either through domestic or foreign borrowing,
• Inflation: Inflation has been one of the most positive macroeconomic indicators largely within the CBK target of 2.5% - 7.5%, despite a one off spike in December 2015 to hit 8.0%, owing to the excise duty tax. We believe the inflation rate will still remain within the CBK target, a positive for interest rates moving forward,
• Currency: The Kenyan currency having depreciated 12.9% in 2015, owing to a strong dollar globally and high capital goods importation, has been stable throughout 2016, appreciating against the dollar by 0.9%. We expect the shilling to be stable in 2016 owing to (i) a reduction in the number of rate hikes by the US Fed from 4-times to 2-times, and (ii) sufficient forex reserves, currently at 4.5 months of import cover, and (iii) the recent approval of a stand by facility by IMF.

Government has tried to address the issues (though not all) that led to a spike in the interest rates, and most importantly, there now seems to be a rapport between the monetary and fiscal side. 2016 is also on its own a unique year. Elections are coming up and politics is set to draw all the attention. However, it is our view that the elections won?t hinder governmental mandate to address the economic state, as the ones in charge of driving the economy are not political leaders.

Factors Driving Current Rate Environment

The operating environment has changed since 2015 and it is of great importance that we try to predict what direction interest rate will take. We track 6 metrics that dictate the direction of interest rates and try to gauge what the future trend will be and the possible effect on the direction of interest rates, as can be seen in the table below

Drivers	Expectations at Start of 2016		YTD Experience	Going Forward		Effect on Interest Rates
Government   Borrowing	Government expected to borrow Kshs 219 bn domestically and Kshs. 402 bn for the 2015/2016 financial year		Government plans to cut its domestic borrowing by 53 bn for the current fiscal Yr., while increase foreign borrowing by Kshs. 6.0 bn	We expect reduced pressure on Government borrowing based on the proposed reduction in Govt. borrowing by Kshs. 46.9 bn. However there still lies an Kshs 200 bn gap in foreign financing which if they choose to fund locally, will have an upward effect on interest rates
Policy Decisions	The CBR to be maintained but the KBRR to be revised upwards		MPC met in January and retained the CBR and KBRR at 11.5% and 9.87%, respectively	The MPC is meeting on the 21st of March 2016, where we expect the CBR is expected to be maintained at 11.5%
Revenue Collection	KRA to continue missing their collection target		The Authorities are expected to reduce their targets by Kshs. 52.9 bn necessitating a reduction in expenditures	Despite the reduction in the collection target we still expect them to miss their target as they are projecting a loss of Kshs. 93.8 bn for the FY?15/16
Liquidity	Liquidity expected to improve given high maturities of government securities		The market has been relatively liquid evidenced by the low interbank rates of 3.7% in March	With a further Kshs.219.6 bn in maturities to June, the market is expected to remain relatively liquid
Inflation	Above the CBK upper-bound, set at 7.5%		Inflation declined from the high of 8.0% in December through January to February at 6.8%	Expected to remain within the CBK target, averaging at 7.0% despite an uptick in September when additional VAT on petroleum is introduced
Exchange rate (USD/Kshs)	To remain under pressure given a strong dollar and high capital goods importation		The shilling has been stable having appreciated against the dollar by 0.9% YTD	We expect the Shilling to remain stable given support from a strong dollar reserve and improved forex inflows from remittances and tea exports
Positive	Neutral			Negative

 
Conclusion

From the above basis, 3 of our indicators are neutral, 2 are positive while 1 is negative. Generally, there is a lot of uncertainty surrounding sustainability of the current interest rates. Given the sharp decline in rates, investors should relook at their fixed income portfolio allocation and rebalance it to highest returning tenor on a risk-adjusted basis as detailed below.

We are of the view that interest rates have bottomed out at the current levels, and looking out a year from now we believe that on a worst case scenario for reinvestment, the rates shall be at the same levels given (i) the higher levels of borrowing to fund the budget, and (ii) given 2017 will be an election year. We therefore advise investors to lock in their funds in short to medium-term papers, with tenors of between six-months and one-year, as the rates are attractive on a risk-adjusted basis.

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.