Economy to recover in 2018 with expected inflation hikes: Arqaam Capital

The Egyptian pound is expected to appreciate by 10% or more in FY 2017/2018 as tourism improves

A gradual recovery in the economy is expected in 2018, with 2017 being difficult but paving the way for a better year with both consumers and investors coping with the changes and absorbing the shocks of the past two years, according to Arqaam Capital.
Arqaam Capital banking group has recently issued a report to look into the status of the Egyptian economy and the expected events and circumstances over the upcoming period.
After the imposition of the 13% value-added tax (VAT) in November 2016, an increase of 1% is expected to take place soon, taking VAT to 14% and causing inflation to jump to nearly 35%, alongside with energy hikes and the re-pricing of many government services, according to Arqaam's report.
Inflation and interest rates should decline in 2018, and the New Investment Law's regulations are nearly complete. The difficult preparations of 2016 and 2017 should reap their benefits for consumers and investors in 2018 if other bureaucratic impediments are removed. "The government, however, is notorious for imperfect communication, an incomplete vision, and following through with comprehensive reforms, all while restructuring public services properly to protect the poor," Arqaam added. In terms of headline inflation, it is expected to decline as of November 2017 as the positive base effect kicks in. It will then prevail in 2018, gradually declining until it breaks the single digit level in late 2019 or early 2020.
Arqaam said that its expectations of inflation accounted for this policy change, and a jump is anticipated to anywhere between 35% and 38% in the summer, depending on the rise in pressures with the simultaneous implementation of other fiscal measures.
According to the Egyptian government's economic reform agenda, the implementation of the second round of fiscal reforms continued in the first year of its International Monetary Fund (IMF) programme. The energy hike is the fifth in nine years since 2008, and the second in less than a year.
Arqaam Capital expects the Egyptian pound to appreciate by 10% or more in fiscal year (FY) 2017/18 as tourism improves, alongside improved remittances and investment flows. The appreciation, however, depends on when the ban on Russian and UK tourists is lifted.
As for the gross domestic product (GDP), Arqaam said, "we maintain our real GDP growth projections, expecting 3.8% in FY 2017, 4.5% in FY 2018, 5.5% in FY 2019, and 6.2% in FY 2020."
Arqaam says there is substantial scope for the government to cut interest rates, provided inflationary pressures come down.
On 29 June, the government started the implementation of its plan to restructure energy subsidies, increasing petroleum products' prices by 40% for gasoline (80, 92, and 95 octane), diesel (gas oil), LPG canisters, and mazut (fuel oil), in addition to natural gas for the household sector by 20%, to restructure government spending as the main aim for this reduction in energy subsidies. The government announced earlier that subsidies on petroleum products would need to be reduced from an expected EGP 145bn to EGP 110bn in the FY 2018 state budget and electricity from EGP 80bn to EGP 30bn. In less than a year (between November 2016 and June 2017), the government raised 92 octane gasoline by 92%, diesel by 103%, and mazut for cement companies by 56%.
"We had expected this step to happen in the third quarter (Q3) of 2017 to get the more difficult measures done in 2017 and clear the way for a recovery in 2018. The step shows continued commitment to reform and a deep understanding of the need to change economic direction, following decades of economic mismanagement," the report noted.
Energy subsidies as a portion of total government expenditures will also decline to around 9% in FY 2018, from 20% in FY 2012.
More fiscal reforms underway
Another package of fiscal reforms is underway and is scheduled to be implemented over the few coming weeks. In fact, the Minister of Petroleum announced that savings expected from the energy hike could reach EGP 35bn, part of which will be directed to additional social spending.
In addition, the government has recently announced a social spending package worth around EGP 85bn. It includes a 15% increase in pensions, 7-10% exceptional annual bonuses for civil servants, with 7% being for those under the New Civil Service Law, and 10% for other civil servants, totaling 14% and 20% respectively, an increase in monthly food subsidies on ration cards from EGP 21 to EGP 50 per person, as well as an increase in the cash transfer programme beneficiaries.
A flurry of increments in prices of government fees and services is expected to take place, including on water, car registration fees, and fees on mobile phone tariffs; besides an increase in taxes on tobacco products expected in July. This follows an increase in prices of sugar and edible oil in the ration card system.
"In our research note "Paradigm Shift in Egypt" we had indicated that an energy price hike would likely happen in Q3 2017, as part of the government's wider efforts to restructure its rigid expenditures and break the decade's long vicious cycle of rising rigid expenditure items undermining the government's ability to improve public services. Next steps are likely to include implementation of the fuel smart card system to better monitor consumption and the possible liberalization of prices in the medium term, whereby a subsidized quota could be sold, and additional consumption may be sold at cost levels. A wider reform program of the energy sector has been agreed on with the IMF," Arqaam's report said.
Forecast for the automotive and property sectors
On the auto front, GB Auto has felt the largest decline in passenger car volumes in Q1 2017 across the discretionary consumer space, and is now offering discounts to stimulate demand and improve cash flows. This suggests limited scope for any further upward pricing adjustments, though an improvement in demand for small engine vehicles (Hyundai, Geely, Chery) would likely result after the instatement of fuel price hikes.
In terms of the property sector, affordable residential product, which is typically purchased by specific users and not as a hedge against inflation/FX, will likely undergo a greater degree of margin compression relatively to high-end property, given the substantial growth in asking prices over the past two years.
"We see limited room for further pricing growth in the low-end segment of the property market. High-end property, in which expat demand has become a significant sales contributor, will likely exhibit margin immunity in an environment of subsidy cuts," Arqaam's report said.
Pricing growth has yet to stall as of the first half of 2017, in which high-end developers have achieved, on average, a 30% year-on-year increase in selling prices across launched projects.
"While expenditures are finally coming under some control, we expect a potential negative impact of the high inflation and interest rates on the economy. This could reduce the anticipated increase in tax revenues in the FY 2018 state budget. Tax revenues make up 70% of total revenues and with our expectation of revenue growth of 27%, compared to the projected 29.5% in FY 2018 state budget, we expect the overall budget deficit will exceed the government's target of 9% to reach 10% of GDP," Arqaam said.
In terms of Arqaam's general projections for 2018, Arqaam said that it maintains its existing economic growth projections. "We had just revised real GDP growth downward after the 200bps hike and our inflation projections had already included the effect of the energy price hike on economic activity," it said.
"We also believe that the apparent resilience of the informal sector and high-income group in dealing with the spike in inflation, coupled with the improvement in the contribution of investment (especially foreign) and net exports in real growth, would partially compensate for the pressure exerted by the inflationary pressures and high interest rates on consumers and local investors, respectively," Arqaam added.
Impact on the industrial and automotive sectors
The second round of energy price hikes affects cement producers primarily via electricity costs, as most producers have moved away from diesel/natural gas to coal/RDF, according to Arqaam. Electricity represents 11% of direct expenses for cement companies. "Our calculations assume a 40% increase in electricity costs (expected to take effect in July 2017) for fuel-intensive industries. Furthermore, we expect Tourah Cement to switch energy usage from heavy fuel (mazut) to petcoke (not impacted by subsidy cuts) which should partially mitigate margin erosion resulting from fuel subsidy cuts. Increase in energy costs should be neutral on earning per share (EPS) at Sewedy Electric and Ezz Steel as both businesses retain strong pricing power, allowing for full pass-through of increases in direct costs (primarily imports of copper and iron ore post-EGP float, electricity post-subsidy removal, but to a lesser extent)," Arqaam said.
Arqaam said that it expects a minimal direct impact on Egyptian consumer names, as energy expenses typically represent 1-3% of operating costs; however, continued inflationary pressure should strain disposable income and further erode purchasing power, which would impede the gradual recovery in volumes.
On the other hand, the social aid package should counteract the pressure on volumes for mid-low income households. Food producers have fully passed on foreign exchange-related cost growth in FY 2017, which translated into an average of 30% volume decline for JUFO, DOMTY, and EDITA.
"We continue to play Juhayna as our top value/defensive pick in the sector and maintain our earnings and margin estimated unchanged across the board," it added.
Arqaam expects very little price hikes in the food sectors at least in the near term as producers continue to prioritize the rehabilitation of volumes over margins in order to avoid inventory accumulation.