Economic Market Review Kenya

ECONOMIC AND MARKET REVIEW DECEMBER 2006

Contents

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Summary Economy Budgetary Developments Interest Rates Bond Market Inflation Exchange Rate Domestic Equity Market Global Economics and Currencies Global Equity Markets Global Bond Markets

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

Summary

Outlook

4th Quarter 2006

1st Quarter 2007

Economy ¾

Economic growth remained robust in the fourth quarter of 2006. Data from the Central Bank of Kenya indicates improved performance for the first nine months of 2006. With increased economic activities in the last quarter, we estimate that the economy consolidated gains over the twelve months to record 6.0%.

¾

We anticipate continued economic growth for the first half of 2007, to be boosted by the financial, trade, telecommunication and construction sectors. Increased political activity in the second half of 2007 may dampen economic growth. We estimate the growth rate to stabilize at 6.0% for 2007.

¾

We expect the government will be able to raise targeted tax revenues on the back of our forecast sustained economic growth in the first half of 2007. However, all privatization proceeds may not be realized during the timeframe because of administrative problems that will likely delay the privatization process.

¾

Improved revenue collections and slower implementation of development expenditure may make rates stabilize. In our view, the main risk is likely to emanate from prolonged growth in money supply and the timing of CBK’s action to stem this growth.

¾

Bond yields are expected to continue to track the movements in short term rates and for the moment short to medium term tenors remain the most attractive considering the long term bond yields have not shifted much higher.

¾

We expect inflation rates to fall gradually in 2007 if growth in money supply declines and infrastructure improves to facilitate product distribution.

Budget Development ¾

By the end of December 2006, the government had collected Kshs 154.79 billion. This is 14% above comparative period of 2005/06, only 2% below target for the period. With improving economic environment and increased efficiency, KRA seems set to meet the target for the FY.

Interest Rates ¾

Treasury bill interest rates were mixed throughout the quarter, rising from 6.681% to highs of 6.914% in October. Thereafter, buoyed by high liquidity levels, the rates declined to lows of 5.636% in early December, before reversing upwards to close the year at 5.831%.

Bond Market ¾

The yield curve shifted upwards and steepened in response to upward movement of short term rates, and higher yields earned in shorter term bonds particularly during the primary issues during the quarter.

Inflation ¾

Overall inflation rose from 10.9% in June 2006 to 15.6% in December 2006. During December 2006, food and non-alcoholic drinks index went up by 4% from November, due to bottlenecks in the distribution channels. Year-on-year, the index was up 22.6% while fuel & power index rose by 13.7%. 3

ECONOMIC AND MARKET REVIEW DECEMBER 2006

Exchange Rate ¾

The Kenya shilling had mixed performance during 2006. It strengthened by 4.1% against the dollar but depreciated by 9.1% and 6.4% against the sterling pound and Euro respectively.

Equity Market ¾

During the year, the Nairobi Stock Exchange (NSE) 20-Share Index and Market Capitalization gained 42.1% and 52.93% respectively with the NSE Index crossing 5,000 points on 26th October 2006. Corporate actions, high liquidity, declining interest rates, new listings and full implementation of the Automated Trading System contributed to the improved performance.

¾

Appreciation of the shilling against the dollar is likely on the back of expected rise in tourism inflows and higher horticultural exports. Private sector financial inflows and stable crude oil prices will further support the shilling’s strength. However, if CBK increases forex reserves, further strengthening may be mitigated.

¾

We expect GDP growth, negative real interest rates and stable macro-economic conditions to provide a favourable corporate environment for listed companies, with subsequent strong earnings announcements continuing to drive stock market performance. Greater integration of the regional markets should offer more opportunities for cross-border investments. Risks to view include concerns over possible rise in interest rates and fears over General Elections.

¾

The interest rate outlook is more favourable for equities than it was in 2006. US interest rates are likely to remain on hold for some months, although there may be further increases in Europe and in Japan in particular. Profit growth is expected to continue this year and we believe equity market gains will at least match the increase in profits.

¾

Expected annual economic growth will prompt rise in interest rates and reduce yields.

Global Equities ¾

Global equity markets finished the year strongly in December, with the MSCI World Index adding a further 2.1% (in US dollar terms). This brings the gains for the year as a whole to 21%. However, US dollar weakness exaggerated gains from overseas markets to dollar-based investors.

Global Bonds ¾

Global bond markets fell in December as economic data was released that reinforced the market’s view that economic growth would remain healthy and that interest rate expectations were in danger of being exceeded, sending markets into reverse.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

ECONOMY Grow th 2006 Grow th 2007E

Estim ated Sectoral Real Grow th in 2007

18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0

Others

Government

Construction

Financial Services

Hotels & Restaurants

Wholesale and retail trade, repairs

Manufacturing

Agriculture, Forestry & Fishing

0.0

Transport and Communication

2.0

Source Central Bank, OMAM

•

Economic growth remained robust in the fourth quarter of 2006. Data from the Central Bank of Kenya indicates improved performance for the first nine months of 2006. With increased economic activities in the last quarter, we estimate that the economy consolidated gains over the twelve months to record 6.0%.

•

Growth momentum for the year was mainly driven by the private sector, with the key sectors being tourism, transport, telecommunications and finance.

•

Improved macroeconomic environment in the first ten months of 2006 as evidenced by low interest rates and strong exchange rates helped spur greater private sector operations. Credit to the private sector was up 13% to Kshs 405 billion in October 2006.

•

Bilateral partners have largely approved government’s fiscal and monetary policies but are still concerned about governance issues. Project financing continued during the year, mainly to the infrastructure and financial sectors. Budgetary assistance however remained on hold.

•

Growth in the financial sector was evidenced by profitability which was up 42% in the first nine months of 2006 to Kshs 19.5 billion. This was mainly driven by increased lending opportunities and lower bad debt exposures.

•

Total banking sector assets rose by Kshs 102.7 billion to end September 2006 at Kshs 734.1 billion (2005: Kshs 631.4 billion). Loans and advances grew by Kshs 48 billion to Kshs 374.3 billion in September 2006. Most of private sector credit (90%) was to manufacturing, telecommunications, building and construction and SMEs.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

Sector

Agriculture, Forestry ,Fishing Manufacturing Wholesale & retail trade Hotels & Restaurants Financial Services Construction Transport and Comm. Government Others Estimated GDP Growth

Growth 2006 (%) 3.50 6.80 10.60 15.80 10.40 6.30 8.80 2.70 3.80

% of GDP 2006 23.40 10.70 10.90 1.80 3.70 4.52 11.26 15.20 12.26

Contrib. Growth Contribution to GDP 2007E to GDP 2006 2007E 0.82 0.97 4.00 0.73 0.74 7.00 1.16 1.19 11.00 0.28 0.22 16.00 0.38 0.31 10.00 0.28 0.27 6.80 0.99 0.98 9.00 0.41 0.42 2.90 0.47 0.48 4.00 6.00

Source: Central Bank of Kenya, OMAM

•

Tourism sector performed well last year, and indications are that this will continue this year, on the back of higher tourist arrivals. Earnings for the first ten months were up 12% to US$ 629 million. The number of tourists in the period was up 14% to 771,418. Increased marketing seems to have borne fruit.

•

The telecommunications sector also recorded improved growth. Total mobile telephone connections stood at about 7.5 million at the end of 2006. Increased competition is expected in this sector, which will lead to reduced costs to customers. More products will eventually be introduced and services improved and differentiated to win customers.

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In the transport sector, the port of Mombasa had improved throughput by 7.5% in the first nine months of 2006. Oil through Kenya Pipeline Company was also up, by 8.2% in the period. Capacity constraints at KPC contributed to moderate this growth.

•

New motor vehicle registration was up by 9.6% to 37,582 units for the first nine months of 2006. This follows increased investments in the private transport sector in the wake of initiatives to streamline operations in the industry.

•

Concessioning of the Kenya-Uganda railways was completed in November 2006. It is expected that the turnaround of the parastatal and enhancement of transportation of cargo and passengers within these countries will reduce strain currently exerted on the roads by trucks. Improved efficiency will enable transport costs to decline significantly over time.

•

Modest growth was recorded in the manufacturing sector, despite being constrained by high energy costs. Beer production was up 6.3% and cigarette output by 18.7% in the first nine months of 2006 as compared to comparative 2005 period. Cement production was however down to 1.56 million metric tonnes for the period to September 2006 (September 2005: 1.58 million metric tonnes). The decline in production was attributed to capacity constraints in the cement companies. 6

ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

Electricity consumption for the first 9 months of 2006 rose by 5.4% to 3,505.5 million KWh. Electricity output growth was up by 4.9% to 4,291.42 million KWh, but constrained by drought at the beginning of 2006 which prompted increased thermal generation.

•

In the agricultural sector, the coffee industry was active, with the licensing of 32 companies to market coffee directly (in the second window), bypassing the auction system. This will result in efficient pricing of coffee and provide desired incentive to the farmers. In the first nine months of 2006, coffee production was stable at 41,000 metric tonnes but average prices were improved by 11.2%.

•

Overall production of tea is estimated to have declined by about 12% in 2006 owing to unfavourable weather conditions, but average prices rose by 42% because of reduced supply and improved quality, leading to an estimated rise in value of about 25% over 2005.

•

Initiatives like the automation of tea auction, granting of Free Trade Zone status to KTDA farms and waiving of taxes levied on tea farmers are going to support development of the crop. Drought at the beginning of 2006 constrained production of tea, but it recovered from the second quarter. Improved quality and the process of packaging based on geographical indication will raise competitiveness of Kenya’s tea.

•

Horticulture output was stable at 125,000 metric tonnes for the first nine months of 2006 as compared to a corresponding period of 2005, while prices were up 3.4%. The strengthening of the Kenya shilling against the US dollar during 2006 slightly reduced real performance of this sector. Strict health standards required for the production of horticultural products and higher freight charges still challenge faster expansion of the industry.

•

Sugarcane production declined during Q1 2006, but also recovered as weather conditions improved during the year. The first nine months of 2006 saw deliveries to sugar companies go up by 13% over 2005 comparative period, but processed sugar was only up 5.7% due to low quality of delivered sugarcane. Rejection of the Finance minister’s proposal to transfer sugar levies from the consumer to the producer brought relief to the sector which is already faced with high production costs.

•

Rice production got a boost with the revival of irrigation schemes in Nyanza and Eastern provinces. Opening up of Kenya Meat Commission plant and planned revival of sugar plantation at the Coast province will help stir overall activity in the agriculture sector.

•

During the fourth quarter of 2006, the government presented a blue print (Kenya Vision 2030) for driving economic growth by 10% per annum for the next twenty five years, yielding a GDP of Kshs 12.2 trillion by the year 2030, from the current Kshs 1.12 trillion.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

This must however constitute major policy shifts that can withstand political pressures and governance inadequacies. The strategy will be steered by a multiministerial committee, thereby posing a challenge to policy continuity when the key political persons change with the change of leadership, making realization of the vision uncertain.

PROSPECTS •

We anticipate continued economic growth mainly for the first half of 2007, to be boosted by the tourism, financial, trade, telecommunication and construction sectors. The private sector will be crucial to sustaining growth momentum; with several anticipated projects in the banking, telecommunications and energy sectors poised to spur growth.

•

Increased political activity in the second half of 2007 may reduce the pace of economic growth. We are however optimistic that the economy can grow by 6.0% in 2007.

•

We expect increased public expenditure to create some temporary employment opportunities with the ripple effect of raising demand for goods.

•

We expect continued stability in macro-economic environment will prevail in the first half of 2007 and support economic growth. Consequently, balance of payment surplus is set to continue with the rise in private sector financial inflows.

•

Intended capacity development in key sectors is going to address the general rise in domestic and export markets, which needs to be supported by infrastructure development during the period.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

BUDGETARY DEVELOPMENTS Revenue collection

35,000

Cum. Jul-Dec 06 Cum. Jul-Dec 05 Cum CBK target 06

Kshs Million

30,000 25,000 20,000 15,000 10,000 5,000

s ax e er T

O th

of M /V

R

eg

Lo ca l T

T

VA

Im po rt

e VA

er I

nc om

YE PA O th

ut y D

Ex ci se

Im

po rt Du t

y

-

Source: CBK

•

•

•

•

•

By the end of December 2006, the government had collected Kshs 154.79 billion. This is 14% above comparative period of 2005/06, only 2% below target for the period. With improving economic environment, KRA seems set to meet the target for the FY. Improved economic growth, increased efficiency of KRA and implementation of electronic tax registers has largely been successful. The cost of the equipment has also gone down, making it easier to acquire. Constraints at the customs department are progressively being phased out and overall benefits of efficiency are coming into place. Kenya Revenue Authority outlined strategies of raising revenue collections through encouraging compliance and enlarging the tax base. Tapping into the underground/shadow economy, implementing risk based audits and simplifying tax filings are to support the process. Sustained economic growth means greater economic activity and profitability, leading to higher tax collections. Privatization proceeds received so far have been from government’s further divestiture from Mumias Sugar Company, raising an estimated Kshs 4.0 billion. Listing of Kenya-Re is expected in Q1 2007 to raise another Kshs 4 billion. However, listing of Telkom Kenya and Safaricom may not be realized within the timeframe due to administrative constraints. Donors have approved Government management of the macroeconomic environment. However, concerns remained over progress in improving governance structures in the public sector. Consequently, budgetary assistance has been put on hold but project financing was impressive in the year.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

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•

• • •

•

Recurrent expenditure for Q1 06/07 was Kshs 80.5 billion while development expenditure was Kshs 13.8 billion. These however are higher than comparative 05/06 period by Kshs 12.8 billion and Kshs 3.2 billion respectively. Development expenditures continue to lag target following delays in procurement. Government’s budget deficit for the first quarter of FY 06/07 was Kshs 16.7 billion, reflecting 1.0% of GDP on a commitment basis. This was a rise from Kshs 9.6 billion (0.7% of GDP) for Q1 05/06. CBK statistics for the first half of FY 06/07 ended 29th December 2006 indicate that domestic debt increased by Kshs 27.3 billion from Kshs 357.8 billion at the end of June 2006 to Kshs 385.1 billion at the end of December 2006. Treasury securities are becoming dominated by bond issues, shifting from treasury bills. Treasury bills rose by Kshs 1.9 billion from Kshs 94.8 billion on 30th June 2006 to Kshs 96.7 billion at the end of December 2006. Treasury bond stock was also up to Kshs 238 billion as at 29th December from Kshs 218.4 billion as at 30th June 2006. Maturity profile of domestic debt consequently rose from 2.2 years (June 2006) to 2.3 years in December 2006. the government’s debt management committee focuses on lengthening the profile so as to reduce volatility in borrowing needs. Cumulative expenditure on interest and other charges on domestic debt rose to Kshs 17.6 billion for 1H 06/07 from Kshs 13.8 billion of 1H 05/06 due to increased borrowing and relative higher interest rates during 1H 06/07.

PROSPECTS • We expect the government will be able to raise targeted tax revenues on the back of our forecast sustained economic growth in the first half of 2007. This will also be supported by the benefits of increased efficiencies being pursued by KRA. • However, all privatization proceeds may not be realized during the timeframe and the effect of increased government expenditures, during an election year, may raise the budget deficit. • With the prevailing high liquidity, the Government will be able to raise any required domestic financing from the local money markets at low interest rates. • Efficiencies in parastatals are expected to generate more income in the form of dividends and taxes while reducing financial strain on the Treasury.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

INTEREST RATES Overall inf lation

TBill & Inflation Rates

Av 91 day Tbill

20 16

%

12 8 4

N ov -0 6

Ju l-0 6 Se p06

06 M ay -

06 M ar -

Ja n06

N ov -0 5

Ju l-0 5 Se p05

05 M ay -

05 M ar -

Ja n05

0

Source CBK, CBS

•

Treasury bill interest rates were mixed throughout the quarter, rising from 6.681% to highs of 6.914% in October. Thereafter, buoyed by high liquidity levels, the rates declined to lows of 5.636% in early December, before a reversing upwards to close the year at 5.831% as the market experienced a pre-holiday tightness of liquidity.

•

Money supply growth has been a major challenge and continued to expand significantly over the months, growing by 15.8% to Kshs 650 billion in the year October 2006 and remains above the growth target of 12.0% growth set by CBK.

•

In its December 2006 meeting, CBK maintained its Central Bank Rate at 10% noting that underlying inflation of 4.39% in November 2006 was below target of 5%. The rate had been raised by 0.25% in August 2006 to 10% to help reduce the impact of money supply on underlying inflation. Despite faster growth in money supply, underlying inflation rate continues to be reasonably stable.

•

PROSPECTS •

We expect short term Treasury bill rates to remain relatively stable between 6.0% and 7.00% over the next quarter on the back of high liquidity.

•

Any revenue shortfall at a time when expenditure is expected to rise will lead to a wider budget deficit. However, we reiterate the view that government borrowing requirements will be met at low interest rates on the back of the prevailing short term high liquidity in the domestic market. 11

ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

High liquidity in the market will enable the government raise required financing from the domestic market. In our view, the main risk is likely to emanate from prolonged growth in money supply and the timing of CBK’s action to stem this growth.

•

BOND MARKET Yield Curve Sep 06 - Jan 07 15.0 14.0 13.0 12.0

%

11.0

Sep-06 Oct-06 Nov-06 Dec-06 Jan-07

10.0 9.0 8.0 7.0 6.0 5.0 0.25

1

1.75

2.5

3.25

4

4.75

5.5

6.25

7

7.75

8.5

9.25

10

10.75

11.5

Years

Source: CBK, KCB

•

The yield curve shifted upwards and steepened in the medium tenors in response to upward movement of short term rates. The longer end of the yield curve did not respond significantly during the quarter due to uncertainty over long term rates.

•

During the quarter, the Government issued short term and medium term bonds – 1-year, 2-year, 6-year and 7-year bonds compared to the longer term bonds of up to 12 years issued previous quarter. All the primary issues were received well by investors, particularly the shorter tenors, which came in at improved yields leading to a flattening of the yield curve.

•

Treasury bond stock was up by Kshs 20 billion to Kshs 238 billion as at 29th December from 30th June 2006. A total of Ksh 16.7 billion was raised from the Primary T-bond auctions in the 4th quarter of 2006, out of which Ksh 3.5 billion was new borrowing by the Government and Ksh 13.2 billion being rollovers.

•

Having raised a sizeable portion of its borrowing requirement for the fiscal year so far, the Government seems on course to realize the budgeted borrowing of Ksh 29.50 billion.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

Overall volumes remained low during the quarter with only Ksh 6.7 billion transacted compared with Ksh 14.7 billion during the third quarter, as investors focused attention to the Primary auctions.

•

The first two months of the quarter saw moderate activity particularly as interest rates declined. However, activity was subdued in December following uncertainty created by the reversing trend in rates as well as the reduced trade as the holiday season approached.

PROSPECTS •

Bond yields are expected to continue to track the movements in short term rates and for the moment, short to medium term tenors remain the most attractive considering the long term bond yields have not shifted much higher.

•

Looking further ahead yields are likely to trend higher, shifting the yield curve upwards, due to high money supply growth and inflation fears. Investors will also factor in political risk premium given this year’s general election.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

INFLATION Inflation indicators

Rate %

Headline

Underlying inflation

CPI

20.00%

250.00

16.00%

200.00

12.00%

150.00

8.00%

100.00

4.00%

50.00

0.00%

0.00

5 6 5 6 5 6 5 6 05 06 05 06 n-0 ar- 0 ay -0 J ulp- 0 o vn-0 ar- 0 ay -0 Julp- 0 o va e a e J J N N M S M S M M

Source: Central Bureau of Statistics

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Data from the Central Bureau of Statistics show that overall/headline inflation rose from 10.9% as at June 2006 to 15.6% in December 2006, mainly due to the effects of high food prices. For the year ended December 2006, food and non-alcoholic drinks index went up by 22.6% while fuel & power index rose by 13.7%. Average Murban crude oil price in the year to September 2006 was up 3.6% to US$ 63.30 per barrel as compared to a comparative period of 2005. Inefficiencies in the distribution networks led to a spike in food index rate in November-December 2006 period by 4%. Capacity and distribution constraints in the supply side also caused general price increases for most food products. Underlying inflation was generally below target, but has been slowly edging upwards, closing the year at 4.39%, despite money supply growth that was up 15.8% from Kshs 565.4 billion in January 2006 to Kshs 649.5 billion at the end of October 2006. CBK raised money supply growth target to 12% from the initial target of 10%. This was expansionary in nature and may pose a challenge to keeping the underlying inflation rate within target in the medium to long term.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

PROSPECTS • •

•

Oil prices are expected to stabilize and this will help reduce pressure on domestic prices, thereby cushioning the fuel and transport indices from sharp rises. Higher food production on the back of good weather conditions will help keep the food prices in check while improvement in infrastructure will facilitate product distribution and reduce capacity constraints. If growth in money supply declines to target, especially if CBK reduces accumulation of forex reserves, we expect underlying inflation to fall gradually.

EXCHANGE RATES AND TRADE Forex Movem ent 150.0

Ksh/Us $

Ksh/GB P

Ksh/Euro

140.0 130.0 120.0 110.0 100.0 90.0 80.0 70.0 60.0 06 06 06 06 06 06 06 06 06 06 06 06 213456789012-0 -0 -0 -0 -0 -0 -0 -0 -0 -1 -1 -1 3 3 3 3 3 3 3 3 3 3 3 3 0 0 0 0 0 0 0 0 0 0 0 0

Source: Central Bank of Kenya

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•

•

•

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During the 4th quarter of 2006, the shilling strengthened against all the major currencies. It appreciated by 4.6% against the US dollar, 0.19% against the sterling pound and 1.17% against the Euro. The Kenya shilling had mixed performance during 2006. It strengthened by 4.1% against the dollar but depreciated by 9.1% and 6.4% against the sterling pound and Euro respectively. The strengthening of the shilling against the dollar was largely driven by rise in the capital and financial account surplus by US$ 1.33 billion in the year to September 2006 and robust tourism and horticulture exports. CBK’s increased accumulation of foreign exchange reserves by Kshs 40 billion to Kshs 154.5 billion in the ten months to October 2006 helped stop further strengthening of the shilling. Large dollar denominated inflows have also been realized from business activities in Southern Sudan and remittances from Kenyans living abroad.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

•

•

Overall balance of payment position as at 30th September 2006 improved to a surplus of US$ 770 million, mainly hinged on net foreign private financial inflows. This largely contributed to the strengthening of the Kenya shilling against the dollar. Trade deficit widened during the period, as indicated by the widening of current account from US$ 491 million in September 2005 to US$ 1,444 million as at September 2006. However, capital account surplus rose by US$ 1.33 billion to end September 2006 at US$ 2.2 billion. Low interest rates and high inflation are indicators for currency weakening. However, due to higher real returns from equities and real sector where more foreign finances are channeled, the shilling has strengthened over the period.

PROSPECTS •

We still feel stability of the shilling against the dollar is likely on the back of high tourism inflows and improved exports. Expected rise in investment inflows to the country and low crude oil prices will also support the shilling’s strength.

•

The rate of accumulation of CBK reserves will determine money supply growth. Increase in reserves will lead to increased money supply growth and reduce strengthening of the shilling, but raise inflation. However, reduction in the growth of reserves will make the shilling strengthen further while lowering money supply growth.

•

Stable macro-economic environment will make the business climate attractive and entice more inflows to the country, and may support strengthening of the shilling.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

THE DOMESTIC EQUITY MARKET NSE INDEX & TURNOVER JAN 2005 TO DEC 2006 NSE 20 Share Index

1,200

7000

1,000

6000

800

5000

600

4000

400

3000

200

2000

Index

Turnover

Kshs mn

Turnover

0 Dec-04

1000 Apr-05

Jul-05

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

Dec-06

Source: NSE

•

•

•

•

During the year, the Nairobi Stock Exchange (NSE) 20-Share Index and Market Capitalization gained 42.1% and 52.93% respectively with the NSE Index crossing 5,000 points during the year. Strong corporate earnings, corporate actions, high money market liquidity, declining interest rates, a stable macroeconomic environment, new listings and implementation of the Automated Trading System (ATS) all contributed to the significant growth in performance. The NSE had four new listings during the year: KenGen, Scangroup, Equity Bank and Eveready. The KenGen IPO, which came to the market in April, achieved a subscription rate of 240%, attracting applications worth Kshs 26.5 bn (US$ 110 mn) compared to Kshs 7.8 bn that Government of Kenya (GOK) was seeking from sale of a 30% stake. The Scangroup IPO, which was launched in July, achieved a subscription rate of 521%. Equity Bank was listed at the NSE during the month of August. The last IPO during the year was Eveready, which came to the market in November. The IPO had a subscription level of 870%, the highest in the NSE’s history. Efforts to accelerate the privatization process continued, with GOK offering 92,999,220 shares in Mumias Sugar Company at a price of Kshs 49.50, which reduced its stake from 38.04% to 20%.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

Various companies announced corporate actions during the year. East Africa Cables announced a 10-for-1 share split in August. Sasini Tea & Coffee announced a 1 for 5 bonus share issue and a 5 for 1 share split in December. ICDC Investment Company announced a 10-for-1 share split in October, on the back of a 106% increase in net profits. Barclays Bank also bucked the trend in corporate actions by announcing a 1-for-3 bonus share issue and a 5-for-1 share split in early November. Standard Newspapers Group announced a 1-for-8 bonus share issue in October. These actions, particularly the share splits, were responsible for significant share price appreciation in the respective counters due to the perceived attractiveness post-split.

Equity Market Turnover 2003

2004

Q1

Q2

2005

2006

36,000

Kshs Millions

32,000 28,000 24,000 20,000 16,000 12,000 8,000 4,000 0 Q3

Q4

Source: NSE

•

Leading stocks during the year included Sasini (427%), East Africa Cables (350%), ICDC Investments (348%), Jubilee Holdings (289%) and Housing Finance (244%). Losing stocks included Kapchorua (-36%), Kenya Oil (-20%), Total Kenya (-15%), Kakuzi (-12%) and Unilever Tea (-12%).

•

Earnings announcements during the year reflected general growth in profitability, in line with improved macro-economic conditions. Strong earnings announcements across the banking sector continued to reflect asset growth owing to increased lending, declining provisions and cost control. Improved earnings announcements from other sectors were attributable to recovery in commodity prices, diversification and improved operational efficiencies.

•

Market activity improved significantly during the year with turnover up 159% to Kshs 95 billion. 1.46 million shares were traded during the year, which is a 79% increase from the previous year. Daily turnover finally touched the record level of Kshs 1 bn during the month of October.

•

Market activity improved for the eighth consecutive quarter with turnover up 23% to Kshs 32.5 bn. 408.4 million shares were traded during the quarter, which is a 7% increase from the previous quarter. 18

ECONOMIC AND MARKET REVIEW DECEMBER 2006

•

Market valuations in most counters of the NSE looked quite stretched during the year mainly due to increased demand for shares and low interest rates.

PROSPECTS • We expect GDP growth and stable macro-economic conditions to provide a favourable corporate environment for listed companies, with subsequent strong earnings announcements continuing to drive stock market performance. • Low interest rates will result to negative real rates of returns, supporting demand for equities. •

Several IPOs from both GOK and the private sector should continue to spur investor interest in the stock market going forward.

•

Greater integration of the regional markets should offer more opportunities for cross-border investments in the Ugandan and Tanzanian stock exchanges, exemplified by the significant interest in the Stanbic Uganda IPO exhibited by Kenyan retail and institutional investors.

•

We expect relative market valuations to adjust to lower levels as corporate earnings rise.

•

Some level of volatility may be experienced during the second half of 2007 due to heightened political temperatures ahead of the General Election at year-end.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

GLOBAL ECONOMICS AND CURRENCIES Economics • After a weak round of US economic data in November, figures generally came in on the strong side in December. This included employment data, preliminary retail sales data and the consumer confidence survey. Inflation data showed little change. Of particular interest was the jump in new home sales in November, prompting thoughts that the worst of the housing market slump may be over. US economic growth seems to have moderated but not slowed sharply. •

The Federal Reserve left interest rates unchanged for the fifth consecutive month in November. However, if economic data shows further signs of strength it may prompt the Fed to reassess its interest rate policy, which would be poorly received by equity markets.

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As expected the ECB tightened monetary policy by raising interest rates by 25 basis points to 3.5%. European economies continue to show strength, with Q3 GDP growth at 1.5%. The German IFO survey is at its highest level since reunification, while M3 money supply growth is at its highest level since the introduction of the Euro.

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UK economic data was also stronger than expected last month with Q3 GDP growth and retail sales both firmer than expected. In terms of the inflation outlook, both average earnings growth and the RPI beat expectations, hence the central bank is keen to ensure that higher pay settlements are discouraged. Of equal concern is the fact that the housing market seems to have firmed again and the central bank will be keen to keep house price inflation in check. Hence a further interest rate increase could be likely in the next couple of months.

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The European economic outlook is better than it has been for a number of years. However against this backdrop, further interest rate increases are likely as we move through 2007.

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In Japan the unemployment rate has now fallen to 4%, which is an eight-year low. However, consumer spending data and inflation data has been weak so the timing of the next interest rate increase is uncertain, but rates will almost certainly rise before the fiscal year-end.

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ECONOMIC AND MARKET REVIEW DECEMBER 2006

Currencies •

After the substantial devaluation that the US dollar experienced in November, it tried to strengthen in the early part of December, only to be pushed back down towards the lows seen in November by month-end.

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The US dollar now looks likely to strengthen as short-term interest rate differentials between the United States and the rest of the G7 countries have improved in favour of the US dollar and given that the trade balance has been improving moderately over the last few months.

GLOBAL EQUITY MARKETS •

Global equity markets finished the year strongly in December, with the MSCI World Index adding a further 2.1% (in US dollar terms). This brings the gains for the year as a whole to 21%. However, US dollar weakness exaggerated gains from overseas markets to dollar-based investors.

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The US equity market made further progress during December with the broad market gaining 1.4%. However, the NASDAQ slipped back a little (-0.7%) after a strong run of performance. The other major markets all made strong gains. After underperforming for some months Japan rallied strongly to close the month 4.9% higher.

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The European ex UK and Pacific ex Japan regions were the strongest markets in 2006 with gains of 22% and 27% respectively. Japan was the underperformer and only managed a return of 3%. Corporate profit growth looks set to be 10-15% for 2006 as a whole. With the exception of the US market most other regional equity indices have risen in excess of the growth in profits, albeit not drastically. Hence valuations in absolute terms have deteriorated slightly. The US market remains at the same sort of valuation levels as this time last year. Relative to bonds and other asset classes, equities continue to offer good value

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The interest rate outlook is more favourable for equities than it was in 2006. US interest rates are likely to remain on hold for some months, although there may be further increases in Europe and in Japan in particular. Profit growth is expected to continue this year and we believe equity market gains will at least match the increase in profits. In particular a weaker dollar will boost US company profits, given that a significant portion of S&P 500 earnings are from overseas operations.

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The markets are currently taking the view that Fed Chairman Bernanke is engineering a soft landing in the US. There is some risk that the perception on this might change if economic data strengthens again and if investors start to become concerned about further interest rate rises.

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The recent Japanese data has encouraged the market to rally, as figures have been more encouraging than expected. However, this strengthens the case for further interest rate increases. 21

ECONOMIC AND MARKET REVIEW DECEMBER 2006

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In the UK small cap shares finished the year very brightly with a gain of 7% in December alone. However, for the year as a whole mid caps led the way, returning 30% against 21% for small caps and 14% for large caps. In valuation terms, large caps look more attractive than both mid caps and small caps.

GLOBAL BOND MARKETS •

Global bond markets fell in December as economic data was released that reinforced the market’s view that economic growth would remain healthy and that interest rate expectations were in danger of being exceeded, sending markets into reverse.

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The greatest change in sentiment occurred in US Treasuries, where the market moved from an expectation of a first half rate cut to rates remaining unchanged into the second half of the year. The US long bond ended the month yielding 4.68%, up from 4.61% at the start of the month.

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In Europe, data continued to support the view that the European Central Bank (ECB) would increase rates further, resulting in 10-year bond yields rising to 3.94% by month-end, up from 3.66% a month earlier.

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Japanese government bonds outperformed in this environment, although yields still rose to 1.68% from 1.60%.

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