Driehaus Frontier Emerging Markets Fund Commentary

Driehaus Capital Management portfolio managers Chad Cleaver and Richard Thies give their views on Egypt, a country which has undergone significant political and economic change

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Feb 23, 2018
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This month we update our views on Egypt, a country which has undergone significant political and economic change over the past several years. We last wrote extensively about Egypt in August 2016, noting that the country was on the cusp of positive change, but likely facing a meaningful currency devaluation. At that time, our positioning was selective, but we anticipated becoming more aggressive as the effects of the devaluation “shrink into the rearview mirror.” We believe we have reached that point today, and have increased our weighting in Egypt over the past several months, expecting marked improvement in a number of key areas in 2018 and beyond.

First, as shown in the chart below (Exhibit 1), equity markets of countries that undergo a significant devaluation tend to underperform heavily eighteen months before the devalua-tion takes place. While policymakers are often late to face the moment of truth that a devaluation is needed due to political pressures, the desire to save face, or the perceived necessity of maintaining a fixed peg currency regime, mar-kets tend to sniff out such events well in advance. However, once the devaluation occurs, equity markets tend to perform much better eight months after the trough in the currency is reached.

The Egyptian pound devaluation occurred in November of 2016, hitting the ultimate low against the US dollar coming at the end of the year. The price of imported goods spiked higher following the devaluation, and consumer price index (CPI) inflation topped out at over 32% in August of 2017.

Importantly, Egypt raised interest rates aggressively as pressure grew for a devaluation in 2016 and continued to do so throughout 2017 to quell the inflationary impulse in the immediate aftermath of the currency weakness. Over this span, the policy rate doubled, reaching 20% at its peak.

The roadmap of past devaluations has largely held to form in the wake of the Egyptian pound devaluation. As inflation and interest rates reached their peak in the second half of 2017, we began to see a robust set of ideas emerge within the equity market, centered around interest rate-sensitive stocks, consumer companies that would benefit from improving purchasing power, and an idiosyncratic catalyst, the discovery of a large natural gas field, Zohr.

Operated by three global majors with significant expertise in developing natural gas fields, Zohr possesses an estimated 30 trillion cubic feet of gas, representing the largest discovery in the Mediterranean Sea. Production began in December of 2017, and the rate of production is expected to double by mid-2018 and nearly triple again by the end of 2019.

This is crucial for Egypt, as the country maintained deficits of gas equivalent to over 15% of demand prior to the contribution of Zohr. Replacing more expensive liquefied natural gas imports with domestic gas can both shore

up external deficits as well as contribute to cost savings for domestic companies in industries such as steel and petrochemicals, which are heavy consumers of gas.

Additionally, as a deficit country, Egypt is welcoming of long-term foreign direct investment, as well as local job creation to support the development of the gas field. Depending on the scale of the development, it is possible that Egypt could even export gas at some point in the future. For now, Zohr represents one piece of a more encompassing energy policy, which is shifting Egypt in the right direction as it addresses a past source of economic and strategic vulnerability.

Finally, we remain optimistic on domestic demand. Similar to many countries we favor, Egypt has a sizable population of nearly 100 million, with substantial growth of the working age segment set to unfold in the coming decades. (Exhibit 3) This lends structural support to numerous areas of domestic demand.

Amid the slowdown in inflation, albeit from very high levels, we could see several hundred basis points worth of interest rate cuts by the Egyptian Central Bank in 2018. Interest rate-sensitive pockets of the consumer economy, such as autos, should benefit in this macroeconomic backdrop.

While we maintain an optimistic stance on Egypt within the portfolio, we are cognizant of both domestic and regional geopolitical risks. Although incumbent President

Sisi looks poised to handily win Egypt’s March elections, politically difficult decisions surrounding the fiscal deficit and sensitive areas such as subsidy reform would face him following the election. Additionally, while inflation remains on a declining trajectory in the coming year, a watchful eye must be maintained for any renewed bouts of pressure, particularly if food inflation, which has been mired in a multi-year downtrend, were to resurface.

Until next month,

Chad Cleaver Rich Thies

Lead Portfolio Manager Portfolio Manager