Changes in perceived risk and reward

Cost of Equity (COE)

Along with changes in the supply of capital and investable opportunities, another factor that influences the prices at which assets change hands is the perceived risk and rewards of a particular investment. Cost of equity (COE) represents investors’ estimate of a fair rate of return required for an investment based on the risk. To estimate the changes in the risk exposure perceived by investors, we have estimated an average cost of equity for each market.

Comparatively, from December2019 to March 2020, increases in COEs were experienced in all countries. These include significant markets such as Ghana, Kenya, and Nigeria, where COEs increased by 2.96%, 2.34%, and 2.59%, respectively. This COE increase is attributable to a universal rise in risk due to the global impact of Covid-19. From March 2020 to June 2020, the COE reduced for most markets under review in response to countries loosening monetary policy measures.

The sovereign credit default spread is a quantitative measure of each country’s sovereign risk. This measure is used to build up the COE of each country. The graph below illustrates how credit default spreads (CDS) changed from January 2020 to June 2021 for a select group of African countries:

Overall, we saw a steady decrease in sovereign CDS from April 2020 to July 2020. This contrasts with the sharp increase previously observed, which was fuelled by the global risk-off environment ignited by the devasting economic impact of the novel coronavirus. Investors had shifted away from riskier emerging and frontier markets towards safer, more developed markets. As African markets are classified either as frontier or emerging, this impact was felt heavily.

Movements in the CDS from July 2020 to June 2021 indicate a rebound for most markets, with some returning to pre-pandemic risk levels. This speaks to the corresponding decrease in the cost of equities over the period. The movement in CDS represents the stabilisation of markets as global economies recovered from initial lows, as well as the impact of worldwide quantitative easing.

All the countries that form part of the analysis showed a decrease in the cost of equity from June 2020 to June 2021. Egypt experienced the most significant decline: 5.1%. Considerable decreases in Egypt’s sovereign CDS and equity risk premiums drove the decline. Egypt’s economic prospects, including GDP growth, continue to improve considerably on the back of a strong increase in the services trade surplus and resilient remittance inflows supported by an affirmed B+ stable outlook. Furthermore, Fitch Solutions anticipates that Egypt’s budget deficit will narrow further into FY22 as the government resumes fiscal consolidation efforts.

The Covid-19 crisis remains a threat given that countries like Egypt are particularly reliant on tourism. The global and local spread of the virus is difficult to predict and could have adverse impacts on our growth forecasts, particularly given the slow rate of vaccination on the continent.

Kenya, Nigeria and Zambia also experienced considerable COE declines of 4.2%, 4.5% and 4.1% respectively. The universal considerable decline in sovereign CDS and varying levels of reduction in equity risk premiums drove the reductions. With ratings affirmed, real GDP in these countries is expected to gradually rebound to pre-Covid-19 levels in 2022.

The increase in Ghana’s long-term inflation expectations drove the rise in the currency premium. This, in turn, drove the smaller reduction in the country’s COE. Fitch Solutions forecasts GDP growth to accelerate on the back of a healthy rebound in private consumption and exports.

The reduction in Ethiopia’s COE was predominantly driven by the decrease in the currency premium, driven by the decrease in long-term inflation expectations. Fitch anticipates that the Ethiopian birr will continue to face downward pressure over the short term, with the pace of depreciation slowing into 2022. Ethiopia and Tunisia’s CDS tails up in the latter part of the period following increased risk sentiment (as illustrated in Graph Credit Default Spreads), and corresponding ratings downgrades underpinned by fiscal consolidation issues.

COE movements experienced for South Africa and Tanzania have been more subdued, which indicates minimal movements in overall investor risk perception in these countries over the past year. Perceived increases in sovereign risk offset expected decreases in COE from the universal increase in appetite for risk. In November 2020, Fitch downgraded South Africa by one notch to BB – and in August 2020, Moody’s downgraded Tanzania by one notch to B2.