Investors are likely to pour more funds into Egypt in 2011 as a strengthening economy and attractive yields outweigh a fragile social backdrop and uncertainty ahead of a presidential election.

Egypt's main stock index rose 20 percent in the past six months even as soaring food prices hit the poor, sectarian tension grew and the country held parliamentary elections marred by accusations of fraud and bullying.

A church bombing in the northern city of Alexandria killed 23 people at New Year and sparked angry protests by Egyptian Christians demanding more protection from Islamist extremists.

Egypt's benchmark index wavered in the days after the attack before rallying to an eight-month high on January 5.

Explaining that strength, analysts point to accelerating economic growth and a broader shift to emerging market risk prompted by quantitative easing in the United States and lingering uncertainty over economic recovery in developed nations.

That also seems to override uncertainty over whether President Hosni Mubarak, 82, will run for a sixth term in office in September. He has no deputy or obvious successor.

We do not believe that either the run-up to the presidential elections or any overhang from the parliamentary elections will impact economic policy -- focusing on supporting growth, said EFG-Hermes in a research report.

The investment bank gave Egypt an overweight rating, saying domestic demand should continue to strengthen this year due to faster credit growth and rising investment.

Election rules and the opposition's weakness make it virtually impossible for anyone but the ruling National Democratic Party's (NDP) candidate to win in September.

Mubarak has not said if he will run for another term that would take him to 89, but ruling party officials say he is their natural candidate. Mubarak has no clear successor and has denied talk that his son Gamal is being groomed for power.

His three decades in office have fostered a stable business environment but the strength in a system that revolves around one man is viewed by some as a weakness as post-colonial Egypt has no precedent of a voluntary handover of power.

Uncertainty over the succession is a source of real concern for overseas investors, said HSBC Economist Simon Williams. But while this will ensure they stay cautious, I think Egypt's economic fundamentals are too good, and the yield on offer is too high, to push them away from the trade.

INFLATION A CONCERN

Egypt's government estimates the economy grew 6-6.2 percent in the final quarter of 2010 after gaining gradually from 4.7 percent in the year to June 2009. It is aiming for 7 percent in the 2011-2012 fiscal year.

The central bank has held its main interest rate steady since September 2009 as the government seeks to push growth high enough to create enough jobs for a fast-growing population.

That means prices, not politics, could pose the biggest risk to the inward flow of portfolio funds, say some economists, who forecast inflation could accelerate in the first half of 2011.

It's mainly about inflation -- politics will be secondary as long as there are no major political shocks related to the presidential election, said Brahim Razgallah, Middle and North Africa Chief Economist at J.P. Morgan.

Core inflation, which excludes subsidised goods and volatile items, rose in November to 8.58 percent from 7.65 percent in October. High prices hurt the poor in Egypt, where about a fifth of people live on less than $2 a day according to the United Nations.

Inflation can also dampen demand for treasury bills, which soak up the biggest chunk of foreign portfolio investments.

Foreigners' share of Egyptian T-bills went from 14.6 percent in July to around 23 percent in early November, according to J.P. Morgan.

Razgallah said he expected it to remain stable in coming months as inflation accelerates further but may rise to around 30 percent once inflation stabilises and slows.

The yield on Egyptian 182-day T-bills rose to 10.3 percent this month from around 9.5 percent in late October, an appealing return as developed nations hold interest rates low in an attempt to kick-start their recession-hit economies.

I think another 0.5-1.0 percent rise in yields is possible, said Monette Doss, senior analyst at Prime Securities in Cairo. This will result in stable exchange rates because I highly believe that if it were not for the high yields the Egyptian pound would have depreciated more.

Economists see the Egyptian pound -- which has been testing five-year lows above 5.8 against the dollar -- strengthening to around 5.7 in coming months and say that prospect could bolster inflows into Egyptian bonds and equities.

The FX is quite important. As long as it remains stable with a bias to appreciation, that will encourage foreign investments, said Razgallah at J.P. Morgan.

Analysts are recommending stocks likely to benefit from a stepped-up infrastructure drive and growing spending by Egypt's expanding middle class after the period of low interest rates spurred consumer lending.

HSBC has buy recommendations on Ezz Steel and Orascom Telecom. Among buys for EFG-Hermes are drugmaker Eipico, Maridive, Credit Agricole Egypt, National Societe Generale Bank El Sewedy Electric and Palm Hills Development.

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