Wednesday, February 11, 2015 14:59 PM / ARM Research
Having concluded our review of capital markets in H2 2014, we round up the serialisation of our core strategy document – The Nigeria Strategy Report with a piece on our proposed capital market strategy for the H1 2015.
Over the past few iterations of our reports, our FI strategy has mainly been shaped by demand side considerations as the FG basically kept supply steady. First with FPI, as the 2012 JPM EMBI inclusion brought about a seismic shift in Nigeria’s bond market and then, more recently, on domestic factors as building liquidity broadened home-grown influence. In the latter regard, the long term AUM growth for the pension industry persists and has received new impetus from the July passage of the PRA. Similarly, banks’ deposit growth drive continues apace though in this instance with full impact of funds sourced tempered by regulatory regimentation. To showcase the overall domestic impact, over the course of 2014 through October, banks and PFAs’ bond holdings jointly increased by
N609 billion against net issuance of N448 billion as at then. In tandem with this increasing buying power, that already made domestic institutions the major holders of domestic debt anyway, an ever growing savvy means that prior passivity might be evolving into a more active role in price setting, once the domain of FPI. Whilst there were signs that this was manifesting late in H1 and early in H2 14, as liquidity drove yields lower, oil price declines—which is shaping up as something of a lightning rod for all economic woes in the current environment, and justifiably so—disrupted that emergent trend. Specifically, given the havoc wrecked on the fiscal management, for the first time in years, FI outlook is set to be more influenced by supply side dynamics.
In this regard, having already highlighted the constraints facing external borrowing at this time, and whilst the projected deficit of
N755 billion (and the requisite amount of bond issuance to fund it) would seem aligned with recent history, we reiterate our analysis of historical benchmarks and resulting deficits which showcase that with current proposal, deficit could end up nearly double the projected amount. Though that analysis focused on 2009 and 2010 because of similarities in oil dynamics with expectations for 2015, comparisons with last year point in the same direction; with 2014 approved budget carrying respective price and production benchmarks of $77.5/bbl and 2.38mbpd (compared with proposed 2015 of $65/bbl and 2.28mbpd) the deficit was N0.94 trillion. Perhaps more sinister is that even our projection for doubled deficit assumes oil prices at 2015 benchmark and if adjustments are made for further downdraft in oil prices then the picture darkens even more. To illustrate, using the same framework, at $50/bbl oil (and maintaining production at 2.28mbpd) the deficit could be well in excess of N2 trillion. Leaving the appropriateness of the deficit estimate aside, a further concern is the lack of options to plug it. Even if the entirety of the ECA were shared for budget augmentation it would not cover the official projected deficit especially as the FGN’s share would only be about 50% of the ~ N680 billion proceeds. It is therefore no surprise that the final budget passage has been moved till after elections to let the FG have a better grasp of where oil will settle and the measures it will need to take.
Regardless, what is clear from all this is that the FG will have to issue significant amount of paper to sustain its operations with attendant stoking impact on t-bill and bond yields. Whilst we believe that the sheer desperation of the FG’s situation mandates some success with its non-oil, specifically, tax revenue generation drive, even as its overhead cutback and revenue augmentation will help reduce total borrowing needs, we believe the moderating impact on yields will be limited—even if only because expected pricing has already recalibrated based on perception of its fiscal straits. In a similar vein, full IFRS implementation for pensions and likely focus by banks on FGN securities have a similar positive connotation for FI pricing, but in our view, ultimately limited impact in tempering yields.
Having noted the potential tamping influences on yields it is important to reassess the important technical considerations influencing the undertone for the yield environment. Importantly, political maneuverings and ongoing insurgency have been factors we have previously identified. The political angle is now imminently at a peak with elections in February 2015 whilst the insurgency angle has, if anything, ramped up over H2 14 further stoking concerns as to its import on investment environment. The direction of the impact from these continues to influence our bearish call on yields. Furthermore, we also note that the same pressures facing the FG also face the states, perhaps even multiplied, and unlike the FG’s more measured approach the SGs will likely be more focused on the fact of getting the funding than its pricing. The competition thus given to the FG’s funding needs even as maturing OMO profile is set to be lower than recent history is also likely to add to the mix of yield stoking influences.
Combining the technical and fundamental factors, and noting the absence of specific liquidity boosting events such as AMCON repayments and such, as was available in H2 14, our strategy is to stay short in the run up to the elections, waiting for yields to climb to a peak, and then rapidly build duration thereafter, all things being equal. To our thinking, any election related upheaval simply extends the window for this buildup with the timeframe also being sufficient for oil prices to have found some stability at a level, which we reiterate, is likely to reflect global oversupply situation.
Catchpenny stocks: but second order risks un-priced?
After H1 14 delivered the decoupling we anticipated in equities with net short FPI flows into equities in the first five months of the year completing an eleven month streak of outflows, the recovery in flows in June re-established that relationship somewhat. Excluding August which was marginally negative, net FPI flows stayed positive till September when it reached its peak level since the NSE started providing monthly data in 2013. Whilst conclusion of tapering by October and scarcity of events to specifically trigger any FPI push had made us conclude that any “recovery in FPI flows will remain too tepid to drive a sustained uptick in market performance”, the scale of the sharp reversals in October and a further dip in November to match largest monthly outflow, ever, indicated there was more at work than just tapering induced capital reversal.
In that regard, the role of oil prices in setting up the dour Q4 14 performance is well documented and the weakness just deepened as the quarter wore on. Incidentally, in light of increasing selectivity of FPI, we had seen Nigeria’s investment credentials as a positive with political brouhaha weighing more on the downside in establishing our weak equity outlook for 2014. That it was the shiny credentials which gave way as oil prices piled on the pressure underscores the significance of crude oil to the overall macro-picture, and with the political bumps still all ahead, sets new hurdles for the scale of headwinds facing equities. Just as the marginal decline in Q3 14 reflects the boost from FPI as domestic support which aided Q2 gains waned, so does the steep Q4 14 NSEASI declines (worst since Q3 11) showcase the depth of uncertainty stirred by crude oil’s collapse. In a sense, FPI’s brief Q3 14 cameo only served to set up equities for the killer blow from oil’s globally felt shockwaves. In all these, one common leg from our prior outlook and recent developments is that domestic considerations are again expected to be at the fore (as they were for a brief while), with the focus they bring on valuations.
As expected the impact of the equity declines has significantly compressed valuations with the NSEASI’s PE multiple shedding 15.5% in Q4 to 11.4x by year end while PEs on our stock classes: defensives, cyclical industrials and cyclical banks; respectively shed 17%, 13% and 17.3% to 22.9x, 14.9x and 5.4x. Whilst the oil fuelled blanket decline is certainly making stocks look attractive the real question is whether those declines reflect the full extent of imminent risks. Specifically, forward looking events suggests significant risk lies on the horizon as market starts to grapple with the aftershocks of the events that already drove current declines. Burgeoning asset quality issues for banks, multi-faceted earning pressures for FMCGs and higher input costs for traders are all issues that are yet to fully manifest and with an undercurrent that could strengthen as events unfold. Along these same lines the overall response of economic players and the FGN in particular to the current challenges have their own reverberations. For instance, FGN’s tax drive in response to its revenue shortfalls includes an effort to review corporate usage of the pioneer tax status with a possible ~
N40 billion to be raised. That’s an amount directly coming out of corporate earnings. In a nutshell, we see no floor yet for the equity market as a whole.
Sector-wise, our bearish view on defensiveness remained on the money in H2 14 with personal care and food producers being, respectively, the worst and third-worst performers on the NSE. This is not really surprising given the overburdened valuations which still remain far ahead of other sectors despite recent declines. Furthermore, with the defensives likely to bear much of the topline pressure from weakened consumer income we reiterate our negative view on the sector as a whole with even the few individual positive prospects still carrying significant residual risk.
Cyclical industrials are a bit of a balancing act. On one hand, reduced capital expenditure as fiscal noose tightens, alongside pressured consumer incomes, portends revenue pressures. On the other hand, lower energy prices, with LPFO down 33% in Q4 14, portends margin expansion as the alternative to gas has now become much cheaper. On balance, we expect this to be the least pressured sector and expect earnings to hold up better than average in 2014.
For the banks, the forward looking risks are perhaps more obvious and these rather than valuations (which have been depressed for years and still the lowest on the NSE) have played a bigger role in shaping our views. Considering the unviability of most reserve-based lending at these prices, delinquencies pose a big challenge going forward. Furthermore, the concomitant cutbacks in credit-creation and the now limited quantum of the SDF suggest readymade outlets and by extension, revenue generating potential, would also be pressured for these banks. In this event, the issue is whether the scale of valuation compression compensates for these risks and historical asset quality and O&G exposure for individual banks will be important factors to dimension in making picks. In order words, while sector return prospects remain attractive risk consideration act as a dampener and at the very least indicate a more measured attempt at entry opportunities with the post-election/Q1 15 results window likely a better time.
One segment not caught in our classifications is the petroleum marketers and it would seem that this category is in the sweet spot of the intersection of all these conflicting factors. Lower energy prices already provide a boost to margin expansion prospects on PMS and lubes and FGN’s reticence in removing subsidy on the former continues to provide significant rent even as the oligopoly nature of AGO suppliers ensures they are capturing significant portion of the upside from recent oil price declines. In an overall equity strategy that suggests waiting out of the equity market to ensure current depressed valuations fully compensate for risk, this petroleum marketers perhaps present the most immediate actionable opportunity.
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