Friday, August 14, 2015 13:27 PM / ARM Research
We draw curtains on the serialization of ARM’s core strategy document – The Nigeria Strategy Report with a piece on the proposed capital market strategy for the H2 2015.
FI markets finding new normal
At the end of 2014 we shared the significant role we expected technicalities of insurgency and political concerns, in the buildup to the election, to play in our expectation for yields to rise in 2015—a call that was fundamentally underpinned by factors that seemed certain to force the government to issue significantly more paper. Both of those technicalities unsurprisingly droned louder coming into 2015 and while other factors like oil and capital flows continued to stake a claim, it was clear the influence was from domestic factors. In our Q1 strategy update just post-elections, we clearly zoomed in on political risk as the primary influence on markets.
Data which emerged thereafter corroborates just how pervasive the influence of electioneering was on markets with currency volatility, FPI flows, FI market transaction volumes, amongst others, clearly highlighting the pressures in the domestic environment at the time. However, at the time and in the heat of the events, the main signal we had to go on was the primary market bid data which show rates rose steadily through the March auction. In contrast, despite still subsisting concerns as evidenced in the yield jumps late in June, rates were quite lower in Q2 and the question is whether the overall Q2 moderation means that risks in the domestic environment have significantly reduced.
On the global front, with the actual rate hike yet to commence and with signs that the crude oil market is not yet fully settled, the answer is a clear no, even if the long lead time means a lot will have been priced in, reducing market impact when both events actually materialize. On the domestic front, the question of whether risk in the environment is lower is perhaps not so straightforward. On the one hand, as captured in our review of fiscal situation, the weakness in crude oil market continues to wreck federal revenues and, with difficulty in selling Nigerian crude, speaks to continued pressures especially as Iran whose market share Nigeria essentially took slowly comes back on-stream. Indeed, whilst our conclusion from the fiscal section is that the adjustments to the budget continue to bring it closer to reality, the deficit remains a moving target and how it will be plugged central to the issue.
It in this regard that the real positive surprises manifested. First, the FG is showing remarkable fiscal restraint. Whilst the pressures on fiscal balance remain evident, the FG via DMO has not reacted as usual, with the net repayment in H1 15 especially in stark contrast with our expectations for a ramp up in borrowing. In addition, we had earlier acknowledged the potential positive from foreign currency borrowing and it looks like that angle is gaining traction by the day. Perhaps the confidence from this is also feeding into the fiscal restraint (though a focus on recovering looted funds and plugging fiscal leakages appear to be the primary driver). Furthermore, to help meet urgent needs the FG and states recently shared a
N400 billion NLNG proceeds and aim to source an additional N300 billion from the CBN representing alternative and unexpected funding sources.
We find this latter point in particular significant, since our yield outlook and strategy was significantly influenced not just by the fact of deficit, which remains in place, but crucially the apparent lack of options, beyond paper supply, to finance it. On the states’ front, while restraint has not been as noticeable as the FG’s, they have simply curtailed expenditure and refused to pay salaries. Notwithstanding, they have also benefited from the fund distributions and that could be enough to keep things ticking over. As such, the overall restraint is a clear departure from the hands-tied situation we expected the FG (and states) to be in and thus represents a fundamental change in how we view the FI environment.
Hence, while investor concerns appear to have shifted to the perceived lack of government direction, with the new government taking its time to make definitive pronouncement, in our view, this new flavour of domestic concern is not nearly as bad as the combination of politics and insurgency. For us, with the latter seemingly under greater control than at any time in recent history and the former unlikely to play as strong a role for another four years, it would appear that markets could recover very quickly from the current malaise.
Interestingly, even our acceptance that global risks remain intact does not hold as dire implication for yields. Indeed, the speed with which FPI inflows resumed post March suggested that foreign investors felt those levels sufficiently compensated for all the existing risks and it’s somewhat unsurprising that those Q1 peaks have not been tested since. Hence, while the weak oil revenue outlook suggests there might be some opportunities to lock in higher yield (than Q2 levels) in Q3 15, the expected release of ministerial list in September could be the trigger that delivers another round of moderation. Either because markets would have what they want after reacting so badly to delayed government pronouncements, or because government efforts focused on plugging leakages should have shown signs of bearing fruit by then, if they ever will, there seems to be scope for downside in Q4.
In that regard, the flexibility focused strategy we started the year with remains very much on the money with our recommendation for duration building around the election time likely to have paid out handsomely with subsequent Q2 15 declines. Similarly, the technicals raising some possibility of a modest yield rise in Q3 and the subsequent expectation of declines in Q4 favour a similar strategy. However, given the overall current dynamic, we recommend investors forget about expecting Q1 15’s yield levels to re-appear. In this respect, the key thing is the apparent total shift in the government’s fiscal mindset evidenced by the complete and unyielding refusal to borrow.
Indeed, it would seem foolhardy to bet against a government that was elected principally on the will to make a change. The ultimate implication if this new dynamic becomes entrenched is that H2 15 levels on average could yet mark the final chapter of still elevated yields as newfound fiscal prudence and leakage plugging deliver a new normal of possibly 200-300bps lower rates than recent history. Investors would do well to act accordingly.
A case for balancing risk and reward
The influence of political risk was also evident in the equity market in H1 15. Perhaps more so, and somewhat unsurprisingly, as domestic investors felt even less comfortable than with FI and foreign investors largely stayed out except for the April surge which was in response to the depths markets plumbed in Q1 15. In some ways, the extent of bearishness also reflects the fact that, political risk aside, the key effect of the weak global environment, ravages of oil and domestic challenges (infrastructure and market), manifested decisively in form of earnings compression. Indeed, unlike the manner in which the FG-dominated FI market found a way to circumvent the worst effect of the funding pressures that we expected to drive oversupply, corporate earnings found no such magic parachutes. If anything, the ‘success’ of the FG which was based on both securing alternative funding (for basic expenditure) and flatly refusing to actually spend on nearly anything else broadened the scope of pressure on the corporate space.
Hence, while banks and consumer goods had been the focus of our negative earnings expectation, the lack of government activity meant industrials also succumbed. The curbs on flow of government funding (affecting mostly capital projects but also salaries), and likely aided by individuals’ adjustment of their own spending in the realization of the challenges, manifested in weaker aggregate demand and compounded the issues facing the consumer companies. For instance, FMCGs practically buckled under the weight of multi-faceted earning pressures as higher route-to-market and operational costs also impacted.
Similarly, currency devaluation and higher input costs dampened the performance of traders. For their part, banks had to grapple with regulation that not only took away the cheap pool of government funds but imposed even higher costs on more competitively sourced deposits. Even petroleum marketers that we felt could be in a sweet spot failed to live up to billing as government inactivity and uncertainty over subsidy, in particular, limited their capacity to do business. In many ways, the particularly dour outcomes affirm our view that combining the political risk with the weakness induced from macro-picture “sets new hurdles for the scale of headwinds facing equities” In all these (and with the weakness so far helping gauge the extent of what is to come), we again revisit the issue of to what extent equity prices compensate for the risks in the market.
Whilst our conclusion at end 2014 was that despite relative attractiveness of the equity market (as whole compared to historical levels), second order risks remain un-priced, for one particular sector the additional declines now suggest that situation may have reversed. Over H1 15, PE multiples on cyclical-banks, according to our stock classification, compressed a further 15%.
This is in stark contrast to flat multiples in cyclical-industrials (cement & construction) and massive expansions of 37% and 51% in defensives (consumer goods) and petroleum marketers respectively. Overlaying this with price patterns indicates that earnings actually held up relatively better for banks, whereas the PE multiple expansion for consumers, despite similar price pressures as banks, underscores the scale of earnings compression in that space. Petroleum marketers embodied this latter dynamic even more completely as one-off earnings boost from 2014 dropped off even as price pressures were somewhat less pronounced. Industrials however held the middle ground as price pressures largely kept pace with earnings declines with no major shift in either. Maintaining our efforts to understand the market’s pricing in the context of risks (and using the extent of current weakness as a gauge of what is to come), the adverse pricing impact on banks appears to reflect a view that somewhat tamer earnings pressures is a consequence of asset quality issues being masked by restructurings, after revised provisioning guidelines.
Whilst we fail to understand the need for punishment for being extended a lifeline, the key point is that even factoring in aggressive provisions under our stress test scenarios fails to dislodge the simple fact of the much more attractive fundamentals of banks relative to the other sectors. At current PE levels of 6x for banks and 39.8x for consumers, we estimate banks can still take a 40% YoY hit to earnings by year-end (average H1 15 PAT performance: -12%) and still remain, not only best priced sector on the NSEASI but also relative to banking sector multiples of most other major EM/FM economies whereas, even sustaining no further earnings damage, the defensives are more expensive than peers from the same climes.
Evidently, on risk-reward balance, we strongly favour banks in the current environment and are neutral to slightly negative on the cyclical-industrials whereas we continue to expect a long-term re-pricing of the value proposition of most consumer names. Whilst our bearish view on oil, and the fact it perhaps remains the single most important factor, means there remains a major risk overhang over the NSEASI, and the banks in particular, we see long-term value at current prices either for long-term or trading positions.
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