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Nigeria Strategy Report H1 2017 (17) - Blessed are the Flexible

Proshare

Thursday, February 02, 2017 5.56AM / ARM Research

Over the past few weeks, we have featured daily excerpts from our core strategy document – The Nigeria Strategy Report – detailing our understanding of key happenings in global and domestic financial markets in H2 2016 and providing our outlook on major investment themes for H1 2017. Today, we conclude the series of excerpts by presenting our capital market strategy for H1 2017.  

In many respects 2016 marked a watershed for Nigerian fixed income markets as sell-offs along the naira curve brought an end to secular bull-run which began after JP Morgan’s inclusion in H2 2012. Beneath the policy induced up-thrust in yields over 2016, the year heralded the return of domestic investors’ pricing power to the reins of local debt markets for the first time since H2 2012 as foreign investors emigrated post JP Morgan’s ejection of Nigeria from its EMBI indices in 2015.

In framing our strategy, the persisting FX market illiquidity picture, a pattern we see remaining intact over H1 17, should continue to rule out Nigeria’s return to global EM bond indices and by extension foreign activity, leaving domestic pricing power in debt markets intact over 2017. Under this scenario, market sentiment should remain driven by a search for yield resulting in the higher short end rates serving as a hurdle rate in discounting longer dated instruments. Going into the last year before politicking commences for the 2019 elections, we see less reluctance by the fiscal side to issue paper at prevailing yields in pursuit of its economic reflationary objectives. Given this backdrop and recent noise regarding CBN deficit financing, we see FGN reverting to statutory mandated limits over 2017. Tying the foregoing with local investor apathy for duration in favour of higher short end yields, we see enough drivers for yield elevation to persist in H1 17.

Despite the rally in crude oil prices over 2016, which ought to have boosted sentiments for naira equities in line with historical trends, persisting foreign apathy combined with concerns over earnings performance to drive negative NSEASI performance over H2 16. Thus, in setting out our strategy for H1 17, it is worth reiterating our view regarding how local and foreign investors interpret equity investing.  Starting off with the foreign class, whilst we think the current peg is rationally sustainable in view of recent improvements in FX reserves which could lull the CBN to retain its stance and posit NGN downside, it is worth emphasizing that FPI apathy towards NSEASI is less about the FX spot closing rates but more reflective of potential impact of other anti-market measures which could further inhibit ease of entry and exit.

Furthermore, shrinking equity market liquidity (in NGN and USD terms) and dour GDP growth picture stand as bulwarks to FPI participation in the domestic bourse. To add, the hike in US interest rates in December 2016 and guidance towards further rate hikes in 2017 has bloated the opportunity cost of investing outside the US economy. Furthermore, the political surprises in 2016 (Brexit and Trump’s victory) increases risk sensitivity across markets and could underpin further safe haven hunt. Tying it all together, it appears obvious that foreign reticence to naira equities should persist over 2017. For domestic investors, our thesis for dovish monetary policy over Q2 17 could provoke a flight to equities for currently yield-chasing investors.

Capital Market Strategy
In many respects 2016 marked a watershed for Nigerian fixed income markets as sell-offs along the naira curve brought an end to secular bull-run which began after JP Morgan’s inclusion in H2 2012. Beneath the policy induced up-thrust in yields over 2016, the year heralded the return of domestic investors’ pricing power to the reins of local debt markets for the first time since H2 2012 as foreign investors emigrated post JP Morgan’s ejection of Nigeria from its EMBI indices in 2015. Though a dovish monetary policy thrust in Q4 15 helped moderate impact of the FPI exodus on yields, subsequent replacement by local investors shifted emphasis to higher yields as is customary of this investor class.

The foregoing does not in any way attempt to belittle the impact of policy which no doubt played a strong hand in yield upswing led by the CBN which after ignoring three years of benign inflation readings latched onto the cost-push driven spiral as cover for fresh tightening. As we have long noted, the CBN which has been on a tightening cycle since 2011, bar short-lived easing in Q4 15, merely used the inflation reading as a convenient alibi to embark on fresh liquidity sapping measures to remove ammunition for currency speculation. The hawkish intervention across debt markets which resonated more strongly at the short end fuelled sentiments among yield-hungry local investors and inadvertently led to yield up-thrust in 2016.

Playing a secondary role was the fiscal side, whose poor timing—electing to delay borrowing till CBN commenced tightening—provided fresh excuse for bearish market twists, particularly for bonds, after the liquidity deluge from the maturing FGN 2016 bond wore off in Q4 16. Even more important was the fiscal’s failure to execute its offshore borrowing plan and subsequently abandoning implementation of the 2016 budget. That said, we think poor timing likely reflected the optionality of above limit back-channel deficit funding from the apex bank.

Tying it all together, whilst policy played a key role in driving yields higher, the switch in investor profile played a non-trivial role in the debt market sell-off. Though the switch in debt market reins went relatively unnoticed following the upsurge in inflation and higher fiscal paper issuance in H1 16, we think the development is important in charting FI market outlook in 2017.

In framing our strategy, the persisting FX market illiquidity picture, a pattern we see remaining intact over H1 17, should continue to rule out Nigeria’s return to global EM bond indices and by extension foreign activity, leaving domestic pricing power in debt markets intact over 2017. Under this scenario, market sentiment should remain driven by a search for yield resulting in the higher short end rates serving as a hurdle rate in discounting longer dated instruments. Going into the last year before politicking commences for the 2019 elections, we see less reluctance by the fiscal side to issue paper at prevailing yields in pursuit of its economic reflationary objectives. Given this backdrop and recent noise regarding CBN deficit financing, we see FGN reverting to statutory mandated limits over 2017. Tying the foregoing with local investor apathy for duration in favour of higher short end yields, we see enough drivers for yield elevation to persist in H1 17. Nonetheless, a subdued inflation trajectory, which we estimate should commence from the February reading should deprive the apex bank of an excuse to tighten. Whilst this does not guarantee dovish monetary policy the foreclosure of the CBN deficit monetization limit which restricts government to high borrowing cost at the domestic debt market should trigger a forceful fiscal rhetoric on the need for policy coordination. Combined with a sizable redemption profile in Q2 17, we see some legroom for yield compression in Q2 17. Farther out, our view about NGN depreciation suggests that the apex bank could return to liquidity curbing tactics over H2 17 to ward off speculative attacks on the NGN.

Having framed our outlook, we see merits in positioning bond portfolios to be agile in H1 17 with a short duration strategy over Q1 17 capturing higher yields at the short end of the curve while avoiding the bearish twists to bond yields. In the event that our call about limited prospects for larger shocks to key prices in the economy, at least relative to 2016, play out in February, investors should adopt a staggered approach to building duration with emphasis on mid-tenored bonds on the downward slope of the naira curve in a bid to ‘run-down the curve’ as dovish influences kick into gear over Q2 17. Farther out, as the liquidity influence wane and currency pressures become self-evident, we advise a rotation back into money markets to wait out the FX market storm. Overall, our strategy calls for investors to position bond portfolios with an eye on flexibility ahead of what promises to be a roller-coaster half year for debt markets.

Riding on the swings of market volatility
Despite the rally in crude oil prices over 2016, which ought to have boosted sentiments for naira equities in line with historical trends, persisting foreign apathy combined with concerns over earnings performance to drive negative NSEASI performance over H2 16.

Thus, in setting out our strategy for H1 17, it is worth reiterating our view regarding how local and foreign investors interpret equity investing. Starting off with the foreign class, whilst we think the current peg on the currency is rationally sustainable in view of recent improvements in FX reserves, it is worth emphasizing that FPI apathy towards NSEASI is less about the FX spot closing rates but more reflective of potential impact of other anti-market measures which could further inhibit ease of entry and exit. Furthermore, shrinking equity market liquidity (in NGN and USD terms) and dour GDP growth picture stand as bulwarks to FPI participation in the domestic bourse. To add, the hike in US interest rates in December 2016 and guidance towards further rate hikes in 2017 has bloated the opportunity cost of investing outside the US economy. In addition, the political surprises in 2016 (Brexit and Trump’s victory) increases risk sensitivity across markets and could underpin further safe haven hunt. Tying it all together, it appears obvious that foreign reticence to naira equities should persist over 2017. For domestic investors, our thesis for dovish monetary policy over Q2 17 could provoke a flight to equities for currently yield-chasing investors.

Scanning across the various sectors beginning with cement, where attractive valuations—average P.E of 13.2x compared to peer average of 17.1x—mark the sector as one to watch on account of several factors. First, less expensive energy mix, on account of recovery in gas supply, should feed-through to margin improvement in 2017 relative to 2016, Second, whilst volume growth should slow following price hikes in 2016, we think improved fiscal revenues, and by extension greater commitment to CAPEX, should combine with stronger sales from non-Nigerian operations in supporting topline. On other fronts, following its loan restructuring, Lafarge should recover from the FX-induced losses of 2016.

Still within the cyclical space, our expectation for a softer NGN depreciation (30% to N400/$ over 2017) relative to the 53% decline in 2016 translates to softer FX revaluation gains for Nigerian banks. Importantly, CBN actions which have resulted in reduction of naira card use for international transactions and impact of dollar illiquidity on trade finance constrain scope for non-interest income. For interest income, given high rates on government instruments and capital adequacy concerns across a slew of banks, loan growth should remain muted adjusted for FX and CBN on-lending schemes. Overlaying the foregoing with subsisting issues around power sector loans and general commerce, a slower earnings trajectory emerges for the sector over 2017. That said, currently depressed valuations, with most banks trading at significant discounts to book value (sector average: 0.4x), provides attractive entry levels.

Elsewhere in the cyclical universe, we see fresh headwinds to the Oil and Gas sector as the FGN grapples with implications of rising crude oil prices for domestic PMS price. Wary of likely populace resistance, we think the FGN would delay price adjustments—a move that has already kicked off in H2 2016 with a subsidy via the FX channel—which holds negative implications for margins of petroleum marketers given Nigeria’s history of delayed subsidy payments. Accordingly, we expect earnings to revert to pre-2016 levels on the back of volume and margin contraction.

On upstream, we note that though higher crude prices should drive positive sentiments for SEPLAT, persisting force majeure on its key export pipeline stokes prospect for a repeat of 2016’s depressed earnings profile in 2017.

For defensives, our views are not clear cut as high imported raw materials, negative real wage growth and lower pricing power, relative to basic food producers, combines with burdened valuations in leaving a bearish bias towards the sectors. For basic food producers, though FX remains a challenge, we are more constructive on outlook due to stronger pricing power, increased import substitution and favorable policy. In particular, palm oil producers should remain in the sweet spot of monetary and fiscal policy and given the fundamental demand-supply mismatch, as annual CPO production of 970,000 MT remains inadequate in the face of national consumption at 1.5million MT, we see more price upside over 2017 and expect stronger earnings performance.

Notwithstanding our broadly bearish outlook on the equities market, attractive dividend yields on FY 16 corporate result hinged on depressed valuation is expected to spur buy momentum in selected stocks with expectation of dividend payment, particularly the Tier 1 Banks and Downstream stocks. The expected dividend play should drive appetite for most part in Q1 17 in most of the selected names, though with a relatively shorter holding period for Naira equities by local investors vs foreign investors, market gains are likely to be short-lived.

Juxtaposing our expected dividend play with the positive view on selected stocks, we assume steady swings in these names for most part of H1 17 and thus recommend a flexible approach to comfortable stocks—buying the dips and selling the rally as against a “Buy and Hold” strategy. Investing in the market at the trough is imperative, and being flexible with tactical positioning can be beneficial.

We emphasize that times of higher market volatility, while often trying for individual investors, can be opportunities for skilled active managers. For us, we think after a strong counter trend move, as long as the longer-term outlook remains intact, looking for opportunities to “buy the dip” and “sell the rally” will be a solid investment strategy for choice names.

For most of these names, we are of the view that as these stocks continue to trend higher, macro events and investor’s short holding period for Naira equities will invariably necessitate pullbacks.

Over 2017, we believe the key risk to performance are unchanged from last year — they include US interest rate normalization, global economic uncertainty, continued dollar strength, domestic macro concerns, FX challenges, and a drag in fiscal push to uplift the economy. Investors will continue to be especially sensitive to the state of the economy, a devaluation of the naira and any policy missteps by the monetary and fiscal authorities. On balance, the outlook for naira equities is more nuanced—low foreign and local appetite for equities combine with weak fundamental picture across most sectors underpins our muted outlook for naira equities in H1 2017.

Related News from ARM’s H1 2017 Nigeria Strategy Report
1.       Nigeria Strategy Report H1 2017 (16) - NSEASI: On A Wing And A Prayer

2.      Nigeria Strategy Report H1 2017 (15) - Yields Set to Succumb to Gravity

3.      Nigeria Strategy Report H1 2017 (14) - Monetary Indicators Ride Currency Waves Higher

4.      Nigeria Strategy Report H1 2017 (13) - Base Effects Set High Hurdle For Inflation

5.      Nigeria Strategy Report H1 2017 (12) - Shaky NGN Outlook as CBN Resumes Playing Ostrich

6.      Nigeria Strategy Report H1 2017 (11) - Balance of Trade Deficit: Moderation In Sight?

7.      Nigeria Strategy Report H1 2017 (10) - Feeble Steps Out Of Recession

8.     Nigeria Strategy Report H1 2017 (9) - Pension Reforms Set Sights On Infrastructure Investing

9.      Nigeria Strategy Report H1 2017 (8) - FG Fiscal Expansion: Once Bitten, But Not Shy

10.  Nigeria Strategy Report H1 2017 (7) - Energy Sector Reforms: An Unbalanced Score Card

11.   Nigeria Strategy Report H1 2017 (6) - Back and Forth on a Political Tight-Rope

12.  Nigeria Strategy Report H1 2017 (5) - Broadly Bearish Twist For Soft Commodities

13.  Nigeria Strategy Report H1 2017 (4) - Crude Oil Prices On Verge Of A Breakout?

14.  Nigeria Strategy Report H1 2017 (3)-Tightening US Monetary Policy Stokes Prospect For Portfolio Flow

15.   Nigeria Strategy Report H1 2017 (2) - Commodity Price Shocks Dim Growth Lights Across Africa

16.  Nigeria Strategy Report H1 2017 (1) - Optimism on US GDP Buoys Global Growth Prospects

Related News on Budgets
1.       2017 Budget:President Buhari presents N7.298trl appropriation to NASS

2.      President Buhari's 2017 Budget Speech - Full Text

3.      Address by Bukola Saraki to the Joint Session of the NASS on The Presentation of the 2017 Draft Bill

4.      Remarks by Speaker Dogara at the Presentation of the 2017 Appropriation Bill

5.      Bukola Saraki's Remarks at Petroleum Industry Bill Public Hearing

6.      Nigeria Strategy Report H2 2016 - Brexit Dust Blurs Outlook for Portfolio Flows ... – Jul 30, 2016

7.      Nigeria Strategy Report Q2 2016 Outlook - Economic ... – Apr 21, 2106

8.     The Nigerian Capital Market Strategy H2 2015 – Aug 14, 2015

9.      Nigeria Strategy Report H1 2014 - ARM Research – Feb 24, 2014

10.  Nigeria Strategy Report H1, 2013 - ARM Research – Jan 28, 2013 


Related News from ARM’s H1 2016 Nigeria Strategy Report
1.     
Juggling moving parts while walking fiscal tightrope demands dexterity...  Feb 03, 2016
2.    
Sustained oil price weakness combines with policy opacity to stoke market downturn
3.    
Monetary strokes normalise yield curve - The case for a lower treasury yield curve
4.    
Monetary Policy: Rewriting the Past
5.    
Inflation rises from 8.2% in January to 9.6% in December 2015; Inflationary Pressure Likely in 2016
6.    
Another low payout from December 2015 revenues by FAAC
7.    
Renewed oil price descent swings trade balance deeper into deficit
8.    
Nigeria's GDP growth stuck in the slow lane
9.    
Petroleum sector reforms lead revamped drive for new policy direction
10. 
Fiscal Imbalance Persists on Soft Oil Price - fiscal deficit to be much higher than budget
11.  
New Government's Progress Threatened by Headwinds
12. 
Soft commodities resume bearish trend but has an inflection point been found?
13. 
FPI flows exit Emerging Market dance floor
14. 
Oil scrapes even lower down the barrel
15.  
Escalating challenges drive Africa's growth lower
16. 
Uneven global growth driving divergent policy agenda - 2016 Outlook  

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