March 19, 2020 /03:33 PM / by United Capital Research / Header
Image Credit: CDC, EcoGraphics
2020 started off on a fresh note, as investors received a huge relief, from clarity regarding the prolonged BREXIT proceedings and a trade deal between the U.S. and China. As a result, major global financial markets soared, buoyed by a rather optimistic outlook for the year. Against the run of play, the outbreak of the coronavirus, recently named COVID-19, is clearly a Black swan. COVID-19 broke out in Wuhan City, Hubei Province, in China, with its first reported case in Q4-2019. So far, according to Worldometer, the virus has spread to over 162 countries, with countries in Asia and Europe being the most infected. The number of confirmed cases has surged to over 220,000 as at 19th March 2020, with over 9,000 deaths. Notably, 85,700 recoveries have also been recorded. However, due to the rapid spread, the World Health Organization (WHO) has declared a global health emergency.
While 2020 was expected to be a year of global growth rebound, driven by recoveries in emerging markets, as predicted by the IMF and OECD, today, the outlook for the global economy hangs on a balance due to the coronavirus pandemic. Under its best-case scenario, the OECD revised 2020 world growth to be 2.4% in 2020, down from a November projection of 2.9%. Also, the IMF has indicated plans to downgrade its growth forecast across world economies.
Navigating through the Black Swan event: How are financial markets reacting?
The impact of coronavirus across the world has been resounding and has affected world economies significantly. Following the outbreak of COVID-19, which has been aggravated by the fallout of the OPEC+ alliance, global stock markets have tanked. However, splitting global stocks into diverse sectors, the negative impacts were unequal across board. Using the S&P 500 sector classification as a proxy, the best performer YTD (as at 18th March, 2020), was the Consumer staples sector (-11.6%), as consumers are stock piling essential amenities. The Utilities sector (-17.0%) followed suit, due to that fact that consumers are spending more time indoors, increasing the demand for water and electricity. Notable to mention, among the less impacted sectors, was Healthcare (-19.3%), due to the expectation of increased profitability, through the need for governments to ramp up health care expenditure, and the race to develop vaccines to tackle the virus.
On the flip side, a huge blow was dealt to the Oil &Gas services (-67.9%) and Energy (-58.6%) sectors, given lower profit expectations, from the drastic decline seen in crude oil prices and lower demand. Also, Financial (-37.9%) and Industrial (-35.9%) companies have declined on the back of a significant drop in economic activities.
Elsewhere, with global stocks declining, investors ran into safe assets. As such, global yields declined dramatically, while year to date return on gold prices peaked as high as 9.4% in early March. However, with the enormous volatility observed in financial markets, following the large spike in the number of confirmed cases in developed markets, and the lack of monetary policy stimulus fuelling positivity, the risk-off sentiment has spread towards gold, bonds and other safe assets. Clearly, investors are seeking to hold cash or very near-cash instruments, to adjust with the imminent economic disruption sparked by the COVID-19 pandemic.
Global monetary policy response
In response to COVID-19, the G7 financial officers pledged to use all appropriate policy tools to ensure that the impact of the coronavirus on the economy was well managed. Notably, the US Fed led the way as it delivered a surprise rate cut of 50bps after an emergency meeting and a subsequent 100bps cut which settled rates at 0-0.25% band. Similarly, the Bank of England also trimmed policy rate by 50bps to 0.25% â€“ its first rate cut since Jul-2016. However, with policy rates already in the negative region, the European Central Bank (ECB) took a more cautious approach as it decided not cut policy rates further while expanding its asset purchase program by â‚¬120bn.
In Asia, the People's Bank of China led the easing bandwagon, cutting 1-year and 5-year lending rates from 4.15% and 4.80% to 4.05% and 4.75%. Also, the Central Bank of Malaysia delivered a 25bps rate cut which sent the policy rate to its 10-year low. Meanwhile, countries like Japan and India have rolled out asset-purchase programs in a bid to stimulate economic activities. Elsewhere, the Reserves Bank of Australia delivered a 25bps rate cut and signalled its preparedness to cut rates further if need be.
What these actions mean, is that the impact of the coronavirus is significant and is threatening growth of economies around the world. The shut down in activities has caused a cash crunch for companies and central banks are supplying cash through expansionary monetary policy actions. However, the general effectiveness of monetary policy tool in solving problems caused by a global healthcare pandemic comes under question.
Global fiscal policy response
To support the monetary policy actions and keep the economy running, governments authorities are using fiscal measures to curb the spread of the virus by providing health care services to the affected. Worthy of note, the Chinese and Korean government made provision for fiscal support through tax-exemptions for industries affected by the outbreak. Similarly, France announced suspension of payment of taxes, rent, water, gas, and electricity bills for companies during coronavirus outbreak.
In U.S, an emergency fund worth $8.3bn was approved by the legislature and assented by the President in a bid to combat the spread of the virus. Also, England made a provision of Â£30bn to cushion the effect of coronavirus on its economy. Relatedly, the IMF set aside c. $50.0bn, out of which $10.0bn is available at zero-interest to low-income and emerging economies, for combating the outbreak.
Restrictions, bans, quarantine and economic shutdown
To curb the contagion, schools, offices, religious centers and factories have had to shut down across the world. Apart from voluntary measures taken by individuals and organizations to cut down travelling, countries have also ordered travel ban on travelers from different countries of the world and airlines have also stopped flying to certain countries. Accordingly, more than 80 countries, including the U.S. Germany, S/Arabia, Kenya, and Ghana, now have a form of travel ban, restriction or flight suspension in place, as measure to curb the spread of the virus.
The caveat is the impact of these restrictions on productive activities and economies of the affected region. For instance, factories across China have not been in operation due to the virus outbreak. The case in Italy seems to be more intense than other countries as schools and all shops except grocery stores and pharmacies are ordered closed. Recreation is not left out of the pandemic as concerts, theater shows, cinemas, sporting events have had to cancel. An example is the suspension of the NBA season, because a player tested positive to the virus. Premier league matches will also be played behind closed doors without the presence of the usually energetic fan base. The loss of revenue from ticket sales, merchandise, elimination of excitement will cripple the sporting industry significantly. However, it boosts revenue for cable television and providers of online streaming service as more people will have to rely on electronic means on entertainment. The activities that have been impacted by the outbreak of coronavirus cannot be counted and the economic impact keeps widening. People have had to make lifestyle adjustments. However, lifestyle adjustments are limited, and a cure needs to be found before the situation spirals into a case of global recession and then depression significantly.
Getting hit from two sides
For the most of 2019, oil prices reacted to developments surrounding the U.S.-China trade war and Middle East tensions. However, developments surrounding COVID-19 as well as OPEC+'s response are determining the current trajectory of oil prices. From a peak of $68.9/b in Jan-2020, oil prices have crashed to $25.5/b, its lowest point since the drastic supply glut in 2016. No doubt, the drop in prices is extremely worrisome. Hence, we note that the oil market is being pressured on both sides of the market - lower expected demand and a potential flooding of supply.
Analysing the effects of lower oil demand, the spotlight is focused on China, which constitutes about 13.1% of total world oil demand. With the Asian economy being the hotspot for the COVID-19 virus, a number of cities are on lockdown, with citizens ordered to stay indoors. As a result, indicators of economic and manufacturing activities flashed worrisome signs â€“ with Feb-2020 Purchasing Managers Index in the contraction region at 40.3pts. Also, Europe, the second most infected continent, is struggling to contain the epidemic, with Italy being placed on total lockdown. In addition, following the increasing risks to global health, world economies are imposing travel restrictions. These actions have had substantial impacts on global production chains, travel and aviation industries as well as manufacturing activities, driving the demand for oil lower. In line with the above, the International Energy Agency (IEA), expects world oil demand to fall by 0.09 mb/d for the first time since 2009, while the OPEC revised its forecast for oil demand growth lower by 0.23mb/d in Feb-2020.
With oil demand heavily impaired, all eyes turned towards the OPEC+, to be the saving grace to the dwindling trend of oil prices. However, the 4-year alliance between members of the OPEC and non- OPEC, with Russia at the center, disintegrated, following Russia's rejection of an additional 1.5mb/d production cut. This was expected, given the fact that the OPEC+'s decision to support prices gave U.S. shale producers a helping hand to ramp up production, at the detriment of Russia's market share. Also, the group failed to extend the current production cut agreement, which is slated to end by March. As such, according to Russia's Energy Minister, Alexander Novak, come April-2020, OPEC members are free to pump at will.
Clearly displeased by the outcome of the OPEC+ meeting, Saudi Arabia, OPEC's de-facto leader, announced its intention to increase supply in April. Through the state-run oil giant, Saudi Aramco, production output is expected to significantly increase above 12mb/d or higher, substantially above its current level of production (9.73mb/d). In addition, the country is reducing its April Official Selling Price (OSP) by offering discounts between $3.0/b to 10.5/b to refineries in Asia, Northwest Europe and U.S. To further aggravate the current situation, the United Arab Emirates announced its intention to join Saudi Arabia in raising oil output, to above 4.0mb/d, from 3.03mb/d currently. This effectively launched the world into an oil price war, with Saudi Arabia, Russia and U.S. shale producers at the center. As a result, oil prices recorded its biggest daily crash since 1991, as Brent oil price fell 24.1% to $34.36/b.
Oil Price outlook: A sea of unpredictable actions
As 2020 continues to unravel, the future trajectory of Brent crude oil price is hinged on multiple outcomes involving the outbreak of the Coronavirus on the demand side and the OPEC+'s ruptured relationship on the supply side.
On the demand side, uncertainty remains as to how fast the virus is spreading across other economies outside China and the continuation of travel restrictions and city lockdowns. Also, the possibility of a near-term cure remains bleak, with several medical agencies estimating between 12 to 18 months for a substantial breakthrough. Accordingly, the timeline for the global economy to overcome the virus remains unclear, perhaps another 6 to 8 months. According to an exclusive note credited to Goldman Sachs Investee call, the virus is speculated to be seasonal, with concentration in the northern hemisphere of the earth between 30-50 degrees north latitude. Basically, this postulation is that COVID-19 prefers cold weather, hence, summer season majority of the countries in northern hemisphere should help slow the outbreak. Providing further analysis, with the virus majorly affecting activities in China, Europe, America and other Asian economies â€“ which collectively account for over 50.0% of world oil demand, prices might remain low for a while. Analyzing estimates, China's oil demand has taken a hit of about 20% - 30% in February, equivalent to a drop of about 3mb/d. With other world economies coming under intense pressure, oil balance for 2020 could be distorted by a demand shortage of almost 1mb/d to 2mb/d. Overall, the incidence of the corona virus outbreak, with no clear trajectory as to when peak cases will be recorded or start slowing, is likely to drag demand for oil in the next 6-8 months.
On the supply side, the most interesting outcome to watch is the price war between major contenders â€“ Russia, Saudi Arabia and other non-OPEC producers. While the major players make moves to increase market share at the expense of prices, a lot remains at stake. Notably, Russia requires oil prices to be around $40.0/b to $42.0/b, for its budget to balance. The Russian ruble is also under serious pressure, having depreciated by 15.4% and 16.6% YTD against the dollar and euro respectively. On the other side of the table, the IMF estimates a $80.0/b oil price is needed for Saudi Arabia to balance its budget. Also, the lower prices are unfavourable for the valuation of Saudi Aramco, the country's most prized possession. Despite this, we could see the oil price war extend further, on the back of substantial external buffers that Russia (foreign reserves: $570.0bn) and Saudi Arabia (foreign reserves: $490.5bn) have to weather the storm. Also, in terms of future profitability, judging by the diagram below, Saudi Arabia and Russia's relatively lower cost of borrowing, which is also below the current price level, means that the oil price war could go longer than expected, being a battle for who can blink first and scale down production.
On a balance of the above dynamics of supply and demand, crude oil prices are expected be relatively lower for the rest of 2020. Notably, with the currently imposed OPEC+ production cuts expiring at the end of March-2020, we expect a clearer direction, as to how oil supply will adjust going forward. However, the outlook for oil prices is hinged mainly on the demand factor, as the spread of the COVID-19 could keep world economies under lock and key, even though the largest oil producers are able to reach an agreement to support prices.
The Domestic Economy
Output level: low reported cases, high economic infection
Although Nigeria as a country stand tall among the countries with the least number of reported cases, one thing is clear from where we stand today, the outbreak of COVID-19 has a negative economic impact and the earlier the virus is contained globally, or a cure is found, the better for world economy, Nigeria Inclusive. This implies that domestic economic growth in Q1 and Q2 2020 may come in weaker than expected, hence, impairing on our 2.3% growth earlier forecasted for the year. With concerted effort by global health and other multi-lateral agencies, we expect economic to rebound from H2-2020. Overall, economic momentum is likely to relapse compared to the prior year.
External Account: A relapse in sight?
Recently, the National Bureau of Statistics published Nigeria's foreign trade report for Q4-2019, indicating the country recorded its first quarterly trade deficit since Q3-2016 (recession period) during the period. Also, according to the CBN's economic report for Nov-2019, Nigeria's current account slipped into a deficit position - first since 2015, on account of oil price shocks, foreign exchange (FX) constraints, and a high degree of import dependency. Notably, the above highlighted factors do not look like improving in 2020, rather the outbreak of COVID-19 is expected to worsen the situation.
First, the pandemic has to a large extent constrained economic activity in Nigeria's two biggest export destinations - Europe (39.7% of total export in 2019) and Asia (28.2% of total export in 2019) which might cascade into lower demand for Nigeria's export. Also, the Coronavirus outbreak coupled with OPEC+'s failure to reach an agreement on additional supply cut, continues to leave a negative imprint on the price of Nigeria's key export resource, crude-oil, which accounts for c. 80.0% of the country's export earnings. Accordingly, if the current realities persist for longer, we believe Nigeria's export revenue will significantly weaken in 2020.
Secondly, c. 50.0% of Nigeria's imports (a major driver of FX demand) is sourced from Asia (mainly China: 25.5% and India: 12.0%) and with COVID-19 threatening production activities in the region, Nigerian traders might be forced to cut imports or turn to the more expensive alternative source in America and Europe. Thus, we expect import levels to moderate marginally in 2020 (less than the expected declines in export) even as the CBN continues to discourage import by restricting FX availability.
Looking at the other component of the current account, we expect a mild moderation in Net Services deficit as businesses cut travel into and out of Nigeria. Meanwhile, net income deficit is expected to widen as foreign investors embark on a massive capital repatriation - a flight to safety. Finally, net transfers surplus is expected to weaken as citizen's abroad cut down the value of money sent back home in a bid to meet their needs abroad.
Foreign Exchange and Reserves: On a knife edge
At the end of 2019 and in the early part 2020, media reports showed that the CBN Governor had told investors in London that the apex bank would only consider a review of its exchange rate management mechanism if the Nigeria's FX reserves were to fall below $30bn. Also, the governor was quoted to have said that "for as long as oil prices remain in the $50-60/b range, there will be no reason to consider a devaluation."
However, fast track to the time of writing this report, Brent price ($25.5/b) is now trading way below the CBN's lower band of $50/b. Also, gross FX reserves now stands at a worrisome level of $36.0bn (vs. CBN's devaluation trigger level of $30.0bn). Accordingly, this has raised the panic level in the market with foreign investors exiting their exposure to naira assets and local players taking speculative position on the naira.
According to data from FMDQ, CBN's intervention at the Investors and Exporters window rose from $0.4bn in Jan-2020 to $2.1bn in Feb-2020 (the highest since the window was created in Apr-2017). Thus, using the Feb-2020 intervention run rate, an exchange rate of N365/$ to convert CBN's outstanding OMO liabilities and assuming no improvement in the macroeconomic environment through Q2-2020, we expect Nigeria's FX reserves to touch the sacred $30.0bn level not later than the early period of Aug-2020 (under 6-months from the date of this report). This is as large-size OMO maturity is expected to resume from Sept-2020.
Accordingly, we believe the chance for a devaluation by H2-2020 is now heightened, with a 50.0%- 60.0% probability if COVID-19 situation does not improve till the early part of Q3-2020 and 60%-70% if OPEC+ members fail to extend supply cut in April-2020. However, a return to the international debt market might erode the chance of a devaluation in 2020 (Our best-case scenario). Give or take, we expect panic purchases and market speculation to keep the local unit pressured for the rest of the year, hence, we expect sustained depreciation of the naira averaging around N370/$ ahead of an imminent adjustment by the CBN.
Fiscal Policy: Wider fiscal deficit; an opportunity to fully deregulate the petroleum sector
On the fiscal side, the Presidency through the Minister of Finance, Zainab Ahmed had provided guidance on the government's plan to review the 2020 budget in tune with the current realities. Clearly, Nigeria's actual oil revenue for 2020 is expected to underperform the budget, as crude oil price continues to trade below the budget benchmark of $57.0/b ($25.5/b - as at the time of writing). Notably, as a response to the new reality, we believe there is so little the FG can do to ramp-up non-oil revenue to cover for the expected shortfall in oil-revenue.
Thus, only two options seem available to the FG in case the current reality persists, which is to drastically cut spending or borrow, to fill the expected gaps or a blend of the two options. However, with c. 70.0% of the budgeted expenditure being recurrent, reduction in government spending is unlikely, hence we expect the FGN to expand its borrowing. Notably, with global risk levels and foreign investors apathy for Emerging/Frontier market asset now high, we believe a return to the international debt capital market might be an expensive option for Nigeria compared to local borrowings.
The only good news for Nigeria in all of these is that government would spend less on petrol subsidy (under-recovery) or even profit (over-recovery) from the current pump price. According to the latest Petroleum Products Pricing Regulatory Agency's (PPPRA) template, open market price (inclusive of distribution margin) of Petrol has dropped to N83.69/liter, lower than the N145.0/liter regulated price. Thus, this provides an opportunity for the government to fully deregulate petroleum sector without the attendant impact of a price hike.
As at the time of going to press, the FG announced a partial deregulation of the downstream sector as it ordered a monthly adjustment of the pump price of petrol in line with the PPPRA template. Accordingly, the NNPC have cut the pump price of petrol from the former regulated price of N145/litre to N125/litre. Also, media report showed that the FG has revised its 2020 budget estimates that will cut the planned spending by as much as N1.5tn and widen budget deficit to over N3.0tn vs N2.18tn in the initial budget. Notably, the benchmark for crude oil price was revised downward from $57.0/b to $30.0/b while production benchmark was maintained at 2.18mbpd. Other revisions include 20.0% reduction in capital budget and 25% cut in recurrent expenditure across MDAs; reduction of projected revenue from excise duty; reduction of projected revenue from privatization by 50%; a stall in new recruitment across MDAs except for essential services like security.
Monetary Policy: To the rescue?
Usually in times like this, when there is growing fears of contraction, the Apex bank will attempt to stimulate demand by cutting interest rates and, in other ways (conventional and un-conventional), make credit more available. Thus, the CBN has decided to take the expansionary monetary policy path, to counter-balance the negative effect of the FG's contractionary fiscal policy stance. Notably, as a policy response to the Coronavirus outbreak, the CBN unveiled six measures to manage the impact of COVID-19 on Nigeria's economy. The measures include;
1. Extension of moratorium on loans
2. Interest rate reduction
3. Creation of a N50 billion fund
4. Credit support for healthcare sector
5. Regulatory forbearance
6. Strengthening of the loan-to-deposit rate policy.
Also, after the roll out of the six policy measures, the CBN announced a further N1.0tn intervention fund to support critical sectors of the economy, especially as more cases of COVID-19 were recorded within the country.
In our view, the policy response of the CBN is laudable but most likely ineffective as the elephant in the room (FX) remained unaddressed. However, given that the current reality has escalated the risk of capital reversal by foreign portfolio investors, the CBN is likely to sustain its recent scheme of un-conventional policy measure to curb capital outflow by unilaterally hiking OMO rates to further compensate FPIs for the added risk in the environment and quell a run-on the naira. However, in the case where foreign investors fail to take the bait, the apex bank might have to turn to the domestic players and gradually step-back on some of its recent pro-growth policies as naira defense gains the upper hand.
Equity Market Strategy: Poised for a swift rebound in the event of a breakthrough
Though no fatal case of COVID-19 has been recorded in Nigeria, the equities market has not been spared from the wrenches of the growing panic. The performance of the equities market has deteriorated, down -15.41 YTD, with the NSE-ASI touching a 4-year low of 22,789.6 points. Notably, foreign as well as local investors ignored the attractive dividend yield some stocks offered and traded against stock-specific fundamentals, as fears of an imminent naira devaluation (key foreign investors' concern) and contraction of economic activities (key local investors' concern), among others, amplified risk-off sentiment.
Analyzing the current realities
Analyzing the current realities around the virus outbreak, we note that putting a timeline to how long this will last is difficult, given how much is still unknown about the spread of the virus and the lack of a historical precedent. However, given the fact that the current bearish trend is largely event-driven (COVID-19 outbreak), we believe the equity market will be poised for a swift rebound once the impact of the event dissipates. Thus, we advise investors to cautiously take advantage of the dip to average down cost, especially in the fundamentally sound stocks.
Fixed Income Market Strategy: Investors to cut duration exposure for clarity
As we have noted in the fiscal policy section of this report, the current realities if sustained into Q3-2020, will widen government's fiscal deficit, prompting the need to borrow, especially at the domestic market. However, the pressure to meet recurrent expenditures might weaken the FG's bargaining power at the primary market and give local investors the higher bargaining power to drive interest rates northwards.
Notably, domestic sovereign yields are likely to continue to track higher in near term spurred by local and foreign investors apathy for naira assets (and FGN Eurobonds) as the risk of a devaluation heightens and pressure on oil prices mounts. Also, if the current realities do persist or worsen, we expect the shape of the yield curve to bear-steepen (a situation where longer-term yields rises faster than shorter term yields), as fiscal as well as external pressures mounts on all sides and local investors continue to dump exposures to naira assets amid the fear of naira devaluation. Overall, given the uncertainty around how the long the outbreak will last, we advise investors to cut duration exposure and position on the short end of the yield curve in anticipation of a further clarity on the direction of interest rate.
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