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Thursday,
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% – 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 €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 £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.
Oil Prices
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 – 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 – 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 – 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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