Saturday, July 30, 2016 01.45 PM / ARM Research
We commence the publication of ARM securities’ core strategy document “Nigeria Strategy Report H2 2016” with excerpts of the review assessing the movement in FPI flows to emerging markets over H1 2016, and the outlook on the same for the rest of the year.
Review of Global Economy and Markets
Amidst concerns about slowing global growth, adverse investor reaction to risky assets on the heels of the 25bps hike in US interest rate in December 2015 and forward guidance about further interest rate hikes drove heightened FPI outflows from emerging markets (EM) in the first two months of 2016. However, following dovish comments from the US Federal Reserve regarding interest rate trajectory over 2016, expansion in ECB’s monetary easing and upswing in oil prices, FPI flows turned positive in March—ending nine consecutive months of negative flows. Nonetheless, reflecting outflows in the first two months of the year, IIF reports a contraction (-86.3% YoY to $11.5 billion) in portfolio flows over the first five months of 2016.
Over the second half of 2016, beyond the weak macro outlook, we believe two events are central in charting outlook for FPI flows. First, fallout from Brexit should herald new layer of uncertainty in both the UK and the EU with the European Council on Foreign Relations (ECFR) noting that a total of 34 referendum votes are being promoted by various political parties across Europe (including in France, Italy and Netherlands) to determine EU membership or other specific policy issues such as refugee relocation quotas. Thus, the higher prospect of copy-cat exits across the EU raises serious question about the future of the European bloc. The second key event on the horizon is the timing of the next US interest rate hike. On this front, we expect the turmoil across financial markets following the Brexit vote should temper hawkish sentiment in the FOMC. The rising uncertainty over the potential outcomes should heighten investor sensitivity to risk assets, driving increased demand for safe haven instruments with negative connotation for portfolio flows to EM markets.
On balance, rising uncertainty post Brexit, increased risk aversion as well as slowing global growth point to tempered FPI flows to EM over H2 16.
Perfect storm for risk aversion drives contraction in FPI flows to EM
Amid concerns about slowing global growth, adverse investor reaction to risky assets on the heels of the 25bps hike in US interest rate in December 2015 and forward guidance about further interest rate hikes drove heightened FPI outflows from emerging markets (EM) in the first two months of 2016. The capital outflows were on the heels of a plunge across global commodities in January1 which spurred a sell-off across global financial markets during the month. Furthermore, renewed concerns over EM growth prospects with manufacturing activity contracting for the 11th consecutive month in February 20162, led by China’s disappointing numbers, dampened FPI appetite for risk assets.
Consequently, portfolio outflows over January and February 2016 printed at the highest levels since the 2008 financial crises.
Nonetheless, following dovish comments from the US Federal Reserve regarding interest rate trajectory over 2016, expansion in ECB’s monetary easing (+20 billion euros to 80 billion euros) and upswing in oil prices (+19% MoM in March), FPI flows turned positive in March for the first time in nine months.
The sustained uptrend in commodity prices alongside largely accommodative monetary policies from advanced countries ensured a run of portfolio inflow to EM countries in the months of April and May 2016. Nonetheless, reflecting outflows in the first two months of the year, IIF reports a contraction (-86.3% YoY to $11.5 billion) in portfolio flows over the first five months of 2016.
Softening macroeconomic picture in EM drives FPI outflows
In EM Asia, the Yuan’s difficult start to the year (-1.8% over the first week of 2016), a reminiscence of August 2015 devaluation, together with China’s disappointing manufacturing activity stoked fears of a hard landing for the Chinese economy and curbed investors’ appetite. As a result, China witnessed its highest monthly portfolio outflow on record3 ($28.7 billion) while India ($1.5 billion) and Korea ($3.4 billion) witnessed similar repatriation of funds from their capital markets in January 2016.
Whilst the PBoC reduced reserve requirement ratio for banks by 50bps to 16.5% in a bid to stimulate economic growth and allay investors’ fears, portfolio flows only turned positive in March. The reversal of portfolio flow in March also reflected accommodative monetary policies from developed economies. Consequently Q1 16 net outflow of $15 billion from China is the highest quarterly outflow on record.
Similarly, South Korea witnessed portfolio outflows of $4.8 billion over the first five months of 2016 on the back of slowdown in economic growth (Q1 16: +0.4% QoQ: Q4 15: +0.7% QoQ) and rising tensions with North Korea. However, India and Indonesia bucked the trend in Asia with net capital inflows of $766 million and $4.5 billion respectively in the first five months of 2016 reflecting improved economic activities (India GDP: Q1 16: 7.9% YoY, Q4 15: 7.3% YoY) in the former and sustained reforms in the latter. The surge in portfolio flows to Indonesia reflects removal of restrictions on 100% foreign ownership in certain sectors. Over in Latin America, FPI appetite for the Brazilian debt waned, with net outflows of $9.5billion, following the deterioration in economic activity as GDP contracted for the eight consecutive quarter in Q1 16 and budget deficit widened over the period4. Nonetheless, as impeachment proceeding against President Dilma Rousseff progressed, Brazilian equities witnessed net foreign portfolio flows of $4 billion over five months ending May 2016. In Mexico, the improving economic picture—Q1 ’16 GDP of 2.9% YoY is the highest in three years—induced capital inflows to its equity market (Jan-April 2016: $2.7 billion). Nonetheless, investors remained apprehensive of sovereign risk with FPI repatriations from Mexican debt ($7.4 billion) more than offsetting inflows into equities. As a result, both countries reported their longest streak of outflow5 since the 2009 financial crises. Elsewhere, Argentina returned to the international bond market for the first time in over a decade following successful negotiation with most holdout creditors regarding the 2002 default. The sovereign bond issuance of $16.5 billion—largest EM bond sale ever—was four times oversubscribed as investors view new President Mauricio Macri’s policies (including cutting export taxes and adopting a flexible exchange rate policy) as progressive.
Net portfolio flows to EM Europe was divergent as Ukraine, Poland, Hungary reported outflows while Turkey and Czech Republic posted inflows over Q1 16. The crises in Ukraine continues to drive net portfolio outflow ($57 million) while Hungary’s surprise GDP contraction in Q1 16 (-0.8% QoQ), which overshadowed Fitch’s upgrade of Hungary’s credit rating above junk for the first time since 2012, underpinned outflows ($1.9 billion). Similarly, Poland’s first GDP contraction (-0.1% QoQ) in 13 quarters over Q1 16 underpinned its first portfolio outflow ($5.9 billion) in 5 quarters in the period. Meanwhile largely reflecting reduced political risks following President Recep Erdoğan’s party’s convincing win at the national elections, Turkey recorded its first quarterly net portfolio inflow in 5 quarters in Q1’16.
In the Middle East, concerns regarding lower oil prices, which drove Fitch and S&P’s downgrade of Saudi Arabia’s credit rating, underpinned a third consecutive quarter of portfolio outflows in Q1 16 (twenty-six fold QoQ larger to $345 million).
Elsewhere in the region, portfolio flows to Tunisia continued to plunge (QoQ: - 67.8%, YoY: -85.6%) largely reflecting subdued tourism activities which has weighed on its economic outlook (Q1 16 GDP: +1% YoY). On the other hand, Egypt’s devaluation of its currency (-14%) as well as interest rate hike (+250bps to 11.75%) buoyed portfolio flows into the country’s equity and debt market over the period.
Deteriorating Economic Fundamentals Soften FPI appetite for African Assets
Capital flows to Africa have been on the downturn since the start of the commodity price rout given the sizable share of commodity exports in government revenues.
On the heels of the price declines, the rising strain on fiscal and current account balances and softening growth picture weighed on FPI sentiment. These fundamental concerns and increased prospect of currency weakness has lowered demand for African assets, requiring higher risk premiums for debt issuance.
Consequently, Eurobond issuances have either been delayed or shelved by most countries. In H1 16, only South Africa ($1.25 billion) and Mozambique ($726.5 million) raised international bonds (Eurobonds) vs. four sovereign bond issuances totaling $4 billion in H1 15.
Looking at trends in key economies across the region, South African equities witnessed portfolio outflows of $3.6 billion over the first five months6 of the year reflecting deceleration in economic activities, underpinned by a sharp contraction in mining output, minimal growth in the manufacturing sector, and declines in electricity production and consumption. However, following accommodative monetary policies in the advanced countries as well as 75bps hike in policy rate (to 7%) by the South African Reserve Bank, South Africa’s debt markets reported $1.5 billion portfolio inflow over the first five months of 2016. Elsewhere, the slide in the Nigerian economy, with real GDP contracting for the first time in twelve years in Q1 16, FX market illiquidity and renewed militant attacks on oil installations in the Niger Delta dimmed FPI appetite for naira risk with FPI flows shrinking (QoQ: - 72%, YoY:-85% ) to $271 million in Q1 16—lowest quarterly flow on record.
Brexit cloud of uncertainty dims H2 16 FPI Outlook
Over the second half of 2016, beyond the weak macro outlook, we believe two events are central in charting outlook for FPI flows. First, fallout from Brexit should herald new layer of uncertainty in both the UK and the EU with the European Council on Foreign Relations (ECFR) noting that a total of 34 referendum votes are being promoted by various political parties across Europe (including France, Italy and Netherlands) to determine EU membership or other specific policy issues such as refugee relocation quotas. Thus, the higher prospect of copy-cat exits across the EU raises serious question about the future of the European bloc. On Brexit itself, the split across Scotland and Northern Ireland raises concerns over the UK as nationalist sentiment in both countries could stoke fresh calls for independence.
The second key event on the horizon is the timing of the next US interest rate hike. On this front, we expect the turmoil across financial markets following the Brexit vote should temper hawkish sentiment in the FOMC. The rising uncertainty over the potential outcomes should heighten investor sensitivity to risk assets, driving increased demand for safe haven instruments with negative connotation for portfolio flows to EM markets.
Scanning across the various regions to gauge potential impact, FPI outflows from China should continue following reigniting of growth concerns as a result of deceleration in fixed asset investment (May’s 9.6% YoY growth is the lowest in 16 years). In addition, continued decline in China’s FX reserves (May’s $3.2 trillion is the lowest since 2011) which raises prospect of further depreciation of the Yuan should dampen investor appetite for China’s securities. Elsewhere in Asia, improving economic momentum in India and continued liberalization policies in Indonesia should continue to attract FPI inflows into both countries. In Latin America, Brazil’s junk bond status and rising budget deficit, projected to widen to a record $45.9 billion over 2016, should continue to moderate investor appetite for its debt securities. Nonetheless, rising investor confidence following Rousseff’s ouster, could drive inflows into Brazilian equities in the second half of 2016 as in H1.
Similarly, EM Europe should see sizable outflows over H2 16 largely reflecting impact of Brexit as well as continued outflows from Russia whose economy is being impacted by lower commodity prices and western imposed sanctions.
In Africa, capital flows should remain tame largely on the back of slower economic growth with 2016 growth forecast lowered by the IMF (SSA: -130bps to 3% YoY) in April and the World Bank (SSA: -170bps to 2.5% YoY) in June from January’s estimate. Compounding the bleak economic picture is the rising political activity across the continent with nineteen (19) elections and three (3) constitutional referendums taking place over H2 16. Furthermore, given the weakening trend across most African currencies, FPI should remain reticent towards African assets leading to higher external borrowing costs and lower Eurobond issuances with only Ghana ($1 billion) and Nigeria ($1 billion) looking to raise Eurobonds over H2 16 vs. $6.7 billion issued in H2 15. Nonetheless, following adoption of a fully floating exchange rate system as well as other market friendly policies FPI sentiment towards Nigeria could progressively turn favourable.
On balance, rising uncertainty post Brexit, increased risk aversion as well as slowing global growth point to tempered FPI flows to EM over H2 16.
1. Nigeria Strategy Report Q2 2016 Outlook - Economic ... – Apr 21, 2106
2. The Nigerian Capital Market Strategy H2 2015 – Aug 14, 2015
3. Nigeria Strategy Report H1 2014 - ARM Research – Feb 24, 2014
4. Nigeria Strategy Report H1, 2013 - ARM Research – Jan 28, 2013
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