Juggling moving parts while walking fiscal tightrope demands dexterity

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Wednesday, February 03, 2016 2:24 PM / ARM Research

Over the past few weeks, we have featured daily excerpts from “The Nigeria Strategy Report” – detailing our understanding of key happenings in global and domestic financial markets in 2015 and providing our outlook on major investment themes for 2016. Today, we conclude the series of excerpts by presenting our capital market strategy for 2016.

 

In many respects, events in the FI market in the latter half of 2015 played out nearly exactly in line with the strategy calls we made. From the call for domestic influences to predominate, to the specific expectation for the insurgency and political risk—the more recent yield influencers, at the time—to wane, reality matched expectation. The equity market posted another poor performance in H2 15, extending the weakness since H2 14. Over the year, the downbeat earnings performance we envisaged broadly materialized and combined with an uncertain policy environment to drive the declines.

 

We expect yields, on average, to stay depressed and barely positive in real terms in 2016, but with that trend to be intermittently interrupted by one or more of the yield-stoking influences which we jointly consider too fundamental to not have their say at some point in the year, especially the fiscal deficit. Strategy-wise, this introduces a change to our duration-building strategy of the past year with inflation pressures narrowing the available room for declines. Longer term, we see the inflationary pressures and potential for yields to turn negative in real terms as perhaps the only significant curtailing factor on the apex bank’s easing measures. However, even if that curtailment does happen, we expect the ongoing reallocation of resources away from the money market by domestic institutional investors to help prevent a sustained rise in yields.

 

On the equities front, the unviability of planned seasoned offerings and shrinking market activity both point to increasing apathy and suggest that the market faces a challenging year ahead. One small positive is the signs of increasing interest in equities by pension funds though the official asset allocation numbers are not yet out. With oil approaching breakeven for most Nigerian fields and a still-negative outlook for fiscal revenues, we see opportunities for bottom-fishing across the depth of the market in 2016.

 

Overview of the Economy

 

 

In many respects, events in the FI market in the latter half of 2015 played out nearly exactly in line with the strategy calls we made.

 

From the call for domestic influences to predominate, to the specific expectation for the insurgency and political risk-the more recent yield influencers, at the time—to wane, reality matched expectation. Similarly, not only did the sequence we set out for duration-building opportunities, for brief Q3 spikes to be followed by significant and decisive declines in Q4, come to life but also our recommendation for investors to expect nowhere near Q1 yield levels fit eventual outcomes with the H2 peak 56bps lower the year peak of 16.8% set in February.

 

Given the extent to which eventuality matched expectation, it then seems somewhat nonplussing to have to so heavily reassess our overarching submission 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”. However, after Nigerian domestic bonds became the second best performing asset globally in 2015 it only prudent that the sustainability of such a run is reassessed and, in this regard, the key drivers bear the first round of the renewed scrutiny.

 

In assessing the quantum of risk in the domestic environment as at our last report, we split our consideration into global and domestic. Of the global factors, it was oil that we felt posed the greatest challenge to the domestic environment as we envisaged portfolio or capital flows were unlikely to have any decisive influence under prevailing conditions. In this regard, we were not disappointed, as portfolio flows stayed negative and FDI posted a non-impactful positive as detailed in our review of the FI section.

 

However, oil contrived to post another dolorous performance, exacerbating the wreckage on government revenues. Ordinarily this should then have reinforced the surviving key factor of the domestic risk influences—fiscal tightness—especially as the oil weakness came with a shift in market share competition away from Saudi vs. shale to competition even among conventional oil producers. To that end, the role of improved crude oil volumes pushed by Nigeria in supporting the fiscal side is quite important, though likely unsustainable.

 

However, the real boon was the extension of the role of “alternative and unexpected funding sources” in easing the pressure on the government, starting with the NLNG dividend (N400 billion) and CBN line (N300 billion). In Q3, the FG then got a windfall of $5.1bn in ‘other official receipts’ which further boosted reserves and government balances. However, perhaps the most important dynamic when it came to the FG’s financing was the commencement of monetary easing by the apex bank which helped midwife much of the impact seen on yields. It is balancing the addition of the easing to the equation that has continued unexpected fiscal support on one side and the even more dire fiscal straits on the other, that we consider essential to determining FI market outlook in 2016. 

 

Already, despite Q4 15 declines, investors appear to be looking at the fluid oil dynamics and the necessity to implement government’s plans to the fullest extent possible and, as a consequence, projecting increased FG paper supply in 2016.

 

Indeed, our projection of a N2.8trillion deficit (vs. budget’s N2.2trillion) only captures downward adjustment to non-oil receipts and if crude prices fall short of budget threshold the gap could be wider. Furthermore, there is the possibility that, in a bid to avoid undue currency risk and potentially higher Eurobond costs as dollar revenues shrink, plans for foreign borrowing could be shelved in favour of domestic, given limited cost differential and better control of naira denominated debt. The yield stoking implication of these is supported by FG’s own projection of higher borrowing costs in 2016. On the other hand, the divergence in government’s response relative to history, by not indiscriminately issuing paper, and the potential influence of plugging fiscal leakages i.e. other receipts, suggests supply may still not be as copious as the fiscal constraints dictate.

 

While the limited evidence regarding the sustainability of the alternative funding sources (with NLNG dividend and other receipts possibly taking a hit in current environment) raises the potential for some yield spikes to occur in H1 16, we expect such to be short-lived. To our thinking, a sustained yield uptick will in all likelihood require, on the fiscal side, an alignment of an urgent funding need, absence of any of the domestic supporting sources, a willingness to change the current mindset and zero external support—a low probability alliance to say the least. Overlaying this with ongoing easing indicates we expect yields, on average, to stay depressed and barely positive in real terms in 2016, but with that trend to be intermittently interrupted by one or more of the yield-stoking influences which we jointly consider too fundamental to not have their say at some point in the year, especially the fiscal deficit. Strategy-wise, this introduces a change to our duration-building strategy of the past year with inflation pressures narrowing the available room for declines.

 

Specifically, we recommend allocating a not insignificant portfolio proportion to trading the bumps on the yield slope as they occur. Longer term, we see the inflationary pressures and potential for yields to turn negative in real terms as perhaps the only significant curtailing factor on the apex bank’s easing measures.

 

However, even if that curtailment does happen, we expect the ongoing reallocation of resources away from the money market by domestic institutional investors to help prevent a sustained rise in yields. In that light and considering we do not see state bonds benefiting from such a cap on yields and, accordingly, expect any state issuance that barely makes it to market to feel the full hurt of the fiscal pain, we think descending the credit ladder (including corporate) is how worthwhile opportunities for yield maximization can be found.    

 

Deadbeat equities looking for trigger to life?

 

 

Like a solitary spike on a flat-lining ECG, but with ultimately the same outcome of forlorn, denied, hope, the MoM gain in September 2015 proved a dishonest harbinger of optimism for equities. The equity market posted another poor performance in H2 15, extending the weakness since H2 14. Over the year, the downbeat earnings performance we envisaged broadly materialized and combined with an uncertain policy environment to drive the declines.

 

Whilst the domestic issues were more than enough flogging for a near-dead horse, it could be argued that the dour performance did not even capture the full scope of negative triggers in the period. Two key events appear to have flown under the rather somewhat, at least in terms of visible impact on Nigerian equities.

 

First, the eventual commencement of US rate hike cycle raises the opportunity cost for portfolio flows which appear to have a more dominant impact in the equity, compared with the FI, market. To that end, while it is likely that the trend of negative flows up to October will continue till the end of the year, the hike itself did not seem to have made much of an impact on share prices. Second, while the bearish expectation for oil prices was always going to be negative for equities, the plunge to the lowest levels in over a decade late in December again seemed a bit of a non-event for Naira assets.

 

Granted, saturation effect might be a factor in both of the foregoing scenarios, with those events not really grabbing markets by surprise. However, the lack of any real response to either one and, given the timing of the events, indeed to the combination of both events, seems to be more like a delayed reaction.  

 

In the interim, the domestic issues that drove much of the weakness remain intact with government spending pattern and finances a key influence in most facets. It is against this backdrop that the anticipation around the stimulus-focused 2016 budget can be understood.

 

Whilst the numbers continue to showcase the dominant role of government spending in national discretionary spend, and in expenditure measured output, our analysis suggests the expected budget-boost might be somewhat delayed and perhaps not as pervasive. In a similar vein, whilst the new administration appears to have found its policy voice, and not only seems quite keen to get down to business but also to have the right priorities, the corporate impact might ultimately proved double-edged. With the unviability of planned seasoned offerings and shrinking market activity both pointing to increasing apathy, it is clear the equity market faces a challenging year ahead.  

 

One small positive is the signs of increasing interest in equities by pension funds though the official asset allocation numbers are not yet out. The development appears to be as a result of both the constricting yields in the FI space and the need to find alternatives to unattractive reinvestment rates especially for money market instruments. The value proposition of certain equity names themselves, despite the extant risks, just further sweetened the pot. Regardless of motivation, this increased interest from a class of investors that has typically been equity-shy could be significant.

 

Indeed, the reforms by PENCOM could then have more import going by our analysis that the multi-fund structure could force a minimum equity allocation of at least 10% compared to no floor under status quo. (Currently, mean equity allocations across PFAs in 2015 are 12%, but implementation of multi-fund structure could potentially raise maximum PFA equity holdings to 61% of total AUM).

 

Notwithstanding, we see this more as a stabilizing influence against the volatility that’s likely to be induced by the eventual reaction to negative developments on the global front and, in particular, the likelihood for oil to be choppy as it tries to settle this year.  

 

Whilst our sector dimensioning focused on the value driven fundamentals last time out, this time we overlay it with the likely developments on the policy front. Banks are still our value proposition for risk-reward, especially top-tier names, but policy does not seem likely to favour them. From a weak macro environment and reduced paper supply taking away their asset opportunities and monetary easing lowering the yield on what is left, to operational risk challenges and global oil rout forcing delinquencies, investors find sufficient reason to continue to discount the steady cashflows the financials find a way to generate. Petroleum marketers appear to be in the next phase of the ‘now on, now off’ attractiveness which essentially reflects the policy uncertainty in the environment.

 

However, with subsidy removal now seriously back on the table, dynamics once again appear favourable aided by potential cashflow boost from interest savings given their relatively high debt burdens. Consumers may benefit from government spending but we consider devaluation, difficulty sourcing forex, reduced inputs, slow recovery in spending power and rich valuations as too potent a cocktail to overlook. Industrials appear to be the ones in the middle ground with moderate valuations and likely to benefit most from government budget implementation and policy thrust. With oil approaching breakeven for most Nigerian fields and a still-negative outlook for fiscal revenues this would probably be the best sector to put money on.

 

However, with the potential for oil to find a bottom aiding pension inflows in creating a floor for equities sometime this year, we see opportunities for bottom-fishing across the depth of the market in 2016.  

 

Related News from ARM’s Nigeria Strategy Report

1.       Sustained oil price weakness combines with policy opacity to stoke market downturn

2.      Monetary strokes normalise yield curve - The case for a lower treasury yield curve

3.      Monetary Policy: Rewriting the Past

4.      Inflation rises from 8.2% in January to 9.6% in December 2015; Inflationary Pressure Likely in 2016

5.      Another low payout from December 2015 revenues by FAAC

6.      Renewed oil price descent swings trade balance deeper into deficit

7.      Nigeria's GDP growth stuck in the slow lane

8.     Petroleum sector reforms lead revamped drive for new policy direction

9.      Fiscal Imbalance Persists on Soft Oil Price - fiscal deficit to be much higher than budget

10.  New Government's Progress Threatened by Headwinds

11.   Soft commodities resume bearish trend but has an inflection point been found?

12.  FPI flows exit Emerging Market dance floor

13.  Oil scrapes even lower down the barrel

14.  Escalating challenges drive Africa's growth lower

15.   Uneven global growth driving divergent policy agenda - 2016 Outlook  

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