Friday, January 13, 2017 12:18 PM / ARM Research
Review of Global Economy and Markets
In today’s cut-out of our core strategy document—The Nigeria Strategy Report, we review movements in FPI flows across global financial markets over H2 16. In particular, we examine the impact of rising US interest rates, a firming US dollar and persisting current account imbalances across several EM countries on capital flows in the global market. We also outline our expectations for the portfolio flows across major regions in 2017.
In contrast to positive readings over the last two quarters (Q2 16: $26.4 billion, Q3 16: $41.7 billion), net foreign portfolio investment (FPI) flows to emerging markets (EM) turned negative in Q4 16 ($38.4 billion, highest outflow since Q4 2008) as investors responded to rising US interest rates and a strengthening US dollar in the aftermath of Donald Trump’s victory at the US presidential elections. Though commodity prices have started to recover, which should have resulted in more upbeat assessment of EM growth fundamentals, the rising voter backlash against globalization and upswing in populist anti-trade rhetoric, as encapsulated by the Brexit, Trump and Italian poll results suggest investors anxiety over EM economies, which benefitted from free global trade over the last decade. Overall, the Q4 16 numbers place YTD FPI flows 42.3% lower YoY at $27.7 billion.
Going into 2017, the hike in rates (+25bps to 0.5%) by the US Fed at the December meeting as well as FOMC’s forward guidance of further rate hikes (three) over 2017 stokes fresh wave of concern for investors’ appetite towards riskier assets. Rising yields in the US and consequent appreciation of the dollar should also compound fiscal vulnerabilities of EM countries which would be forced to offer higher interest rate to attract more expensive US funds. Further risks to portfolio flows may arise from disagreement between EU and UK on future terms of economic relationship on one hand as well as election jitters in the Euro-Area which could usher in populist political parties—skeptical on European integration—on the other hand leading to greater FPI reticence towards EM securities. However, rising growth prospects across most EM countries, which according to the IMF should rise 40bps YoY in 2017— could see investors increasingly discriminate across EM countries. On balance, notwithstanding upbeat growth projections across EM countries, rising yields in the US and political concerns in Europe should weigh on portfolio flows over 2017.
Political concerns drive FPI apathy towards EM assets
In contrast to positive readings over the last two quarters (Q2 16: $26.4 billion, Q3 16: $41.7 billion), net foreign portfolio investment (FPI) flows to emerging markets (EM) turned negative in Q4 16 ($38.4 billion, highest outflow since Q4 2008) as investors responded to rising US interest rates and a strengthening US dollar in the aftermath of Donald Trump’s victory at the US presidential elections. The latter factor combined with persisting current account imbalances across several EM countries resulted in currency weakness with the EM currency index sliding 4.5% in H2’161.
The rally across US equities over the same period imply investors are pricing in stronger growth prospects under a Trump presidency and a hawkish US Federal Reserve. Though commodity prices have started to recover, which should have resulted in more upbeat assessment of EM growth fundamentals, the rising voter backlash against globalization and upswing in populist anti-trade rhetoric, as encapsulated by the Brexit, Trump and Italian poll results suggests investors anxiety over EM economies, which benefitted from free global trade over the last decade. Overall, the Q4 16 numbers place YTD FPI flows 42.3% lower YoY at $27.7billion.
Figure 1: FPI flows to EM
Fluid EM economic picture drives divergent FPI flow pattern
Examining flow patterns across the various regions, FPI flows to EM Asia were largely positive over Q3 16 with India2 (six- quarter high of $4.6 billion), Thailand (14-quarter high of $5.9 billion), and Indonesia (highest in nine quarters at $4.8 billion) all witnessing sizable inflow on the back of resilient economic picture. However, reflecting lower interest rate (-25bps to 6.25%) in October and demonetization policy in November which weighed on economic output3, capital flows to India bucked its positive trend with combined outflows of $3.1 billion over October and November being the highest of any two months since August 2015, when China’s currency depreciation induced apathy towards Asian assets.
Monetary easing (-50bps to 4.75%) was also responsible for the capital flight from Indonesia debt securities so far in Q4 16 (October: -$716 million) while projected impact of lower government spending ($10.2 billion budget cut) on economic output weighed on appetite towards the country’s equity instruments (October: $174 million). Elsewhere, political concerns following the4death of the Thai Monarch King Bhumibol Adulyadej in October induced aversion towards Thailand assets with $3.5 billion5 worth of assets sold and withdrawn between October and November. In contrast to positive reading witnessed across most Asian countries in Q3 16, net capital flows to China contracted 16.3% QoQ to $14.53 billion with the outflow largely stemming from the debt market (-50.9% YoY to $6.3 billion) where potential Yuan trajectory—on the back of Brexit fallout—weighed on appetite. Outflows from the debt market more than offset higher inflows to the equity market (+80.6% QoQ to $8.3 billion) which we believe tracked upbeat economic picture with composite PMI reading rising to a 22-month high of 51.9 in July, while both industrial production (+6.3% YoY in August—highest in five months) and retail sales also improved (September 2016: +10.7% YoY—highest in eight months).
Over in Latin America, capital flows to Brazil extended its negative run into the fifth consecutive quarter in Q3 16 (+129% QoQ to -$7.2 billion) tracking sustained economic weakness (GDP extended its run of negative growth for the ninth consecutive quarter in Q3 16). The run of outflows continued in October 2016 ($1.7 billion) following a 50bps cut in the benchmark Selic rate to 14.25%. Elsewhere in the region, FPI flows to Mexico turned positive in Q3 16, after three negative quarters, with net inflows of $9.3 billion (Q2 16 outflow: $6.1 billion) being the highest in nine quarters. The improved capital flows largely mirrored activities in the debt market where the Bank of Mexico raised its benchmark interest rate by 100bps between June 30 and end of September 2016 to 4.75%—highest in three years. Elsewhere, after its record breaking Eurobond issuance in H1 16, portfolio flows to Argentina likely slowed on the back of weaker than expected output with GDP contracting for its second consecutive quarter at -3.8% YoY in Q316 (Q2 16: -3.7%). In response to the country’s recessionary environment, the Central Bank of Argentina lowered its benchmark interest rate (35-day Lebac rate) nearly 500bps to 24.75% which given rising yields in the US interest holds negative connotations for flows towards Argentina’s debts securities.
Notwithstanding ECB’s continued monetary easing, EM Europe witnessed portfolio outflows largely reflecting subdued growth picture as well as political uncertainty. In particular, the failed coup in Turkey which resulted in the massive crackdown of perceived members of the Gullen movement—the group suspected to be responsible for the coup—drew widespread condemnation from western countries with potential sanctions from the EU weighing on investors’ sentiment. Amid the marked rise in risk premium, FPI flows to Turkey swung from positive in Q2 16 ($5.7 billion) to negative in Q3 16 ($659 million) a pattern which continued into Q4 16 with outflows in October ($688 million) and November ($1.7 billion). In a similar vein, political undertones combined with softening macro data resulted in capital flows from Poland (-$762 million). Political concerns came to fore after Poland’s ruling Law and Justice Party (PiS) —which was elected in October 2015—moved to amend the country’s constitution, which amongst other things seek to increase government’s control6 of the judiciary. The Judiciary’s prompt rejection of the reforms as well as a rebuke from EU7 weighed on investors’ confidence. In addition, growth remained weak evidenced by the first contraction (-3.4% YoY in July) in industrial production as decelerating growth in retail sales (July’s MoM growth of 2% was the slowest in four months).Elsewhere uninspiring growth picture in both Czech Republic (Q3 16 GDP of 1.9% is the lowest in eleven quarters) and Hungary (-60bps from reading to 2.2% YoY in Q3 16) underpinned the first FPI outflow (Q3 16: $2.1 billion) in five quarters in the former and a 107% QoQ jump in net outflow to $510 million in the latter.
In the Middle East, Saudi Arabia conducted the largest-ever emerging market Eurobond sale in October selling $17.5 billion of debt in the government's first international offer. The Sovereign issuance was nearly four times oversubscribed as rebound in oil prices, lower yields across developed markets and desire to further liberalise the economy boosted investor’s appetite. Meanwhile FPI flows to Tunisia contracted 33% QoQ to $5.2 million in Q3 16 on the back of uninspiring growth picture while political uncertainty trailing legislative elections in Morocco likely weighed on investors’ confidence. Egypt’s decision to implement pro-market policies including the floatation of its currency, subsidy reduction, raising energy prices (between 35% to 47%) as well as monetary tightening (+300bps to 14.75%) boosted market sentiment. Improved confidence also stemmed from the country’s ability to secure $12 billion IMF loan as well as $4 billion Eurobond in November which eroded concerns over devaluation risk.
Deteriorating growth picture turns SSA into dystopia for portfolio flows
Notwithstanding lower yields across developed markets, FPI flows to Africa remain reticent as subdued growth picture, depreciating currencies and fiscal account imbalance continue to dampen appetite. Impact of the foregoing underpinned continued decline in Eurobond issuance in the region which contracted 44.2% YoY to $3.75 billion in H2 16. In South Africa, net portfolio flows extended its negative run into its fourth consecutive quarter in Q3 16 (-66% QoQ to $439 million) largely reflecting fragile economic picture (Q3 16: +0.7% YoY), lingering political uncertainty and concerns of potential downgrade of the country’s credit rating into junk status. Despite South Africa’s $3 billion Eurobond issuance in October, net portfolio flows took the turn for the worse as the combined outflow of $3.9 billion over October and November is the highest of any two months since the 2008 financial crises. The worsening investor sentiment largely tracked happenings on the political scene where corruption charges levied against President Jacob Zuma stoked fears of a possible impeachment.
Over to Nigeria, portfolio inflows rose to a three-quarter high of $920 million in Q3 16, largely reflecting strong appetite for the country’s debt instrument which witnessed a thirteen-fold QoQ jump in flows to $719 million. Demand for Nigeria’s securities stemmed from sizable currency depreciation (-42%) in late June 2016, but more importantly, monetary tightening which drove the naira yield curve 493bps QoQ higher to 17.39%. However, lingering challenges on the economic front (contractionary growth, elevated inflation, and shortage of FX supply) continues to dampen foreign appetite towards Nigeria equities, with inflow contracting 28% QoQ to a record low of $201 million8. The worsening economic picture evidenced by sustained contractionary PMI reading as well as rising rates in the US further dampened FPI appetite in October with portfolio inflow contracting 60% MoM to $103 million in October.
Figure 2: FPI flows into Nigerian financial markets ($’million)
Tightening US monetary policy and political risks dampen FPI flow prospects
Going into 2017, the hike in rates (+25bps to 0.5%) by the US Fed at the December meeting as well as FOMC’s forward guidance of further rate hikes (three) over 2017 stokes fresh wave of concern for investors’ appetite towards riskier assets. Whilst financial market uncertainty and subdued global growth could dampen the pace of US monetary tightening, firming inflation outlook which should be boosted by Donald’s Trump expansionary policies (tax cuts and increased federal government infrastructure spending) and rising energy prices lends credence to higher interest over 2017. Rising yields in the US and consequent appreciation of the dollar should compound fiscal vulnerabilities of EM countries which would be forced to offer higher interest rate to attract the more expensive US funds.
Further risks to portfolio flows is the potential invocation of Article 50 of the Lisbon Treaty in March 2017, thereby opening the two-year window in which the United Kingdom will negotiate its future economic relationship with the EU. Disagreement between EU and UK on future terms of economic relationship on one hand as well as election jitters in the Euro-Area which could usher in populist political parties— which are skeptical on European integration—on the other hand could spark global uncertainty and induce reticence towards EM securities. Nonetheless, rising growth prospect across most EM countries, which according to the IMF should rise 40bps YoY in 2017— could see investors increasingly discriminate across EM countries.
Scanning across the various regions to gauge potential impact, EM Asia should experience downturn in capital flows over 2017. Concerns about China’s continued transition to a consumption driven economy which should weigh on economic growth, worries about Trump’s trade policies, impact of strengthening dollar on Yuan’s outlook all bode negatively for capital flows into the Chinese economy.
Similarly, potential growth deceleration in India reflecting impact of demonetization policy on domestic consumption as well as political uncertainties in South Korea9 following the impeachment of President Park Geun-Hye in December should dampen capital flows towards the respective two countries. In contrast, rising commodity prices (palm oil, rubber, and coal) stokes prospect for greater investor risk appetite towards Indonesia and Malaysian risk.
In EM Europe, Turkey’s sustained crackdown on political opponents as well as rising spate of attacks in turkey should continue to induce reticence towards the country’s assets, while political standoff in Poland and rising fiscal spending which could trigger ratings downgrade in the country holds negative connotation for portfolio flows. However, expected rebound in economic growth in Russia alongside higher oil prices should drive portfolio flows into the country.
Latin America should experience mixed flows with Brazil likely witnessing sizable capital inflow as the government makes progress with fiscal reforms and the economy emerges from a deep recession while Donald Trump’s trade and immigration policies could weigh on Mexico output. Particularly, the US president-elect has threatened to renegotiate NAFTA which could result in higher tariff on US imports from Mexico nearly 80% of total Mexico exports) whilst clamp down of immigration as well as withholding of remittances could significantly 10 affect FX reserves in country.
In addition to recovery in oil prices which lowers risk premium across GCC countries, Saudi Arabia’s plan to allow foreign investors to invest directly in Saudi stocks at the time of their IPO, should boost flows towards the country’s equity market, whilst Egypt’s government plans to raise $6 billion in Eurobond should drive capital flows to its debt market. For Africa, lingering fiscal imbalance, tepid growth prospect and depreciating currencies should continue to dampen Eurobond bond issuance while political uncertainty trailing December election in South Africa should further compound capital flows.
In Nigeria, notwithstanding upswing in Brent crude oil prices continued disruption to oil installations in Nigeria should cap potential gains on export proceeds. Furthermore, given ongoing economic weakness which limits scope for further monetary tightening, rising yields in the US should further dampen FPI appetite for naira assets.
On balance, notwithstanding upbeat growth projections across EM countries, rising yields in the US and political concerns in Europe should weigh on portfolio flows over 2017.
1. Nigeria Strategy Report H2 2016 - Brexit Dust Blurs Outlook for Portfolio Flows ... – Jul 30, 2016
2. Nigeria Strategy Report Q2 2016 Outlook - Economic ... – Apr 21, 2106
3. The Nigerian Capital Market Strategy H2 2015 – Aug 14, 2015
4. Nigeria Strategy Report H1 2014 - ARM Research – Feb 24, 2014
5. Nigeria Strategy Report H1, 2013 - ARM Research – Jan 28, 2013
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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
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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
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12. Soft commodities resume bearish trend but has an inflection point been found?
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