Thursday, May 04, 2017 04:35PM / ARM Research
Equities attractiveness remain depressed
In our H1 17 Nigeria Strategy Report, we projected a nuanced outlook for naira equities against the backdrop of subsisting reticence of foreign and local investors towards naira equities as well as weak fundamentals. Pertinently, US interest rate normalisation, rising political concerns on the global front and FX worries in the domestic market, continue to drive foreign apathy while local support continues to dissipate as rising yields which aside from raising discount rate for equity valuations provided a significantly compelling investment outlet in the fixed income market.
Certainly, market performance played out as expected with the NSE ASI extending the bearish trend of Q4 16 (-5.2%) by contracting another 5.1% QoQ in Q1 17, after reporting losses in January (-3.1% MoM) and February (-2.7% MoM). After recording two consecutive months of negative FPI flows (Nov 16: N9 million and Dec 16: N5 billion), net FPI flows swung positive in Jan 2017 (N1.2billion) while the month of February witnessed an outflow of N2.3billion.
Unbundling market performance by sectors, sell pressure in the cement sector (-3% QoQ) which mirrored weakness in construction activities as well as expectation of weak full-year corporate scorecard accounted for 36% of the downtrend in the NSE ASI. Elsewhere, investors priced in asset quality concerns and weak dividend expectation on the banking sector which lost 1% QoQ and accounted for 29% of Q1 17 market declines by our estimate. To add, our attribution analysis reveals that investors priced in weak full-year results and economic headwinds on Brewers (-10% QoQ), Oil & Gas (-4.8% QoQ), Personal care (-2.9% QoQ), Real Estate (-2.9% QoQ), Insurance (-2.4% QoQ) and Food (-0.2% QoQ). Bucking the negative trend was the Construction sector which closed positive (+13.8% QoQ). Overall, at close of Q1 17, the equity market’s performance proved to be a tale of macro headwinds, weak fundamentals, attractive FI returns and feeble full-year expectation – all flagging appetite towards equities.
Figure 5: Attribution analysis of monthly sectoral performance
Muted outlook remains Intact
Over the second quarter of 2017, political uncertainty in Europe, swelling predictions of geo-political crisis, prospects of further rate hike by the US Federal Reserve should continue to drive cautious approach to EM/frontier market investing. Whilst domestic FX markets have seen improved liquidity since March 2017, we expect FPI participation to be gradual with more allocation in the FI market. Complicating the outlook for equities is the elevated domestic yield environment which works to dilute local investor interest in equities.
Dimensioning our outlook based on sector fundamentals, our views about fiscal revenue struggles constraining capital expenditure at federal and state level translate to muted demand for construction materials. Further confounding the sectors’ revenue picture is the potential pull back in demand following an over 47% increase in cement price. That said, margins should recover from battered 2016 levels largely reflecting price hikes and a more efficient energy mix, with the latter stemming from restoration of gas supplies and construction of coal plants. In addition, Lafarge’s restructuring of its dollar loan obligations, which shrinks its FX exposure to $106 million at the end of Q1 17 (-82%) should mitigate the risk of earnings compression from future NGN depreciation.
Undertaking a similar exercise for banks, asset quality fears on the Power sector, General commerce and Manufacturing sectors remain a cause for concern. In addition to loan quality issues, capital adequacy worries remain on the horizon after the over 180bps shrinkage across our coverage banks which should drive muted organic loan growth (excluding NGN depreciation and CBN on-lending).
Nonetheless, as in 2016, our prognosis about further naira weakness retains scope for FX revaluation gains for banks with net long positions even as improved FX liquidity should support trading income and ultimately NIR for banks with liquid balance sheet. Outside these banks, the underlying earnings picture is soft.
Elsewhere, for Oil and Gas, upstream names should benefit from sentimental buying associated with rising crude oil prices though production woes imply limited reprieve for battered earnings. Downstream, the dark side to the double-edged sword of the crude price rally should force upward adjustments to the retail pump price. That said, we think fears of a backlash from the populace would drive the FGN towards absorbing these increases for some time which holds negative portents for petroleum marketers’ margins.
Away from cyclical names, depressed valuations for basic food producers and strong pricing power implies this segment should come to pique investors’ interest. For more elastic sectors, negative real wage growth should continue to see price increases trail cost pressures leading to gross margin compression. Given currently elevated valuation levels, bearish bias should remain dominant for these names.
Lastly, palm oil producers should remain in the sweet spot of monetary and fiscal policy and given the fundamental demand-supply mismatch, as annual CPO production of 970,000 MT remains inadequate in the face of national consumption at 1.5million MT, we see more price upside over 2017 and expect stronger earnings performance. Notwithstanding strong YTD price performance, we believe current pricing is yet to fully reflect the stellar earnings performance reported so far, but more importantly, the robust earnings outlook.
Overall, we believe the key risk to performance are unchanged from our last call—they include US interest rate normalization, political uncertainty, domestic macro concerns, and a drag in fiscal push to uplift the economy. Investors will continue to be especially sensitive to the state of the economy, a devaluation of the naira and any policy missteps by the monetary and fiscal authorities. On balance, the outlook for naira equities is more nuanced—low foreign and local appetite for equities combine with weak fundamental picture across most sectors underpins our muted outlook for naira equities in Q2 2017.
Quest for currency stability to leave rate elevated
After climbing a whopping 873bps over 2016, the naira yield curve maintained its ascent by rising by another 122bps QoQ to a record high of 18.13% at the end of Q1 17. The upswing in yield curve coincided with views in our H1 2017 Nigeria Strategy report where we noted that CBN’s desire to ensure currency stability should keep interest rate elevated over Q1 17. Alas, buoyed by accretion in the FX reserves, the apex bank raised its FX sales which magnified impact of OMO issuances on system illiquidity with the resultant effect driving T-Bill yields (+247bps QoQ to 20.58%) higher. Meanwhile, a combination of sizable external borrowings and lower inflation helped keep bond yields largely in check (-2bps QoQ to 15.69%).
Examining the yield trajectory on a monthly basis, the naira yield curve expanded 25bps MoM in January largely reflecting yield uptrend on longer dated instruments (+47bps MoM) and muted movement in T-bill yields (+3bps MoM to 18.13%). The rise in the former reflected investors’ reaction to activities at the January bond auction where aggressive borrowing patterns by the DMO20 drove average marginal rates to a record high of 16.96% (+74bps MoM). Similarly, at the short end of the curve, the apex bank maintained its tightening policy evidenced by a more than twofold MoM rise in net OMO issuance to N492 billion. Notwithstanding a net maturity of N136 billion in February, the monetary authorities’ decision to raise dollar sales (+32% MoM to $588 million), including an offer of $500 million in its Secondary Market Intervention Sales (SMIS), kept the banking system relatively illiquid with the overnight rate rising to 133% (mean: February: 26%, January: 9%).
Unsurprisingly, T-bill yields climbed a further 39bps to 18.52% over the month. At the long end of curve however, successful issuance of the $1 billion Eurobond and increasing prospect of other external financing tempered scope for elevated domestic borrowings by the FG. Against this backdrop, the bond market experienced a bullish run (yields fell 7bps on average MoM) with the sentiment driving cautious bid rates by investors at the monthly bond auction which by extension underpinned a 32bps MoM contraction in mean marginal clearing rates to 16.64%. Buoyed by the first inflation decline in 16 months, which drove concerns about a potential monetary easing, the buying pressure at the long end of the curve extended to March with bond yields declining another 41bps MoM to 15.69%. In contrast, T-bill yields rose at the fastest pace since the MPR hike in July 2016 (+206bps MoM to 20.58%) as raised FX sales (+104% MoM to $1.2 billion by our estimate) and net OMO issuance of N130 billion weighed on system liquidity. Overall, CBN hawkish policy drove the naira yield curve to new highs.
Hitherto, we had projected yield downtrend over Q2 17 largely reflecting potential descent in YoY inflation reading on monetary easing and elevated maturity profile.
However, the rising MoM reading, which the monetary authorities have noted as a concern, should dampen influence of YoY inflation movement on interest rate trajectory over the quarter. Hence, we focus our attention on the currency market which have been the biggest driver of monetary tightening over the last few months.
In the wake of rising crude oil proceeds and gains from other officials receipts which have boosted the FX reserves, we believe recent gains in parallel market would incentivize higher dollar sales as the CBN attempts to bring confidence back into the interbank FX market. Moreover, the apex bank’s flirtation with a floating FX market in the name of a specialized FX window for Investors and Exporters makes any easing in the short term unlikely. Consequently, we project a continuation of aggressive OMO issuances which together with liquidity sapping effect of FX sales should keep short term interest rate elevated. At the long end, we believe DMO’s sensitivity to higher borrowing cost should put a cap to yield upswing leaving the humped yield curve unchanged.
Figure 7: Movement in the naira yield curve
Farther out, whilst a combination of improved revenue picture, prospective foreign borrowings, and positive impact of currency stability on economic growth should dampen agitations for monetary easing by the fiscal authorities over the near term, we believe an extended tightening cycle that threatens the issuance of the budgeted, but conservative, N1.3 trillion domestic borrowings (Year to April net borrowings: N406 billion) could redirect attention to YoY inflation reading. On this wise, projected downturn in the headline numbers on the back of dissipating base effect and impact of parallel market naira appreciation on food and energy prices (key drivers of renewed uptick in MoM inflation) could compel a temperance in the tightening stance which we believe should be initiated via lower clearing rates at the OMO auction. However, we see this scenario only playing out in the second half of H2 17 after sufficient time as been given to forestall confidence in the FX market.
Capital Market Strategy
Flexibility remains crucial
Coming into H1 17, our call was for a flexible approach to fundamentally strong stocks—buying the dips and selling the rally as against a “Buy and Hold” strategy—given subsisting bearish sentiment for equities. Basically, notwithstanding our cautious outlook on equities, we expect depressed valuation to spur buy momentum in selected stocks even as expectations of earnings recovery and improvement in FX liquidity keep prices upbeat. The expected dividend play should drive appetite in most of the selected names, though with a relatively shorter holding period for Naira equities by local investors compared to foreign investors. Thus, market gains are likely to be short-lived. Indeed, the muted equity market performance despite pockets of gains across selected stocks suggests our call largely played out.
Going forward, our views regarding tempered local and foreign activities on the bourse amid slight improvement in the fundamental picture suggest caution. That said, we look out for sentiment triggers majorly from expectations of upbeat H1 17 earnings, recovery in the macro climate as well as improved confidence in the FX market which should create enough incentive for portfolio flows. Here, as in Q1 17, we continue to feel positive vibes around palm producers with favourable CBN disposition on FX as a boon for the sector. On banks, we reiterate our preference banks as those with net long dollar positions to benefit from naira downside, liquid balance sheets to tap into the rising yield environment and tight lid on asset quality.
Elsewhere, higher cement prices, energy efficiency and expected roll-out of government capex plans should support the cement players. For the FMCG, while depressed real wages should continue to stifle sales, we think naira appreciation at the parallel market, improved FX liquidity and higher prices across product lines moderate the bearish view on the sector. In sum, elevated rate environment which keeps a pricey opportunity cost for equity exposure and broadly unsavoury fundamentals call for a highly flexible approach in Q2 17.
Investing in the market at the trough is imperative, and being flexible with tactical positioning can be beneficial. We emphasize that times of higher market volatility, while often trying for individual investors, can present opportunities for skilled active managers. For us, we think after a strong counter trend move, as long as the longer term outlook remains intact, looking for opportunities to “buy the dip” and “sell the rally” will be a solid investment strategy for choice names.
Barbell Strategy to generate Alpha
In our H1 17 NSR, we recommended a short duration strategy, capturing higher yields at the short end of the curve while avoiding the bearish twists to bond yields. To add, we suggested a staggered approach to building duration with emphasis on mid-tenored bonds on the downward slope of the naira curve in a bid to ‘run-down the curve’ as dovish influences kick into gear over Q2 17. Farther out, as the liquidity influence wane and currency pressures become self-evident, we advised a rotation back into money markets to wait out the FX market storm. Overall, our strategy call was for investors to position bond portfolios with an eye on flexibility ahead of what promises to be a roller-coaster half year for debt markets.
Going forward, the rising MoM inflation reading, which the monetary authorities have noted as a concern, should dampen influence of YoY inflation moderation on interest rate trajectory over the quarter. Hereafter, we focus our attention on the currency market which have been the biggest driver of monetary tightening over the last few months. In the wake of rising crude oil proceeds and external borrowings which have boosted the FX reserves, we believe recent gains in parallel market would incentivize higher dollar sales as the CBN attempts to bring confidence back into the interbank FX market. Moreover, the apex bank’s flirtation with a floating FX market in the name of a specialized FX window for Investors and Exporters makes any easing in the short term unlikely. Consequently, we project a continuation of aggressive OMO issuances which together with liquidity sapping effect of FX sales should keep short term interest rates elevated. At the long end, we believe DMO’s sensitivity to higher borrowing cost should put a cap to yield upswing leaving the humped yield curve unchanged.
Hence, Q2 17 should see an extension of the current yield curve dynamics. Thus, in this humped yield environment, Barbell strategy remains the reasonable call - building duration at the short and long end of the naira curve with emphasis of the latter to benefit from possible macro induced monetary policy reversal farther out in the year.
Related News from ARM’s Q2 2017 Nigeria Strategy Report
Related News from ARM’s Q2 2017 Nigeria Strategy Report