Thursday, May 04, 2017 01.35PM / ARM Research
In this edition of our quarterly strategy report, we take an in-depth look at economic indicators on the global and domestic scenes over Q1 17 as well as isolate influences of more recent developments on our outlook for the rest of Q2 17.
The ever-reverberating twist in global economy was again the toast of discuss over the past quarter, with investors ruminating over fledging recovery in advanced economies and what turned out to be a mixed growth picture for Africa. On the former, a combination of healthy jobs data and rising inflation in the US, export-led growth in Japan, as well as a shock economic expansion in the Euro zone appears to have catapulted economic growth expectations across DMs to a place of relative comfort. Elsewhere though, dour outlook for soft commodities in the aftermath of the El-Nino weather shock, which once provided inorganic support for CPO and rubber prices, and broadly expanding oversupply picture appear to have thrown a spanner into growth works across emerging and frontier economies with Sub-Sahara Africa (SSA) indisputably on the receiving end. Expectedly, with the possible surge in commodities’ output expected to compete for an increasingly constrained market demand, the IMF swiftly revised its 2017 growth expectation lower for the region.
Amidst this broadly weaker macro tapestry, recent resurgence in crude price should dovetail to slight re-channelling of growth pressures from oiled SSA economies to their oil importing counterparts.
However, near term growth in the latter should be protected by relatively stable currencies, lower inflation, improved agricultural production and large infrastructure programs built over the last three years of soft crude oil prices.
Against this backdrop, this report seeks to distil possible pass-through to a Nigerian market fettered by a three-quarter old economic recession for which emerging forward indicators have failed to provide tangible hopes for forbearance despite sustained gains in oil prices and a CBN-induced improvement in FX liquidity.
On the issue of currency, the apex bank’s reversion from a celebrated entry into a fully float regime to a controlled float in less than 3 months is hardly news.
Thus, our research focuses more on the sustainability of ongoing market interventions as well as a realistic fair value for the naira. By way of linkage, we also investigate the implications of currency developments on overall inflation basket with keen attention paid to an over six month’s old food demand pressures from neighboring West Africa. Perhaps adding more strength to our enquiry is the conscious effort made to situate Nigeria’s economic dilemma in the context of its volatile socio-political environment that could very easily revert to boiling point if the shenanigans embroiled in the last two gubernatorial elections and the characteristic unpredictability of the Niger Delta is anything to go by.
Review of Global Economy and Markets
Global recovery shrugs political worries
Global financial market closed the first quarter of 2017 on a positive note (MSCI World Index: +5.9%) despite lingering geopolitical tensions, as optimism on US growth prospects and sustained pace of economic recovery elsewhere boosted investors’ confidence. Particularly, despite Brexit worries and political concerns ahead of the Dutch, French, and German elections, which were meant to weigh on output, the Eurozone economy expanded 0.4% QoQ in Q4 16 (unchanged from prior quarter) even as improved net exports1 and resilient household consumption drove a faster growth in the growth in the United Kingdom (Q4 16: +0.7% QoQ, Q3 16: +0.6% QoQ). Elsewhere, Japan recorded its first ‘fourth consecutive quarterly growth in three years’ as higher exports, government spending and nonresidential investment buoyed output in Q4 16 (+0.3% QoQ). Though growth in the United States eased off its Q3 16 peak of 3.2%, an annualized economic growth of 2.1% in Q4 16, robust jobs data2 and rising inflation2, all of which painted a strengthening economy, underpinned the US Fed’s second rate hike in 3 months in March (+25bps).
Economic picture also improved across emerging markets with as a rebound in China’s GDP from multi-year lows of 6.7% YoY in Q3 16 (Q4 16: +6.8% YoY, Q1 17: +6.9% YoY) combined with Russia’s first economic growth in eight quarters (Q4 16: +0.3% YoY) trumped demonetization-induced slowdown in India (-40bps from prior quarter to 7% YoY in Q4 16) and sustained economic contraction in Brazil (Q4 16: -2.5% YoY). Specifically, the Chinese rebound mirrored higher investments and a greater industrial output and government spending while gains in Russia remained consistent with the country’s monetary easing (-50bps QoQ to 10% in Q4 16)3. Against these backdrops, the World Bank, projected a 2.8% QoQ growth in global output in Q4 16 (2016: +2.3% YoY). Perhaps a more lucid backing to this upbeat expectation is a robust global manufacturing PMI of 53 in February—a reading unchanged in March—and printing at the indicator’s highest level in over 69 months. Relatedly, and further aided by strong readings on the Services end4, the IMF revised its global growth projection to 3.5% in April (+10bps from its October 2016 forecast). This upward revision largely reflects better than expected output in advanced economies (+20bps from October forecast to 2% YoY) with Japan5 and the US6 notable contributors.
Going forward, we expect these growth prospects to engender greater appetite for global risk assets. However, prospects of further rate hikes in the U.S could negatively impact EM currencies, even as political considerations in Europe (elections in France, Britain, and Germany as well as Brexit negotiations), rising geopolitical tensions in Asia (Syria and Korean peninsula) trigger volatilities across financial markets over the rest of the year.
Resurging commodity prices tilt SSA growth higher
After decelerating 180bps from an average growth of 5% in prior five years to 3.2% in 2015, Sub-Sahara Africa (SSA) growth decelerated to a 21-year low of 1.3%7 in 2016, re-highlighting impact of the end of commodity super cycle. Precisely, dour performance from commodity giants such as Angola, Nigeria and South Africa (~60% of SSA GDP) stoked subdued growth across the zone, with the latter and a few other key East African countries (Ethiopia, Mozambique, and Uganda) experiencing severe drought due to the El Niño weather phenomenon which prompted a decline in agricultural production and cutback in hydroelectric generation. On the former, Angola’s GDP stagnated while growth contracted in Nigeria (-1.5% YoY) largely reflecting impact of lower crude oil prices and weaker production. The decline in Angola’s crude production reflected price induced slowdown in investment while material militant incursion on oil and gas infrastructure weighed on production in Nigeria. In South Africa, GDP printed at its weakest level in seven years in 2016 owing to the aforenoted declines in agricultural output, deterioration in political environment, and unfriendly investor policy environment which cascaded to two major credit rating downgrades8 in March and April. Elsewhere, whilst other commodity exporters, particularly exporters of metals, also struggled to adjust to softer prices, non-resource intensive economies such as Ethiopia and Tanzania continued to grow above 6% due to benefits from lower crude price-induced energy savings, strong infrastructure investments and healthy private consumption.
Amidst the relatively improved risk environment, Africa bourses closed higher (S&P All Africa Index: 5.7% Q1 17) as gains in Ghana (+10.4%), Egypt (+5.3%), South Africa (+2.9%), and Tunisia (+1.0% ) outweighed losses from Nigeria (-5.1%) and Kenya (-9.9%). To our minds, improved equity performance in the period was reflective of impact of relatively upbeat growth momentum on consumer confidence.
In addition, currency have fared relatively better in 2017 after a deplorable 2016 with the Egyptian pound down only 0.2% after the country’s pro-market switch to currency floatation. Elsewhere, the South African Rand rode sustained monetary easing across Europe and expectations of relatively subdued interest rate adjustments in the US to record a 2.4% gain over Q1 17. Going forward, we expect growth rates to vary across countries in Africa with recovery in crude oil proceeds slightly shifting pressures from SSA oil producers to SSA oil importers such as Côte d’Ivoire, Kenya and Ethiopia. Irrespective, near term growth in the latter is expected to be protected by stable currencies, lower inflation, improved agricultural production and large infrastructure programs built over the last three years of soft crude oil prices. Elsewhere, North Africa is expected to post strong growth in 2017 owing to improving crude production from Libya with IMF’s latest review implying a 460bps upward growth adjustment to 10% for the sub-region.
Push-pull factors strengthen FPI flows
Despite two rate hikes in the US and lingering political concerns across Europe, FPI flows to emerging markets (EM) hit a ten-quarter high of $61billion (+141% QoQ) with net portfolio inflow of $29.8billion in March been the highest in fourteen months. The strong capital flows to EM markets reflected recovery in commodity prices (GSCI: +5.1% QoQ), but to a greater extent, broader economic recovery across EM markets. In addition, a more dovish outlook by the FOMC on interest rate trajectory fueled appetite for risk assets, with the IIF reporting an upsurge in flows after the rate normalization in March. In terms of asset classes, FPI flows to EM equities and bonds came in strong at $35.7billion (Q4 16: $3.8 billion) and $26.8billion (Q4 16: net outflow of $29 billion) respectively while, EM Latin America experienced the biggest inflows based on region. Argentina ($17.5 billion) and Brazil ($14.4 billion) were biggest destination for foreign flows following implementation of pro-market reforms and improved political stability, especially in the case of the latter.
Across Africa, FPI flows also improved as uptick in commodity prices and sustained monetary tightening boosted investors’ confidence. Hence, despite currency concerns in Nigeria, FPI inflow of $256 million over the first two months of 2017 is 22% higher YoY—though still significantly below trend levels, while despite deterioration in South Africa’s political environment, the pace of net FPI outflow subsided (-76% QoQ to -$1.2 billion in Q1 17). The picture was much better with dollar denominated debt as strong foreign appetite ensured Eurobond issuances by Egypt ($4.0 billion) and Nigeria ($1.0 billion) were both oversubscribed by 3.5x and 7.8x respectively.
Going forward, we expect recent slowdown in US economic activities to temper the scope of monetary tightening in the country which together with sustained monetary easing in Europe and Japan on one hand and upbeat economic fundamentals in EM markets on the other to sustain the positive momentum in portfolio flows over the near term. That said, likely deterioration in conflict in the Asian Peninsula or election of anti-EU candidates in France or Germany could trigger a temporary flight to safety. Across Africa, we expect a mixed movement in capital flows as ratings downgrade of South Africa credit rating should spook investors while improved FX supply in Nigeria should improve demand for naira assets.
Commodities market Review
Crude price goes from bang to whimper on untempering Shale
Despite the double whammy in the crude oil market, we believe the market remains on track for rebalancing in 2017 as near term bearish sentiments continue to shove crude oil prices pending further impetus from fundamental. On the heels of a bull run in H2 16 (+14.4% to $56.82/bbl.)—following OPEC’s production cut in November 30 which saw crude price track higher in December (+12.6% MoM), Brent crude commenced 2017 on a soft note with prices sliding 2% to $55.7/bbl. in January. This moderation was pinned to faster than expected increases in oil inventories and production in the US. In addition to rising shale production, a stronger dollar also supported the bearish run in the crude price, albeit subsequently moderated by lower crude oil productions from OPEC countries (-900kbpd QoQ) and Russia (-100kbpd QoQ) which saw crude prices close marginally lower in February (-0.2% to $55.59/bbl). That said, a March recovery in US crude stocks9 compounded re-invigorated downward pressures on crude prices. Consequently, Brent prices closed Q1 17 7% lower QoQ to $52.83/bbl.
Away from impact of investor expectations, actual global demand remained relatively upbeat in Q1 17, slowing only 0.7% QoQ to 95.4mbpd after cutback in demand from OECD and other regions. Specifically, OECD demand contracted 30kbpd owing to declines in Europe’s crude oil consumption (-270kbpd to 13.7mbpd).10 In addition to this, mounting sales of alternative-fuel vehicles—a product of improving government backing—and extended turnaround maintenance for US refineries further accentuated squeeze on crude demand.
Elsewhere, slower demand in India and China underpinned a mild contraction in non-OECD demand (-680kbpd). On supply, OPEC and non-OPEC outputs declined 3.4% and 0.4% (QoQ) in the review period following syndicated supply cuts across the industry.
Booming Shale poses risk to OPEC supply cut
In view of elevated prices over Q1 17 (average: $54.60/bbl.), US oil producers became fully active with associated rig counts rebounding (+31% QoQ to 688) and crude inventories touching a record high of 532m/bbl. In addition to this, the US had a record number of contracts on short positions against the WTI in the period. Elsewhere, the energy policies of the Trump administration, in relation to the removal of regulatory/environment roadblocks which has forced the opening of more onshore and offshore leasing on US federal lands and waters to oil exploration as well as relaxation of restraints on US energy exports, supported US production (+10% QoQ to 9.25mbpd). Overall, we think a renaissance in US shale production could cap the OPEC-induced crude price rally. Perhaps providing further backing to this position, the U.S. Energy Information Administration (EIA) said it expected full year 2017 production to average only 9.2mbpd (+8.3% YoY) which amounts to circa 60% of the OPEC cut.
Will extension in OPEC cut support crude oil prices?
Going forward, the big question is whether OPEC will extend ongoing production cut at its next meeting on May 25. To start, given the influence of Saudi Arabia on the cartel, we look to the kingdom’s body language in relation to expectations of further production cut. Indeed, Saudi Arabia and OPEC’s technical committee continue to reference global crude inventories relative to five-year average as a gauge of rebalancing. Thus, with global inventory unlikely to fall that much before May, it is our view that an extension of the productions cuts seem inevitable.
Basically, the combination of high global inventories and recent oil price weakness should prompt OPEC to extend its production cap through the end of the year.
Looking at the demand picture, EIA projects a rise in demand to 1.4mbpd in 2017 supported by China and India. Thus, largely reflecting expectations for an extension of OPEC’s cut as well as the possible rebalancing, we are still positive on oil prices over 2017. However, an extension in cuts and a tighter oil market would put upside pressure on prices and could encourage an even steeper rebound in US oil output. Based on the foregoing dynamics as well as immediate impact of an OPEC cut extension, we envisage that the steady rebalancing of the crude markets should cause prices to trend higher in Q2 17. Brent crude prices averaged $54.60/bbl. in Q1 17, we see a slight uptick keeping crude oil prices at $55/bbl. in Q2 17.
Surplus picture sustains bearish trend in soft commodity prices
Growth in global soft commodity prices was muted in the early months of 2017, with the S&P GCSI Agriculture index rising only 0.06% YTD (2016: +2.6%). To our minds, tame growth in commodity prices reflected pass-through from weather induced increases in production and inventory levels which reversed earlier commodity price gains. A scan through our coverage commodity universe reveals that surplus picture across CPO, sugar, cocoa, barley and rubber markets was the trigger for bearish undertone in commodity prices.
Specifically, CPO prices turned bearish (-13.9% YTD) due to a rebound in production levels in Southeast Asia following recovery from El-Nino weather shock. Also, aiding the price moderation were slowing demand from major importers (India and China) and global oversupply of edible oils which are effectively substitutes to CPO. In a similar vein, contraction in cocoa prices (-8% YTD) was stoked by benign weather conditions, bumper harvests, elevated inventory levels and political stability in Cote D’Ivoire which bolstered outlook for production levels.
Akin to CPO and cocoa, sugar prices (-17.75% YTD) also turned bearish following reports of weaker demand as well as stronger output from Brazil with Thailand’s decision to auction off 107,000 tonnes of rubber acquired at weaker prices also flinging rubber prices into red zones (-29.7% YTD). Elsewhere, oversupply also weighed on barley prices as elevated inventory levels, favourable weather conditions, greater availability of pasture and competing feedstock for livestock worsened investor sentiment towards the commodity. That said, wheat prices however bucked the bearish commodity price trend following its 6.9% YTD growth driven by significant fall in US’ wheat planting area, unfavourable weather conditions in the Americas and Europe and rising demand. Our overall outlook on soft commodities remains bearish as we expect the impact of improved weather conditions to drive stronger harvests and further exacerbate the impact of elevated inventory levels. In addition, weakening demand from consumers in key markets11 should also weigh on bargaining power of key commodity producers thereby exerting additional layer of pressure on commodity prices.
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