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NSR Q4 2017 (10) FI Strategy: Go Long but Be Mindful Of Duration Risk

Reviews & Outlooks	3262 VIEWS
Reviews & Outlooks
3262 VIEWS

Friday, October 13, 2017 2:20 PM / ARM Research

In our Fixed Income review and outlook section, we made our call of a further downtrend in yields up till H1 2018 on the back of accommodative monetary policy and FG lighter borrowing patterns on the domestic leg. To be clear, we see a subsisting downtrend in the level and slope of the naira yield curve over the next six months with dovish monetary policy, lower domestic borrowings, and perhaps some form of coordination with monetary policy to ease financing costs to drive yields lower.

Irrespective, beyond the first half of 2018 comes a looming risk that can volte-face our call – political risk gearing towards the election. First off, increased electioneering spending—expected to commence in the latter period of H2 18—raises scope for some temperance in the pace of inflation deceleration towards the close of the year. Secondly, a possible desperation by the FG to fulfil its earlier mandate will moderate earlier sensitivity towards borrowing cost and channel a sizable portion of deficit financing on the local market as the uncertainty gearing towards election may keep foreign investors jittery, moderate inflows and stir capital flight, thus pushing yields up.

Consequently, naira would likely come under pressure. Tying it all together, we see a more volatile pattern in the level and slope of the naira yield curve over the next 15 months with dovish monetary policy and elevated repayment cycle in H1 2018 creating a gravitational pull on yields. Farther out, the political risk in H2 2018 implies some form of yield uptick, which would certainly point to further yield curve twists.

Having framed our outlook, we see merits in positioning bond portfolios towards the long end of the curve but slightly lowering position at the very long-end. Short and medium term is a good place to be at this point because the segment has been doing well. We are not completely in favor of going all-out long-end because that would mean higher volatility as our H2 2018 call plays out.

Basically, we recommend a staggered approach to building duration with emphasis on mid-tenured bonds on the downward slope of the naira curve in a bid to ‘run-down the curve’ as dovish influences kick into gear over H1 2018. Farther out, as yield uptick slightly sets in and currency shows up, we advise a rotation back into the money market to wait out the political risk storm. Overall, our strategy calls for investors to position bond portfolios with an eye on flexibility ahead of what promises to be a roller-coaster 15 months for debt markets.

Equity Strategy: See buying opportunities in coming shocks

In our H2 17 outlook, we held the view that investors adopted a contrarian approach to selected names as against a ‘Buy and Hold’ strategy. This view reflects our less sanguine outlook for equities over the second half of the year relative to H1 17 given the rich valuation across most of our selected names in the equities space which limited the scope of significant upside compared to H1 17.

In all, we projected a more tepid rise in the NSE-ASI with short term market volatility attributed to the intersection of profit takers and bargain hunters. Indeed, the muted equity market performance measured in terms of average daily traded (volume and value) in Q3 17 relative to Q2 17 suggests our call largely played out.

In arriving at our strategy for the rest of the year and the first half of 2018, we retain our view that the trajectories of crude oil prices, domestic macro, FX liquidity, fiscal policies, and pension reforms remain crucial with developments in the last four expected to support further rallies. To be clear, we expect gains from the quartette to make up for impact of potential interest rate hike and balance sheet downsizing in US, European tilt towards hawkish monetary policy orientation and prospective crude price contraction going into 2018.

That said, initial reactions to global monetary policy changes and shocks to oil are still likely to provoke transitory upsets in the market even though our overriding view remains bullish. To re-iterate, a major underpin for our equity market optimism is the projected moderation in yields that would limit investment options for both domestic and foreign investors in the coming months. Even now, institutional appear to have switched into panic mode as they attempt to lock in higher yields for fear of the coming interest rate downslide.

Thus, with the allure of higher yield gone, 2018 should see a gravitation towards investments powered by company fundamentals with companies currently burdened by high domestic interest expense (i.e. UACN) likely to be among beneficiaries. In passing, we also note that on the back of expected rates moderation, tier two banks’ funding costs should fall more quickly than their interest income to provoke some rebound in net interest margin in the coming year.

Thus, juxtaposing this tempered bullish run with the positive view on selected stocks, we assume steady swings in coverage names for the rest of 2017 and H1 18 and thus retain our recommendation of a flexible approach to comfortable stocks—buying the dips and selling the rally as against a “Buy and Hold” strategy. For instance, we expect the intersection of lower crude price as well as interest rate increase & balance sheet downsizing in the US to present the last buying opportunity of 2017 by December.

Farther out, with 2017 largely a year of strong earnings rebound for most coverage names, attractive dividend yields on FY 17 corporate result is expected to spur buy momentum and create selling opportunities early in the second quarter of 2018. For clarity, this expected dividend play should also drive appetite for most part in Q1 18 though with the incline for profit taking currently high amongst foreign portfolio investors and domestic retail players, market gains are likely to be shortlived.

In conclusion, we re-emphasize that times of higher market volatility, while often trying for individual investors, can be opportunities for skilled active managers. For us, we think after a strong counter trend move, if 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.