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NSR Q4 2017 (9) Fixed Income: Yields Trend Lower As Apex Bank Changed Front

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Friday, October 13, 2017 11:59 AM / ARM Research   

Coming into the third quarter, our prognosis for the naira yield curve was a subsisting uptrend over H2 17 followed by moderation over H1 18. Our expectation for the yield uptrend was premised on retention of the hawkish monetary stance due to concerns on recent naira stability as well as persisting inflationary pressure, even as we expected higher FG borrowings over the period. However, the extent to which actual yield trajectory matched expectation was limited by the evolution of two events. First, the CBN signaled an inflection point policy wise, going by historical patterns.

Pertinently, the apex bank allowed liquidity build up into massive demand at the primary market which eventually resulted in rates decline at the primary market auction (PMA). In addition, the CBN ceased issuance of the one-year bills at its OMO auctions, which led to a downtrend in Treasury bill yields with longer term rates dropping faster than that of shorter-term instruments. The second is tied to the FG’s growing concerns over the debt service metrics with recently released Q2 17 budget implementation report showing that debt service to revenue ratio has hit 41%.

 

Consequently, the FG was less aggressive with its bond issuance even as market favored the primary auction for short-dated securities. Overall, the outcome of these events underpinned a 98bps contraction in the yield curve to 17.47% over Q3 17 against expectation.

 

Taking a closer look at the evolution of the yield curve over Q3 17, yield movement at the short and long-end of the curve was divergent in the first two months of the quarter, though contraction in September cuts across both segments. Largely reflecting the build-up in system liquidity in Q2 (Net OMO maturity of N79.8 billion vs. Net issuance of N933.4 billion in Q1 17), the CBN cut back on rates at its OMO auction in the review period.

 

In addition, banks increased purchase of treasury bills following sustained issuance of stabilization securities which raised the opportunity cost of sitting on excess liquidity6. Farther out, the CBN ceased issuance of the one- year bills at its OMO auctions. Overall, the combination of liquidity build-up, increasing purchase of treasury bills at both the primary and secondary markets, as well as cessation of the one-year OMO bills drove a downtrend in treasury bill yields (-160bps QoQ) with longer term rates dropping faster than that of shorter-term instruments.

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At the long end of the curve, mean marginal clearing rate rose in July (+5bps to 16.25% on average), reflecting lower subscription (bid-ask ratio contracted 25% MoM to 1.56x) and higher government borrowings (+7% MoM to N106 billion). Bond yields further climbed in the subsequent month (August) as investors reacted to the higher marginal clearing rate (+59bps to a seven-month high of 16.83%) at August’s bond auction, reflecting lower subscription7 (-47% MoM to N56 billion) which compelled the DMO into allotting only 42% of the N135 billion on offer.

 

However, over September, amplified subscription levels at the bond auction, on the back of declining rates at the PMA and cessation of the one-year bills drove a decline in bond yields. Specifically, at the last treasury bills’ auction in the quarter, the stop rate on the one-year paper dropped by 152bps (compared to prior auction) to close at 17.0%. The attendant impact of this has cascaded into a downtrend in secondary market rates on bonds. Overall, bond yields declined 34bps relative to prior quarter. Insert chart on T-Bills and bond auction in the last 6 months and 4th quarter of 2017 (Offer, Subscription, Allotted, Marginal rate)

 

Rates sensitivity and waning inflation meld into dovish yield outlook

Having established the key influence of CBN’s change of stance in fueling yield decline in Q3 2017, likely policy trajectory of the apex bank remains central to our yield outlook. In our monetary policy forecast, we expect the CBN to assume a less aggressive stance at its OMO windows to continue to drive rates lower in the near term. On the strength of the mentioned, we expect T-bill yields to decline to sub 18% levels in Q4 2017, with a sizable decline (100-150bps) in H1 2018.

 

At the longer end of the curve, FG’s borrowing pattern remains crucial in formulating an outlook. As noted in the fiscal review, we have a base case scenario8 suggesting an implied fiscal deficit of N3.4 trillion in 2017E (vs. N2.4 trillion stipulated in the budget and N1.8 trillion over the first five months of 2017).

 

Consequently, we assume a fiscal deficit of N1.6 trillion for the second half of the year. Precisely, excluding N724billion issued in Q3 2017 (Net Treasury bill issuances: N318billion, Bond Issuance: N406billion), the FG would need to borrow circa. N900billion over the rest of this year. Given the foregoing, we adopt a successful Eurobond issuance of $2.5billion, translating to N900billion to fully cover our proposed borrowings by the FG and displacing the need for domestic borrowings.

 

We go on to provide a further N450billion (Q4 17 Bond issuance: N300billion and Net T-bills issuances: N150billion). To add, we believe concerns over mounting debt service burden will keep the FG mindful of borrowing cost in the near term. On balance, this would mean moderated domestic borrowings for the remainder of the year and, by extension, sustained yield downtrend at the long end.

 

Tying it all together, 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.

 
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Equities set to maintain upbeat momentum

In our H2 Nigeria Strategy Report, we had predicted that sizable foreign and domestic demand for equities, aided by improved fundamental picture and greater pro-market FX initiatives, would underpin upbeat performance for naira equities. True to this, the NSE ASI posted an 8.3% QoQ gain in Q3 17 largely reflecting strong market performance in July (+8.5% MoM) which more than offset weaknesses in August (-0.3% MoM) and September (-0.1% MoM). As foreign excitement over the introduction of IEW tapered in July—with net FPI flows having shrunk 46% MoM to N16.38 billion, it was domestic participation (+13% to N133.65 billion) that left the bourse in positive territories.

 

Precisely, the domestic support for markets came from the relatively stickier institutional investors, ~60% of local equities participation in the period (vs. 47% in May), who are less apt to cash in on profits in the near term.

 

That said, this resilience on the domestic front slightly gave way in August after domestic retail investors extended profit taking activities to the home turf. As can be inferred from the narrowing moderations in the nation’s equity market bourse (September: -0.1% MoM), investors appear to be gradually re-entering to strategically position ahead of the Q3 17 results.

 

Cascading to sectoral levels, our attribution analysis revealed that the food sub-sector (+29.7% QoQ) had the greatest impact on the equity bourse in the quarter accounting for 49.7% of the uptrend in the NSE ASI with banking (+7.95% QoQ), cement (+3.6% QoQ) and brewer’s stocks (+7.6% QoQ) following closely contributing 32.3%, 14.3% and 13.0% respectively. On the food front, performance was largely supported by rallies in Dangote Sugar (+52.2% QoQ), Dangote Flour Mills (+27.9% QoQ), and Nestle (+34.0% QoQ) following substantial price increases across product portfolios and improved dollar liquidity which buoyed investor sentiments on earnings.

 

Elsewhere, Nigerian banks tactfully cut back on loans to private sector to rewrite lingering issues on asset quality and further stamp their preference for lending to FG via treasuries—with the drive to the latter ably aided by elevated interest rate environment. Similarly, cement sector largely rode price-induced topline growth which offset the impact of expensive energy-mix across the sector.

 

On brewers, support largely stemmed from rallies in Guinness (+32.8% QoQ) and International Breweries (+21.0% QoQ) following impact of price-induced revenue growth and belt tightening measures on earnings. Beyond noted gains across named sectors, investors were also endeared to Personal Care (+4.8%) sector in the period.

 

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Irrespective of the recent rallies, Nigeria’s equity bourse remains cheaper relative to some Africa climes given its P/E of 13.2x (vs. 17.9x for JSE top 40, 14.5x for LUSEIDX, and 13.2x for MXEE9). However, equity investing opportunities look more attractive in Egypt (EGX 30 P/E: 13.1x) with fall-outs from the country’s tilt to pro-market initiatives such as removal of the cap on dollar deposits & withdrawals and an eventual floatation of the Egyptian pound in late 2016 viewed as particularly pivotal.

 
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Equities to ride domestic and foreign excitements.

In arriving at our broad outlook for the rest of the year and the first half of 2018, we retain our view that the trajectory of crude oil prices, domestic macro recovery, FX liquidity, fiscal policies, and pension reforms will continue to dictate the performance of the equity market. On crude oil, we believe that the concussion of US supply resurgence post hurricane setbacks, reported production ramp-up in Nigeria and Libya, coupled with the potential squeeze of spot crude demand & new contracts leave scope for deceleration in crude prices going into 2018.

 

Nonetheless, domestic macro appears set to extend its positive momentum going into 2018 with recent PMI numbers providing earliest indications of sustained resurgence. Beyond this, continued rise in crude export proceeds leaves the nation’s reserves well above the $30 billion mark with CBN’s cash flow position also providing positive re-assurances that the apex bank’s FX market interventions across strata is not yet done and dusted.

 

Needless to mention, recent efforts at achieving unification of FX rates via relatively pro-market and transparent measures are feelers that the market could still see further FPI flows to equity. Perhaps providing some support for this view is the sharp resurgence in net FPI inflows to equity (over seven-fold MoM to ~N123 billion) that came off the back of some profit taking in August. To be clear, with the re-entry targeted towards the end of the third quarter, we believe that foreign investors may have started taking positions in anticipation of further FX-induced earnings.

 

Elsewhere, we expect domestic equity investors to carefully latch on to the bandwagon with key support expected to come from institutional players. Precisely, with alternative yield-paying investment outlets such as treasuries set to become relatively unattractive in line with our expectation for yield downtrend, we expect domestic investors to pay greater attention to equities with companies currently burdened with high domestic interest expense potential benefactors.

 

Cascading to sectors, while lower interest rate environment should ordinarily deem prospect for strong gains in interest income for most banks, we are of the view that the gap would be largely plugged by a tilt towards private sector loan growth. In addition, recent recoveries in crude oil prices and ongoing power sector loan restructuring should limit concerns on asset quality front. Similarly, improved crude production should give hand to upstream O&G share price even though weaker margins in petrol segment—owing to higher input cost—remains likely to drive earnings lower in the downstream.

 

Elsewhere, sectors that largely rode on priceinduced gains this year (i.e. cement) are unlikely to reproduce the aggressive top-line growth momentum in 2018, but investors are likely to take solace from a relatively stable energy cost environment. On balance, we see improved economic fundamentals and gradual recovery as potential drivers of a bull outlook in the coming months.

 

From ARM’s H2 2017 Nigeria Strategy Report 

 

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