Monday, October 24, 2016/ 10.44am /Meristem Research
The Nigerian economy officially slipped into recession in the third quarter of 2016 and the output gap has been widening. The economy has been experiencing severe strains and macroeconomic instability being aggravated by its exposure as a commodity exporting country.
Worrisome fiscal imbalance combined with tight financing conditions and dry external funding pipeline have also contributed to the challenges. Balance of risks to growth has been tilted to the downside.
Domestic private demand has been subdued by high unemployment and rising inflation while business investments have been scaled back on account of high borrowing cost and mounting credit risk.
Net export has also been a drag on growth from the treble combination of low oil prices, low production volumes and relatively high import levels.
Convoluted Macro Indicators
Oil price averaged USD46.99pb over the period and production was 1.47mmbpd (August) vs. budget benchmark of 2.2mmbpd and Q2 average of 1.55mmbpd. Inflation hit a multi-year high of 17.85% up from single digit at the beginning of the year.
Unemployment was at 13.3%, underemployment at 19.3% and labour productivity declined. Reserves dropped by USD1.8bn (7%), while the naira almost touched 500 at the parallel market before being rescued. The interbank Foreign Exchange (FX) market however knew much respite and exhibited little volatility in closing prices for the period.
The period saw the Monetary Policy Rate (MPR) increased from 12% to 14% with the intent of making the yield environment more attractive for capital inflows, deepening the FX market and improving liquidity in order to combat inflation and boost the desired growth via improvement in industrial and manufacturing output.
Capital importation in Q3 (July and August) was 203% higher than the corresponding period of 2015. The flows were concentrated in portfolio investment in bonds, money market instruments and loans, and can be adjudged to re-affirm the expected high interest rate sensitivity of capital flows.
However, 75% of those funds came in from the UK relative to 30% average inflows over the preceding 12months. This might not be unconnected to the reduction in UK Bank rate to 0.25% on August 3rd. This therefore raises some skepticism about the sustainability of these inflows.
Stable Financial Sector
The financial system was quite stable except for the rising non-performing loans (NPL) by corporates, and some trickles of new flows that suggested the recourse of some banks to the discount window to finance their settlement obligations, which implies above-average liquidity risk.
Notwithstanding, there are no systemic risks in sight. The apex bank, CBN, has also reaffirmed this position and its resolve to support the system.
The state of the economy threw up alternative financing means for the government and the issue of asset sale was a major theme towards the end of the quarter. Fiscal fragility has crippled the ability of the government to realize their expansionary policy intentions. Debt levels are rising, Federal Government of Nigeria (FGN) debt to GDP ratio of 15%, and interest payment to revenue of circa 51% in 2016 are not encouraging.
What does Q4 hold in store?
The high uncertainty in the economy makes it more challenging to properly gauge expectations, however, trends in some key macroeconomic indicators provide good guide for the outlook for the current quarter, Q4.
· Global Economic Outlook: Global output expansion is expected to be weak following subdued growth in the EU and UK, and bouts of macroeconomic instability among emerging markets economies.
If the inventory cycle in the US has run its course, as expected, there will be some mild uptick in growth but this will be insufficient to offset the drag from other regions. Bond yields response to the widely anticipated Fed funds rate hike is also expected to narrow the interest rate differential with Nigeria and might claw back capital inflows except if there is a policy response from the CBN, such as ‘corresponding’ hike in MPR to maintain the differential.
The recent developments with global banks is also increasing the flight to safety. The above suggests a weak external environment with implications on capital and trade flows, as well as on domestic monetary and fiscal policy responses.
· Domestic Growth: Developments so far in October do not suggest that the output contraction will be narrowed in the quarter. Private domestic demand has been weaker, being pressured by rising inflation and higher job losses. Business investment is largely on hold as firms are striving to maintain their current levels of operation.
Fiscal consolidation conditioned by the inability to optimally implement the NGN6.08tn 2016 budget as well as the need to adjust to the current imbalance is not providing any expansionary drive to support growth. Net export appears to give some impetus to growth on account of rising oil price and the positive outlook on November and December oil export volumes. This is however masked by the expected drag from other GDP components.
From a sectoral perspective, we project marginal growths in the Information & Communication, and Arts, Entertainment and Recreation sectors while we are downbeat on Agriculture (due to seasonal effect), Construction, and Manufacturing, Wholesale and Retail trade.
· Fiscal Stance. We expect Q4 to be dominated by the legislative approval of the 2017 budget and assessment of facilities from both the IMF and the AfDB. Progress is being made with the latter but the disbursement is not expected until 2017.
Conditionalities of IMF loans; which might embed such policy adjustments as ‘tighter monetary conditions’ than current level of 14% policy rate, more exchange rate flexibility in absorbing the external shocks, which are expected to persist, ‘significant fiscal adjustment particularly on the revenue side’ in order to contain the deficit; need to be clearly evaluated in the light of the broader impacts on other macroeconomic variables.
The floatation of the USD1bn Eurobond of the USD4.5bn FG Medium Term Note program in the International Capital Market (ICM) is also expected to gain traction during the quarter. On another note, if the MoU between Nigeria and India on the USD15bn investment, which is expected to be finalized in December, comes through, it will shape fiscal policy outlook in 2017, especially with respect to the external funding mix of the deficit.
A back of the envelop analysis
Government intends to spend NGN6.86tn of which it believes it can generate NGN4.17tn, thus, leaving a deficit of NGN2.69tn. If the deal goes through, to avoid double counting, we will net the expected revenue from the crude sales to India. This is however not very substantial given crude oil/gas sales to gross federallycollected revenue at 14% over the last 9 quarters and 8% in 2016, FGN’s federation account share of the gross federally-collected revenue 30% each over both periods. The link is of course non-linear but a 5% reduction in estimated revenue is a fair approximation.
Not to lose sight of the bigger picture, the government should be battling with a deficit of c.NGN2.9tn, which at the benchmark exchange rate translates to c.USD10bn. If half of the 2-year USD4.2bn AFDB funding comes in 2017, and 600mn from the difference between replacement of the maturity value of the maturing Eurobond obligation and issue volume of the proposed issue, and a third of the USD15bn from India flows in (one-third assumption for fiscal prudence since it is an accrued revenue for a medium-term contract), the naira equivalent of the deficit will amount to c.NGN0.7tn and can be easily absorbed by the domestic market. So the point, if the deals goes though, it will be a substitution for the IMF loan but if it goes mute like the China deal, then recourse to IMF loan might be explored.
· Yield Environment: The MPC still has a meeting before the end of the year (on November 22), and the case for an upward revision to the monetary policy stance might not be met with favorable sentiments considering the economic strain in the last quarter. However, given the option of the concessionary external funding from the IMF in the midst of external liquidity squeeze and the soft recommendation for a more tightening stance, the trade-off for tighter monetary conditions cannot be completely ruled out. But we think this might be on hold until the outcome of the proposed investment relationship with India in December. Notwithstanding the current tight stance of monetary policy, the yield curve level has been stable and we do not expect major shift except if the MPC decides to favour a tighter monetary policy stance, which will invariably shift the yield curve higher.
· Inflation. Price development in October has been trending upwards and is expected to add more pressure to the CPI inflation for the month and persist till the end of the year with constant re-pricing of goods in the light of the FX scarcity. If we go by data generating process of inflation and the gradual reduction in the month on month (MoM) inflation since May, statistically, we will be inclined to expect inflation to nearly flatten out for the quarter. However, if we factor in the recent price shocks in October, this supposition will break down and on this note, we expect inflation to increase to c.18.5% for December.
· Unemployment. We expect the current trend to persist given the slack in the economy, low capacity utilization and operating challenges faced by firms in a bid to stay afloat. Underemployment is also expected to rise over the quarter.
· Reserves. There has been increased supply of FX to BDCs with the on boarding of Travelex, who sells home remittances through autonomous sources to the BDCs.
However, the monthly remittances averaged USD23mn in 2016 and USD13.9mn in July. This does not appear adequate to match the estimated BDC demand (proposed supply of USD50,000 per week to each BDC) and the appreciation witnessed in this market segment might suggest some cushion being provided by the monetary authorities.
For this to be sustained during the quarter, some reserves will need to be released. This is very key as the alignment of the BDC rate with the interbank rate to ensure adequate positioning for accessing the concessionary funding if the government decides to, appears to be getting attention.
Be that as it may, is the level of reserves adequate to maintain confidence in the currency? Based on the import cover, the current level of reserves can cover 6 months vs. minimum of 3 months as suggested by the IMF and 6 months West Africa Monetary Zone (WAMZ) criteria.
Another traditional benchmark, the ratio to broad money, suggests that the reserves at 22% of broad money at NGN/USD197 (34% at and NGN/USD305 interbank rate) is at the threshold of the required minimum of 20% for fixed exchange rate system and more than double the 10% for floating exchange rate system and.
Lastly, we adopt the Greenspan-Guidotti rule, which recommends that the reserves be at least 100% of the stock of short-term debt. In this regard, the level of international reserves is very adequate at over 200%.
The concerns with the reserves therefore bother on its adequacy when stressed against a prolonged period of low oil receipts, low capital importation and high import levels.
Beyond 2016, Nigeria at its potential
At present, the economy does not appear to be giving encouraging signals but does that tell the whole story? Most definitely not, when the potential real GDP growth is factored in. The potentials of the economy have been masked by the current headwinds and the near-term deteriorating prospects. International Labour Organization’s (ILO) estimates of labour force participation rate showed a downward trend from 57% in 1990 to 55% in 2004 during which it witnessed a structural break and has since grown at an average of 0.1% to 56.2% in 2014.
Population estimates by UNCTAD show a potential expansion to 59% by 2050 and 66% by 2100. We therefore estimate a labour force participation growth rate of 0.5% which falls within the lower limit of the 0.1% historical average from 2004 and 0.9% upper limit based on the population outlook. Adding this to the expected 2.2% growth in labour force through to 2050 (0.3% higher than estimated long-run population growth rate), we expect an increase of c.2.7% in labour supply.
This growth appears reasonable based on the supporting demographic features of higher participation by females, and secondly, addition of newer sectors such as the entertainment and telecommunications sectors within the last two decades, and the budding ICT sector as well as many others that are anticipated to emerge and/ or deepen in the import substitution drive of the government. 25-year historical average labour productivity growth rate stands at the 2.3%.
This underestimates the 3.2% post GDP-re-basing average as well as 3.6% 13-year OECD average of the basket of emerging markets. Technological improvement and better work organization makes us believe in a slightly higher growth rate than the historical average suggests, and we are thus inclined to lean towards an estimate of 2.8%.
When added to the estimated labour supply growth rate, it yields an expected real GDP growth rate of 5.5%. A more optimistic expectation of growth in potential labour force of 2.9% produces a 6.3% real GDP growth rate. The variance between the two estimates is not too wide and even if the underlying assumptions were relaxed, the narrative still points to a healthy long-run growth prospect for the economy.
What do these mean for us?
The economy is currently experiencing a negative output gap due to the recession and also partly because of a huge resource slack (even in boom times) as a result of the economy being deep inside the production possibility frontier. The implementation of a comprehensive fiscal policy framework complimented with supportive structural policies and optimal monetary policy, and the realization of the government’s inclusive growth plan should see a gradual reduction in the margin of slack, and also open up ample employment-generating opportunities.
The influx of private equity firms into the country is a testament to this growth prospects. Notwithstanding the current headwinds, the economy still presents ample investment opportunities. Typically during recession, aggregate demand is weak and both inflation and bond yields are low, but the reverse is the reality in Nigeria, and it has created attractive fixed income investment opportunities
What are the expected impacts on asset classes?
Earnings are a key driver of equities valuation and the current underperformance of the Nigerian equities market is a not unconnected with weak corporate earnings releases amongst other factors.
As the economy begins to show signs of growth at the initial recovery phase, equities market should respond favorably by amplifying the growth momentum. Given that the duration of the recession is expected to last between 12 and 18 months, the stakes are favorable for a market rebound.
We estimated the long-run earnings growth rate of the equities market to be c.9.3%, which is a composite of 4% expected inflation rate (long-run target estimate taking into consideration the WAMZ convergence criteria) and 5.3% real earnings growth rate.
The latter was derived by discounting the real GDP estimate to account for 3 factors; (1) the weaker expected earnings growth in the equities market index relative to the broader economy, a wider disparity in the composition of the equities market index (74% industrial goods, banking and consumer goods) relative to the aggregate economy (>50% agriculture and services sectors combined), and (3) a large number of private and unquoted companies relative to the listed counterparts.
Nigerian equities market is currently valued at about 14x its earnings, which is same as frontier market average, slightly below 15x for emerging markets, and significantly below 24x for developed markets.
The PE series is not covariance stationary based on the KPSS test which rejects the null hypothesis of stationarity, and the Autocorrelation Function (ACF) which decays very slowly, and so statistically, there appears to be no long-run mean or equilibrium level to which the PE is expected to revert to.
However, from a behavioral finance perspective, the market seems to have set a psychological mean PE at around 13x-15x and it has been oscillating closely around the lower bound. The volatility of the PE ratio as measured by the standard deviation is 1.7, and the minimum and maximum values being 2.4 and 3 standard deviations around the average respectively. We do not envisage that the distribution of the PE will be substantially different from the historical.
Market rebound must be driven by strong demand for equities which must outweigh supply. Whither the demand? Local investors, both retail and institutional, have increased their asset allocation to fixed income instruments due to the current high yield environment and as long as it persists, demand for equities might hover around current levels.
Foreign portfolio demand for equities has been shallow as seen in the chart below, and more importantly, it took a hit in August just after the MPR was increased by 200 basis points in July, while capital importation into bonds and money market instruments surged.
We witnessed similar surge in February 2015, when the RDAS market was closed, and this current episode might not be significantly different due to the concentration of the inflows from a single country, UK, as earlier expressed.
Based on the outlook on the drivers of the equities market as stated above, we are not very optimistic on the near-term rebound in the market. Market recovery is a function of emergence of tailwinds (i.e. some conditions or situations that will help move growth higher) in the broader economy. Consumer goods companies, conglomerates, construction/real estate are not well poised to offer attractive returns in Q4 given the pressure on their earnings as seen in the Q3 results. Most stocks in the oil & gas sector are either fairly valued or overvalued.
In the industrial space, DANGCEM has the potential of enjoying December effect. Banking stocks with healthy prudential ratios and high trading volatility, such as GUARANTY, ZENITHBANK and ACCESS, are good picks for the quarter. Also, in the financial services sector, AFRIPRUD and UCAP have shown operational resilience and should offer good dividend, hence, a good pick ahead of the dividend.
Expectations on the level and shape of the yield curve is key to gauging our optimal strategy. For this analysis and given the negative nominal spread of bond yield over T-Bills, we include the yield in the T-Bills in the curve to have an appreciation of the market
Case for an upward shift in the yield curve
The case for an upward shift is related to the possibility of a further monetary tightening stance.
· The IMF advised that monetary conditions need be tightened beyond current levels because the pressure on the naira is due to monetary conditions not being tight enough. This therefore suggests that the tightening cycle might not just be over yet. If the India deal does not go as planned, the government might default to the IMF offer given the paucity of alternative funding windows and the need for effective implementation of the 2017 budget.
· In view of a likely hike in the Fed funds rate before the end of the year and the need to maintain a reasonable interest rate differential, the case for tightening becomes more appealing.
· The MPC has been motioning positive real rate of return and with inflation at 17.85% and average bonds yields stable at c.16.05%, the argument for tightening is further justified.
· Given the quantum of inflows into the bonds and money market space in August, just after the MPR hike, the MPC has more evidence to re-affirm the need for a contractionary monetary policy stance.
Case for a downward shift in the yield curve
· The increase in average T-Bills yield from 5.9% in January to 19.5% was triggered among other factors by the expectation of the market of government’s recourse to domestic borrowing to fund the budget. With the early commencement of preparations for the 2017 budget and discussions around funding, T-Bills yields have the potential to moderate.
· Primary valuations, which reinforces the secondary market pricing has been tempering as seen in the recent stop rates for T-Bills. Average bond yield has also not been responding to inflation and other pressures as expected and the trend might persist. Bond yields have been flat at c.16% over the last 2 months.
On a probability weighted basis, there appears to be a likelihood of policy tightening in the near-term.
How long will the tightening stance be?
We view it optimal for the monetary authority to begin tempering its policy stance to stimulate both consumption and investment once government spending has ramped up and the multiplier effect has filtered into business investment and consumption.
Thus, the timing for monetary policy easing will be contingent on the degree to which fiscal policy, via the expansionary budget, has created a more enabling environment for business investment.
In other to lubricate the interest rate channel for effective policy transmission, the CBN can, in addition to the existing risk-based lending framework for banks, have banks offer both floating and fixed rate loans such that borrowers have the luxury of choosing either at the point of taking a facility. If the divide between fixed and floating rate loans are fair, the latter will help a more effective policy transmission.
How will the shape of the yield curve evolve?
We are of the opinion that the inverted curve (T-Bills) might persist for a while. The anticipated FPI inflows on account of the yield environment will seek to be hedged and the longest FX forward contract is 1 year. This presupposes that most of the investment will be locked in for the short-term.
In addition, that segment of the curve is the most attractive and to attract the desired FPI flows and possible increase it, the yields must remain attractive. All these points towards the likelihood of a higher yield at the short end of the curve and impliedly an inverted curve.
Strategy to Play Market in Q4
· In the light of the above, a shortening of bond duration to maturities in the short to intermediate range, while not losing sight of the average duration of liabilities for the likes of pension funds and insurance companies, will be optimal in capturing value in this current terrain.
· In addition, a bond swap strategy, specifically pure yield pick-up swap in which low coupon bonds are substituted for high coupon bonds and T-Bills, will also serve to boost current income.
· Asides the 2018 series, which is off-the-run, average yield in the intermediate to long run maturities is 11.1% while the short to intermediate maturities is 13.4%.
· A pure effective duration approach might not be very appropriate given the expectation of a non-parallel shift of the yield curve.
· As the monetary policy begins to ease, we advise a swap to long duration bonds, which are trading at decent discounts and will provide good capital appreciation.
· This strategy is a bet on the level and shape of the yield curve and thus has, its own risks but the underlying assumptions are modest and should not unduly expose a portfolio to unwarranted downside risks if the future path of interest diverge from expectations.
1. Reviving Nigeria’s Economy: Experts set agenda for 22nd Nigerian Economic Summit
2. Nigeria Outlook - Seeking a Winning Formula
3. Nigeria: Finding Gems in the Rough
4. Nigeria and Lessons of Ethiopia's Development Model
5. Federal Republic of Nigeria Ratings Lowered To 'B/B' On Weak Growth Dynamics; Outlook Stable
6. Ways Out of Recession – FSDH