Economic Update

H2 Report (July 2016)

By July 22, 2016 No Comments

ECONOMIC AND FINANCIAL

REVIEW & STRATEGY

report picThe macroeconomic environment deteriorated further in H1 16, with fuel scarcity in the first quarter of the year and oil price disruptions in the Niger-Delta further complicating an already precarious climate, while a rebound in oil price during Q2 has yet to have a meaningful impact on Nigeria’s economic fundamentals.
Even as the CBN aggressively tightened policy in Q2 in a bid to fight inflation, CPI skyrocketed in May (+15.6% YoY) on the back of scarcity of domestic farm produce and the impact of currency woes on imported goods prices; forex reserves dipped -10.8% YoY to $26.9bn as dollar demand continued to drain reserves, while the Petroleum Product Pricing Regulatory Agency (PPPRA) hiked the retail price of PMS ~67% to N145.
The CBN eventually caved to persistent currency pressures, introducing a new FX trading structure aimed at floating the naira in a bid to improve market liquidity. It added Dynamic Secondary Market Intervention Mechanisms (DSMIS) auctions in a bid to ensure transparency and moved to promote trading on the FMDQ platform led by market participants.
However, despite a 42% devaluation, the market has yet to achieve meaningful traction as forex sellers have stayed away amidst suspicion that the apex bank continues to tele-guide trading within an effective peg.

CAPITAL MARKET REVIEW
Tracking global trends, Nigerian equities opened to the worst start to a year since 2009 (-16.5% MoM), on bearish sentiments following a drop in Brent crude to thirteen-year lows of $27.9/bbl. While subsequent recovery in crude prices in the months which followed (+76% to $49/bbl), provided scope for positive sentiment towards NSEASI, it was the perceived adoption of pro-market policies in May (PMS pricing) and June (FX floatation) that helped unwind the negative start leading to a positive close to H1 16 (+3.3%).
Markets fell 11.7% in Q1 as lower crude price and unclear domestic policy (delayed budget, FX market). However, as recovery in Brent prices recovered in Q2 16, the implementation of greater flexibility in PMS pricing in early May and CBN’s adoption of flexible exchange rate system in June underpinned the 17% jump in Q2 16–highest quarterly return in thirteen quarters. Significantly, Q2 16’s recovery emerged amidst a barrage of negative macro-economic data, contraction in GDP, fresh attacks on oil production and soaring inflation.

Indeed, even with the dampening impact of the Brexit turmoil in late June, the NSEASI was on track for its best quarter since Q1 2010, as investors appeared to overlook these issues.

Interestingly, the strong market rebound occurred without foreign participation, with a net short foreign positions of N32 billion for domestic equities.

In the fixed income space, after a gradual uptrend in yields in Q1 16, markets were jolted in March by the MPC’s unexpected hike (100bps) in MPR to 12% along with a 250bps increase in cash reserve ratios (CRR). The MPC also narrowed the asymmetric corridor to +200/-500bps (vs. 200/-700bps previously), which effectively increased base rates, setting yields on a definitive upwards trajectory. The Committee cited the need to curtail inflation and encourage foreign portfolio investments as justification while market yields adjusted accordingly, lifted by further remarks from the apex bank on the need to raise real interest rates. Yields maintained this trajectory in Q2 16–even after the CBN flooded the market with $1 billion in June, causing a temporary drop in yields– as the apex bank continued to intervene in the open market, significantly boosting OMO sales during the period.

In line with our expectations the DMO has increased bond issuance to plug the bulging FG budget deficit. It sold N641 billion worth of bonds in H1 16 which is ~43% higher YoY and 9% above the proposed issuance. On the other hand, though demand was fairly robust with bid-cover ratio in excess of 2x in each quarter, investors began to price-in inflation expectations into bid rates. Upper bid rates climbed 2.4pps QoQ to 18% on average in Q2 16, forcing the DMO to sell over 40% on a non-competitive basis at the April auction and reject nearly half of the N100 billion on offer at the May auction. However, with subsisting fiscal pressures, the DMO sold the entire N120 billion at the June at highest marginal rate (14.53%) in 10 months.
The steepness we highlighted in our last report remains, but the biggest impact was in medium tenors even as the entire curve shifted substantially higher.

Significantly, the CBN policy shifts introduces a new dimension into outlook in the form of heightened uncertainty for monetary policy direction.

H2 16 OUTLOOK

For H2 2016, our expectation for the economy is hinged on the sustained recovery in oil prices; the FG’s success in curtailing the pipeline vandalism and the success of the new FX structure.
Oil prices have rebounded since the January 20, 2016 low of $27.88/b. However, while crude has seemly found support at the $45-$50 levels, recent recovery in the rig counts suggest a future pull back in prices.
While the dynamics of the new FX structure are still unclear, inflation is expected to remain high for the remainder of the year and we expect GDP to remain in negative territory in H2 16. Positive policy shifts seem to be taking hold, but are very unlikely to provide fundamental support in the short term.
Finally, as earlier mentioned, the outlook for yields is murky given the CBN’s wavering policy positions.
Consequently, we remain cautious in our outlook and investment strategy. On the one hand, there is a case for further tightening in H2 16 given the substantial advances in inflation, and to counteract the impact of the Naira depreciation. On the other hand, weaker growth and the government’s substantial borrowing needs may put a collar on the MPC’s ability to act aggressively. In general, we expect the recent equity market rally to be short-lived and see further market turbulence in H2 2016, as a weakening naira continues to spook foreign investors and domestic economic and policy woes dampen local investor appetites.

IDEA FOR

THE TIMES

At the end of yet another quarter, we find new validation for a paradigm we have been canvassing these past few years. Situating the discussion in the context of the prevailing domestic and global economic uncertainty our last newsletter made a strong case for investment in risk assets taking advantage of historic valuation lows.
Nigerian equities had endured a long period of adverse sentiment leading to in marked discounts on their value. Our prescription was fairly straightforward: given the great importance of beginning period valuations to long term investment success, we saw this circumstance as an opportunity for investors to gain a head-start on the markets on the journey to their life goals. However, we also highlighted certain prerequisites that conduce to a successful trip, ultimately crafting our advice around arguments that identified high quality, dividend paying stocks—purchased at the right price—as robust vehicles for wealth preservations and growth.
The markets seemingly got the memo. As if on cue, the NSE All Share Index promptly jumped 17% over Q2 2016, the second best performing quarter in nearly a decade; which is all the more remarkable coming from a cumulative 24% dip in the three preceding quarters of consecutive losses. As anticipated in our previous newsletter, the rebound was led by the high
quality (dividend paying stocks) with the stocks in banking, brewery and food sectors—which dominated dividend yield rankings—returning 35%, 24% and 17% respectively on average during the period.
While not entirely unexpected, we did marvel at the strength of the recovery in Q2 2016 given that the underlying economic weaknesses are still very much with us. Nigeria likely entered its first recession in two decades during Q2 2016; government policy was no clearer at the end of the quarter than it was at the time of our earlier newsletter and the dual pressures of high inflation and currency weakness which featured heavily in the arguments we presented therein show no signs of abating.
It would seem that the immediate drivers of equity recovery during the period was the anticipation—and subsequent announcement—of the CBN’s new currency framework that
was widely expected to relieve the capital markets of a profound overhang of uncertainty, the materialization of which we still await. Thus, unless we see a marked change in fortunes, we are under no illusions about the current bullishness in the markets and how long it can hold out.
Nevertheless, in an ironic sort of sense, this was precisely the point: markets invariably overreact; correction in either direction is really only a matter of time; and astute investors make their success of knowing how to time this to advantage.
However, that is by no means the end of the story. There is certainly much more to investing than buying dividend paying stocks, and at this point we return to our paradigm of investment goal setting and financial plans as cues to building a more comprehensive picture.
No longer at ease Before we go on, some charts would be helpful:
The first is one we presented at the client forum in the not too distant past. It shows the performance of UK stocks segregated in to buckets of similar “seasoning”, which refers to the average post-listing longevity of stocks in each category. The original idea that Credit Suisse was presenting in this analysis was that companies that had spent long years weathering the storm (i.e. established companies) tended to be surer bets for investors. Incidentally, considering that these categories of stocks tend to coincide with the quality-dividend spectrum we underscored in the earlier newsletter, this is yet another nod in the direction of that particular argument.

However, our intention here is slightly different. We were trying to highlight the two distinct regimes that could be inferred from the chart, which incidentally cuts across all the stock categories. One remarks that in the period 1980-2000, equities were marked by a rather smooth upward drift which definitely paid off handsomely for the investors. The next 15 or so years was no less rewarding, however it was accompanied by a distinct shift in behavior, with all categories showing a much more pronounced degree of raggedness in their ascent.
For investors who either mistimed their investment and/or didn’t stay the course, this was clearly a much more gruelling journey, with many tears along the way.

CF: Credit Suisse Global Investment Year Book 2014

Buy and Mould

As we discussed previously, equities are important because they can move in leaps and bounds, giving the investor a fighting chance of nullifying the damaging effects of inflation (and currency depreciation) on long term living standards in a way that fixed income investments never could. However, equities also have an unfortunate propensity for moving in the adverse direction at very inopportune times. As can be seen, increasingly frequent episodes of substantial draw-downs in the equity curve can be much more deleterious in eroding investment returns and jeopardizing savers’ goals than the factors (currency depreciation and inflation) we focused on in Q1.

Source: NSE

The basic idea behind a buy and hold strategy is to wait out the slumps in the hope of coming out on top eventually. While this apparently sensible strategy worked well in the calmer regimes of yesteryears, this approach may not be entirely satisfactory in today’s market environment given the much higher orders of magnitude in draw-downs. Clearly, a different line of action is required which incorporates the idea of portfolio insurance to provides investors with safety nets that limit the impact of market downturns, while preserving the intermittent gains that come from rallies. Incidentally, with the rapid evolution over the past two decades, markets now offer a plethora of tools that can help investors better control outcomes. It is within this context that we situate our financial goal setting and planning paradigm, within which all these factors (inflation, currency risk, drawdowns etc.) can be systematically managed to give investors the best chance of meeting their short or long term goals.
Our solution is to offer clients structured investments, which expertly selects a suitable asset allocation to match the investor’s goals, ensconced within a carefully constructed set of defenses against adverse movements, using a wide variety of goal-appropriate tools. The objective is to carefully control downside risk by putting a floor to the worst-case, whilst leaving the investor unconstrained in taking advantage of the massive opportunities on the upside, especially available to less predictable (but potentially much more rewarding) variable income securities (e.g. equities).
Every client’s circumstance is different, as will be the most appropriate plan devised by our advisors and portfolio managers, but the objective is absolutely the same: to help our clients fulfil their biggest ambitions by giving them access to the best the global markets have to offer.

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