Economic Update

H1 Report (April 2016)

By July 22, 2016 No Comments

ECONOMIC AND FINANCIAL REVIEW

h2-reportThe impact of low oil prices continued to drive weakness in the Nigerian economy in Q1 2016.
The NBS released a worrisome combination of macroeconomic data in which Q4 15 real GDP figures slowed to +2.11% YoY and February inflation jumped 180bps to 11.4% YoY. The GDP numbers reflected the combined impact of an 8.1% YoY decline in oil-GDP and flatness in non-oil, while the inflation figures were linked to the ongoing fuel shortages, costlier imports, and the rise in utility tariffs.

The data presented a stagflationary backdrop to the most recent Monetary Policy Committee (MPC) meeting where the Central Bank tightened MPR 100bps to 12%, raised CRR 250bps to 22.5%, and narrowed its asymmetric corridor to +200bps and -500bps; surprising analysts by its hawkishness in a time of macroeconomic distress. From the MPC minutes, the Governor highlighted the weak foreign portfolio investment flows (FPI)
and the need to curtail inflation as reasons for the switch in stance. This was all puzzling for two reasons: First, the bank had hitherto been at pains to emphasize that, in contrast to the previous regime, FPI was not a major factor in its decisionmaking. Secondly, the Governor admitted, in his speech, that inflation was driven by “structural problems” outside the ambit of monetary policy. It is not clear then how a tightening stance addresses the issue.

Nevertheless, while it was clear that currency concerns remained at the forefront of the MPC minutes, no clear policy was set forth. Over Q1 16 as the CBN’s reserves continue to decline (-4.07% to $27.88 bn) even as oil prices recovered from a decade low of $28.71/bbl in February. Nevertheless, the Q1 16 average price of $35.20/bbl is still about 34% less than the 2015 average—Brent closed the quarter at $39.6/bbl. For the moment, the CBN continues to defend the currency at the N197-N199/$ range but it is evident from widening parallel market premiums that the real economy continues to face major headwinds from currency woes. Ask prices at the parallel widened 22% more to N320/$ over the quarter.
On the positive side, after two failed attempts, the FG finally got its 2016 budget through the senate, though at N6.06 trillion, the budget is substantially lower than the N6.6 trillion initially proposed. Progress with budget comes as positive news because in the face of unpredictable monetary policy, the lack of fiscal spending continues to squeeze the real economy.

Equities 

Weakness in the macroeconomic environment continued to reflect in equity markets as the NSEASI closed 9.6% lower at the end of the quarter. The Banking sector (-13.93%) was driven lower as largely positive FY 15 performances were marred by poor Q4 15 numbers. Other noteworthy sectoral underperformers were Brewers (-11.67%), Consumers (-15.33%), Personal Care (-22.58%) and Oil & Gas (-12.15%)–all of which were driven in main by the sustained weakening of the consumer’s purchasing power and bearish oil prices performance. Incidentally, the best performing sectors were Construction (-0.85%) and Cement (-5.17%), both which are expected to be direct beneficiaries of increased capital government expenditure.

Fixed Income 

73bps and 383bps below the corresponding reading in Q3 15 and Q4 14 respectively 

High levels of market liquidity in Q4 2015 drove rates lower across the yield curve; in which, in combination with duration risk at the longer end of the curve, caused a pronounced steepening. In Q1 15, the CBN returned to the market in an attempt to mop of the excess liquidity from the previous quarter, providing some support for yields. Average yields trended higher following the latest MPR hike, pushing T-bills and Bonds yields 200bps and 170 bps respectively at the end of Q1.

Figure **: Yields and Market Liquidity

Q2 16 Outlook & Strategy

Our expectations for global oil prices remain bearish, and while the 2016 budget proposal is suggestive of some growth stimulus, the acceleration of inflation undercuts optimism for any incremental real benefits to the consumer. In addition, monetary policy inconsistency doesn’t leave much promise for the economy. However, the CBN did promise currency market reform at the last MPC meeting, which may alleviate pressure on FX and its knock-on effects on businesses and the real economy, but until it provides further clarity, we can expect that parallel market premiums will continue to widen.

Our expectations for equities for Q2 16 are slightly bearish given our prognosis for oil prices and consumer weakness.
Nevertheless, year-long market declines have brought valuations to multi-year lows with the high quality equities trading cheaper than they have been in years. Our strategy continues to focus on selecting names in preferred sectors wherein we see long term fundamental value e.g. Banking (GTBank and Zenith), Consumers (Nestle, Presco), Cement (DangCem) etc.
We expect these, which form the core of our portfolio holdings, to outperform their peers in the short to medium term.

Our fixed income strategy has shifted slightly from Q1 16. We expect the CBN intensify efforts to rein in liquidity levels as persistent currency weakness apparently drives a change of strategy at the apex bank in its recent volte face to attracting foreign capital to the financial markets. We also believe that the impact of the MPR hike has not fully reflected in yields and expect longer term yields to trend higher in the near to medium term. In addition, we expect investors to steepen their pricing of future risk in consideration of erratic policy and incipient inflation, as well as continued uncertainty in the local currency, all of which will act to undermine longer term investment. On this basis, while we maintain interest in the 1 – 3 year range where yields remain most attractive, we will likely expand trading activity to take advantage of a probable increase in debt market volatility in longer tenured securities.

Your Investments:

WHY IT SHOULD BE
GOAL BASED

In recent years, ARM Investment Managers has sought to build a platform for working with our esteemed clients to develop a robust investment programme via our complimentary Financial Planning Service. This service seeks to optimize outcomes for our investors based on the principle of Goal-Based Investing; an approach which we believe has been validated by recent economic and sociopolitical developments in Nigeria.

Goal based investing wasn’t always considered mainstream or entirely consistent with the key theoretical pillars of modern finance, but as market globalization spurred pronounced asset class volatility and the preponderance of downside risks, progressively invalidating prevailing investment paradigms,
recent evidence, beginning at the turn of the century and accelerating since the last global financial crisis, has mounted in its favour as a more realistic and robust approach to building an investment programme.

Goal-based investing invites investors to identify their primary goals, understand the threats and vulnerabilities economic and market uncertainties impose on achieving these goals and design a tailored investment programme that mitigate these and optimally interact with match market opportunities (as
articulated via astute asset allocation and risk management) in the context of these vulnerabilities.

To bring this discussion home, we take, as an example, of one of our more popular offerings: the education plan. With the panicked monetary policy response to macro-economic dislocations and currency pressures from the onset of a rapid collapse of oil prices many parents and guardians suddenly find themselves challenged in funding the foreign currency expenditure of their wards, and many well laid plans, either for their ongoing or prospective education may very well be endangered. However, having identified this as a key life goal, much of this uncertainty may have been contained by an education plan which specifically seeks to address the risks around this goal—which after all are not entirely new, Nigerian having gone through several bouts of devaluation in the past.
The next section explains the working of the various strands of education plans we have developed for clients.

The Education Plan
Few things are as important as a child’s education; it is an investment with potential for exponential returns, and a necessity in the competitive race of life. Unfortunately, the best education often comes at a high but often unpredictable costs. At ARM, a dedicated team of highly trained professionals who have personal understanding of the challenges, and are equipped with the array of tools and skillsets necessary to making your child’s education financially secure. For financial advice, feel free to send us your contact details and an ARM Relationship Manager will contact you.

How much will it cost?
Over the last 10 years, education inflation in Nigeria has averaged 11%. This means that by 2026 the cost of the average four-year undergraduate degree tuition at a Nigerian University could be around N7 million – just for tuition. Adding the cost of accommodation, upkeep, books and other associated expenditure, the price tag for a good education is likely to accelerate as growing demand from a youth bulge continues to outstrip sluggish supply of school placements.

How much will it cost?
Over the last 10 years, education inflation in Nigeria has averaged 11%. This means that by 2026 the cost of the average four-year undergraduate degree tuition at a Nigerian University could be around N7 million – just for tuition. Adding the cost of accommodation, upkeep, books and other associated expenditure, the price tag for a good education is likely to accelerate as growing demand from a youth bulge continues to outstrip sluggish supply of school placements.

Figure 1: Expected Cost of Nigerian Private Undergraduate Education (N mil)

Downside risk refers to a permanent diminution in asset value (relative to target in a given period) as opposed to volatility which is more akin to value fluctuation and uncertainty in timing.

How much do you want to save?
The great thing about ARM’s approach to education planning is that it is designed to be flexible enough to respond to client’s changing circumstances and always save them money in the long run. For instance, a client may favour lower annual contributions, and in this case benefit by starting the plan earlier, whereas a client who prefers making fewer contributions could benefit both from starting early and contribution more.

Clients can choose how the structure their contributions e.g. bullet payments or lump sums, they can also decide on the specific number of years for which they would like to contribute.

Relying on market research to tailor our solutions our clients’ circumstances, our plans can offer unparalleled stability and
reliability.
How can ARM help you?
At ARM we have created propriety models for helping our clients save for their children’s education. We develop investment plans designed to suit the specific needs of clients. For example:
Tope is 9 years old and currently in her final year of Primary school. She is bright and has a passion for sciences. Tope has made clear her ambition to be a Mechanical Engineer. To insure their child’s dreams, Tope’s parents wish to save enough money using an ARM education plan to fund her education at a prestigious private Nigerian University. ARM prepares the following plan;

Bespoke plans for your specific needs…
As a fully integrated financial services firm, ARM has access to global capital markets. Leveraging this with our grounding in comprehensive research and financial tools, we can possess the capacity and infrastructure to cater to clients that wish to fund plans in US Dollar and Pound Sterling.

Taking into account the future impact such variables as FX movements, education inflation and expected market returns, our plans emphasize value preservation and offer a versatile tool which enables clients fulfill their wishes to educate their children anywhere in the world come what may.

Idea for the times:

DIVIDEND INVESTING

he fall in global commodity prices set in motion a series of adverse reactions in the Nigerian economy and a policy response that, so far, leaves much to be desired. These events have also accentuated phenomena that have pockmarked the Nigerian investment scene over the past few years: Uncertainty, devaluation and inflation. While these features may appear highly undesirable on the surface, they have very significant and potentially beneficial implications for an investor’s asset allocation plans, particularly in the context of goal based investing. We take these in turn.

This is why crises periods are sometimes an astute investor’s best friend, since the uncertainties they engender in markets invariably lead to mispricing of varying degrees of severity, as a majority of market participants succumb to fear.

Devaluation and inflation: The collapse of Nigeria’s fiscal revenues and import earnings has also driven currency devaluation and inflation. This is highly significant from an asset allocation perspective because due to a common psychological phenomenon termed “money illusion ” the effects of these important factors become more insidious, but no less destructive. Consequently, investors will often react to bouts of market uncertainty with an ostensible “flight to safety” which in this context often means the “predictability” offered by fixed income. But safety and predictability usually do not coincide, especially in this particular context, since fixed income is more susceptible than virtually any other asset class to the immense combined value eroding effects of devaluation and inflation over. An optimal allocation in this case must include assets that have the tendency to preserve real value, i.e. to so called real assets (e.g. real estate) and equities. Both classes of assets have very different characteristics which apply to a variety of investor circumstances, but are similar in the one feature where they historically demonstrate a strong propensity to preserve real value over time.

We have seen this many times before. The chart below makes an example of the performance of T-bills vs equities in the Nigerian market in real terms over the 25 years since 1990—a period within which period the Nigerian economy witnessed significant bouts of both currency devaluation and inflation.
For comparison we also include the performance of USD purchased in 1990 and held across the period in real naira terms. Equities were clearly the most volatile over the period and the past few years were particularly unkind but they generally retained real value best. In contrast, despite high yields averaging 13% over the 25-year period, investment in T-bills would have lost an investor nearly 70% of their value in real terms.

Source: CBN

The second chart shows inflation adjusted performance of some prominent value stocks (with steady dividends) relative to T-bills since the turn of the century. The performance of these equities is clearly superior and have all preserved and even improved value over the period despite significant market movements.

Figure 2: Real returns on asset class holdings

Tying all of this back to the foregoing discussion on market uncertainty, we take it for granted that for a vast majority of individuals and most life contexts, even an uncertain success is to be preferred to sure failure to meet one’s goals. On the back of financial results and market performance in Q1 we are now asking to clients with longer term goals to shift their perspective.
We recommend a dividend focused strategy recognizing the following important points:

Valuations are very attractive: Indeed, one of the reasons why dividend yields have risen sharply for some good quality stocks is because the rapid drop in prices has put many equities at historical valuation lows, setting the stage for potentially very strong medium term performance.

Dividends are a good proxy for quality under current economic conditions: The very fact that some companies are able to declare attractive dividends comparable to long term bond yields despite the tight fiscal environment is an indicator of the underlying robustness and sustainability of their business across the cycle; the second key quality in a successful long term
equity strategy.

Dividends provide income even as capital gains recover value: The one area where fixed income excels in an asset allocation programme is in the provision of steady, predictable income. This in itself is a valid investment goal, but in the context of our earlier discussion, it is easy to see where exclusive focus on this goal can lead to problems, especially for investors facing long term horizons. In brief, it is rarely a good strategy to rely on fixed income to provide income in markets and economies that are defined by macro-instability as Nigeria doubtless is.

It turns out that high dividend stocks are a more effective near substitute that not only provides the required income (near) certainty but also preserves purchasing power over the long term. Incidentally, what makes a stock high dividend rarely has to do with the dividend it pays itself—the only requirement
here being that the payout levels are relatively stable—but the price at which the security was bought originally. This is another area where opportunities presented by market crises to buy high quality companies on the cheap become invaluable. Good companies tend to pay stable, increasing dividends, and where they are bough at low valuations, these payouts can rival and even outperform fixed income instruments over the long term as income generators, whilst resetting value with economic cycles (unlike fixed income) to preserve purchasing power.

Equities preserve liquidity and allocative flexibility:
Attractively priced real assets typically provide better value preservation than equities in general, however their income streams are usually more uncertain in an economic down-cycle and it is usually several orders of magnitude more difficult to make an emergency exit the investment under adverse market conditions—at least without compromising the value preservation feature. Thus real assets are appropriate only to investors with minimal interim liquidity needs and a much larger diversified asset base. Equities with stable dividends are the next best thing when it comes to value preservation and are therefore a much more appropriate vehicle for most investors.

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