In our Economic and Financial Market Outlook 2019 titled “On the Precipice”, we noted that Nigeria desperately needs structural and market-driven reforms, human capital and infrastructure investments to put Nigeria on the path of sustained growth and prosperity. We reiterated our resolve that the performance of the economy over the medium-term would depend on the policies of the winner of the presidential elections. Fast forward to June 2019, President Buhari was re-elected for a second term with 56.0% of the 26.5 million votes cast. Now, we are more concerned about the direction of the economy over the next four years with President Buhari’s continuity. Barring any assurances of possible implementation of delayed structural reforms that will attract investment and boost Nigeria’s competitiveness, we retain our view of weak growth trajectory in the short to medium term. Critical reforms are inevitable to get back to historic levels of growth which averaged 7.1% between 2000 and 2014.
While we know that the focus of fiscal authorities would still be on the economy, security and anti-corruption, the strategies to improve outcomes in these areas has not been spelt out. On the economic front, growth at 2.0% in Q1:2019 is still below potential and population growth of 6-7.0% and 2.7% respectively. Inflation has trended downwards from 16.5% in 2017 to an average of 11.3% in May 2019, but this is still sticky due to unresolved security woes which have affected agriculture activities and caused high food prices. Recent data also show that unemployment remains elevated at 23.1% from 8.2%. On security, little progress has been made in the North-East, but insurgency has persisted. In other regions of the country, kidnapping, cattle rustling, secessionist agitations and conflict over resource sharing are significant security risks. Institutions have also not been reformed, leaving huge gaps that can be exploited to perpetuate corruption.
The cabinet is yet to be formed, making it difficult to have a clearer view of economic policies under fiscally important ministries such as finance, trade and investment, petroleum, infrastructure, education, power and health. The President’s democracy day speech offers only scanty details. In our view, without implementing necessary reforms, the economy risks being stuck in the cycle of low growth, high unemployment and high poverty. Should the current economic situation subsist, investors will, as seen in H1:2019, maintain a risk-off approach to the equities market and consequently take solace in the haven of fixed income securities. This plausible eventuality guided our sentiment which imagined “Next Wave of Inertia” that may not augur well for macroeconomic prospects, ditto attraction of much needed capital to catalyse portfolios to the realm of positivity. We reason therefore that investment strategy for H2:2019 had “Better be Safe than Sorry”; hence, we preach overweight allocation to fixed income assets.
Global Economy: Trade Protectionism Weighs on Growth Prospects
One year ago, the global economy was on the uptrend as growth was stronger and broad-based across regions of the world. This was due to accommodative fiscal and monetary policies and rising commodity prices. Accordingly, global growth was projected to reach 3.9% and stay unchanged between 2018 and 2019 from 3.8% in 2017. But the escalation in global trade tensions, geo-political concerns and tighter financial conditions led to a slowdown in global growth to 3.6% in FY:2018. Global trade, which was projected to advance to 5.1% slowed to 3.8%, significantly lower than 4.9% in 2017. In Advanced Economies (AEs) and Emerging Market and Developing Economies (EMDEs) growth slowed to 2.2% and 4.5% respectively from 2.3% and 4.8%.
Based on the April 2019 edition of the World Economic Outlook (WEO), global growth projections for 2019 have been revised downwards to 3.3% from 3.6% a year ago and 3.5% in January 2019. The moderation in growth is expected to be broad, with AEs and EMDEs affected. In AEs, growth is expected to slow to 1.8% in 2019. This would be affected by US’ trade protectionism which has led to a hike in tariffs on trade with China, Europe, India and Mexico. In EMDEs, growth is projected to moderate slightly to 4.4%. This would be driven by slowing growth momentum in China, which is constrained by high tariffs on its exports to US as well as lower credit growth as the country plans to rein in debt.
At the end of 2018, oil prices witnessed a decline owing to a large build-up in stock resulting from weaker-than-expected demand conditions. This follows the trade tensions arising from US protectionist sentiments which dampen global growth. Nevertheless, at the start of 2019, oil prices began to rally on the back of OPEC+ decision to cut supply by 1.2mb/d. Furthermore, this was sustained as oil prices trended higher following the decision by the Trump administration not to renew waivers that allowed countries buy Iranian oil without sanctions. From the 2018 close of US$50.6/bbl, Brent crude oil price has increased 30.5% to an average of US$66.0/b in June 2019, although still lower than the average of US$71.3/bbl. in 2018. In line with our expectation, the prospects for higher prices in 2019 relative to 2018 remain dim, although we now expect the average oil price for 2019 to exceed our expected average of US$60.0/bbl. Although oil prices have recently moderated from the YTD high of US$74.9/bbl. (25/04/2019) to US$65.2/bbl. (02/07/2019), we are optimistic of an increase going forward.
In our Economic and Financial Market Outlook for 2019, we had hinted at monetary tightening across the world due to policy normalisation in advanced economies. However, a much sharper slowdown in global economic activity together with largely slowing inflationary pressures has prompted a shift towards looser monetary policy stance across many developed and developing economies. The US Federal Reserve paused the initial plan for two interest rate hikes and signaled no increases for the rest of the year. In June, the FED committee was dovish although rates were held at 2.25%, with the FED chairman signaling a possible cut later in 2019. The recent monetary policy shifts in advanced economies and relatively subdued inflationary pressures domestically have opened room for looser monetary policy to support growth in developing countries. Similarly, emerging and frontier markets have benefitted from increased capital flows due to higher interest rate differential with advanced economies.
Domestic Macroeconomic Highlights
In our Economic and Financial Markets Outlook released in January 2019, we created three scenarios indicating how the economy would perform. The bear scenario assumed widespread escalation in insecurity, which has not come to pass. In the optimistic scenario, the case for market-based reforms have also not emerged as the opposition lost at the elections. Thus, we follow our base case which assumes policy continuity regardless of the winner of the presidential elections. In this scenario, we projected growth to expand 2.5% in 2019. In Q1:2019, the Nigerian economy grew at a slower pace of 2.0% Y-o-Y relative to 2.4% in the previous quarter. We highlight that the headline figure masks the broad-based improvement seen in the quarter. In the non-oil sector, growth expanded at a slower pace of 2.5% from 2.7% in the previous quarter but this was the second highest since 2015.
We retain our base case forecast of 2.5% in FY:2019, which is below population growth rate of 2.7% and unsupportive of job creation. We expect sustained expansion in the non-oil sector to support growth. In the oil sector, we expect a recovery in growth due to base effect as oil production for the last three quarters of 2018 was weak.
The exchange rates in the various FX markets were stable in H1:2018 due to sustained CBN interventions despite a deterioration in Nigeria’s external balance. There was broad stability around N305.00/US$1.00 and N360.00/US$1.00 in the official and NAFEX markets in line with our expectation. However, we saw an adjustment in the rate at which trade duties are calculated from N306.00/US$1.00 to N326.00/US$1.00. Going into H2:2019, we review our expectation from a devaluation to a stability in the exchange rates. This is due to a strong external reserves balance, FG’s likely Eurobond issuances and sustained capital flows due to monetary easing in advanced economies. We expect the current account balance to continue to be pressured as imports continue to accelerate, albeit slowly, but at a faster pace than exports.
We created three scenarios to forecast the path of inflation in 2019, in line with our growth scenarios. The optimistic case assumes that the removal of energy subsidies would push prices higher. Similarly, there was a higher inflation forecast under the bear case due to assumptions of insecurity and exchange rate devaluation. As at the end of H1:2019, the base case has been the more realistic outcome due to lack of reforms, stable exchange rates and improving agricultural output. In H2:2019, we expect inflation to rise until the start of the harvest season in July. The recent adjustment in the exchange rate used in the computation of import duties from N306.00/US$1.00 to N326.00/US$1.00 would also stoke inflationary pressures. We expect the implementation of the recently passed minimum wage to have a muted impact on inflation. As the harvest season moves into full gear in August, we expect a deceleration in inflation for the rest of season. We retain our inflation forecast of an average of 11.3% in 2019. We reiterate that energy subsidies – electric and petrol – are major downsides to our inflation forecast.
Against market expectations, Godwin Emefiele was re-appointed as Governor of the Central Bank of Nigeria (CBN) for the next five years (2019 - 2024) in June 2019. Over this period, we believe the direction of financial system regulation, monetary policy and development financing is unlikely to change. This is considering the CBN’s recently released 2019-2024 strategy. Our concerns are that the inconsistency of monetary policy targets, continued financing of the FG and the Apex bank’s perceived lack of independence would continue. Similarly, we worry about the bank’s expanding development financing agenda rather than a focus on price stability.
Contrary to our expectation of a stable Monetary Policy Rate (MPR) at 14.0% through 2019, the MPC in March, reduced the rate by 50bps to 13.5% while the asymmetric corridor was kept at +2.0%/-5.0%. This came as a surprise given CBN’s tightening rhetoric and inflation at 11.3%. We attribute this to a shift by the MPC towards monetary easing due to poor economic growth and high unemployment. In H2:2019, we expect the MPR to remain stable. The room for a monetary easing could open if the expected reduction in interest rates in advanced economies occur. However, this would depend on Nigeria’s current account position which in turn depends on the trajectory of oil prices and production. Currently, these parameters are not as strong as they were a year ago, hence, we expect stability in the MPR.
AfCFTA: Nigeria Finally Joins Africa’s Trade Party
The African Continental Free Trade Area (AfCFTA) agreement, a plan to boost intra-Africa trade by removing tariff barriers, came into force on 30th May 2019. This was after it was ratified by twenty-two countries out of the fifty-two countries that signed the agreement. Out of the three outstanding countries – Nigeria, Benin and Eritrea – Nigeria finally agreed to join on July 2, 2019. We believe Benin would also sign the agreement due to its large trade with Nigeria. What this means is that the trade bloc offers a potential market of over 1.2 billion people and a GDP size of US$3.0tn. By signing the trade agreement, we expect Nigeria to sustain its trade within Africa.
There is still a lot of work to be done around the standards and processes of the agreement. The full implementation of the agreement would extend into the medium-term. Upon implementation, the AfCFTA would lead to the removal of tariffs on 90.0% of goods produced by 2020 while 10.0% of traded goods is expected to be phased in later. Similarly, it will ease non-tariff barriers to trade on the continent and provide economies of scale as firms try to sell to the bigger African market, leading to increased efficiency. We are aware that labour and manufacturing unions in Nigeria have concerns about the agreement because of weak domestic competitiveness, which could lead to loss of jobs and income due to cheaper imports. Although there is merit to these concerns, trade creates long-run benefits that outweigh short-term pains according to academic literature drawn from the experience of several countries. However, as government intensifies efforts to improve the business environment, competitiveness would improve.
FINANCIAL MARKET HIGHLIGHTS
Our Scenario Analysis for H2:2019…Calling the Market is a Herculean Task
Following the trend at the close of 2018, the Nigerian domestic bourse sustained its bearish performance going into 2019 as investors watched from the sidelines in anticipation of a positive trigger. As expected, the market opened on a negative note as the All Share Index (ASI) shed 2.8% in January. This presented an opportunity for investors to lock-in on attractive and fundamentally cheap stocks. As such, there was a recovery in the market, despite election jitters, as the YTD return on the index rose to as high as +4.1% (02/15/2019).
Subsequently, the local bourse started paring gains after the conclusion of the Presidential elections suggesting that the market perhaps did not envisage the outcome of the elections would favour the incumbent. Nonetheless, the benchmark index closed positive at +0.9% in February. Notwithstanding the decent corporate FY:2018 earnings performance, by early March, the market had shed all gains ahead of the release of Q1:2019 earnings results. Within H1:2019, despite the weak market sentiment experienced in the period, the ICT sector of the Nigerian Stock Exchange received a major attention as the much awaited MTN Nigeria Plc (MTNN) listing was consummated, though by introduction while the Airtel Africa Limited IPO was also being finalized as at the time of this report.
Now, although fundamentals remain fairly sound, share prices continue to worsen amid waning foreign portfolio attraction to the market on the back of policy uncertainty within the domestic economy. This presents Nigeria’s equities market as one of the most attractive across frontier and emerging markets. Against our forecast base case index level and P/E of 44,632.25 and 11.4x at the start of the year, the market posted a loss of 4.7% (29,966.87) YTD. At the current levels, Nigerian equities are undervalued as the index shed 4.7% as at H1:2019 despite average earnings growth of 3.2% over the period relative to our prognosis of 6.8%. The undervaluation case is also consistent when compared with the price to earnings multiples of MSCI frontier market index (12.1x) relative to NSE ASI (7.3x). Nevertheless, it is not enough for a basket of equities to be cheap; what guarantees capital appreciation that meets investors’ horizon? This is the peculiar case of the Nigerian market. Country risk remains the main drag to performance as foreign portfolio investments target short term high yielding fixed income assets. We do not think the current market pricing dynamics will be altered in H2:2019 as Nigeria’s structural faults continue to elevate her risk profile especially when benchmarked with peer frontier markets.
At the start of the year, our scenario-based projection for equities anticipated a bear market for H1:2019 and a fairly bullish market post-elections and inauguration of New Government in H2:2019. We had believed that the scenario of a return of the incumbent President would result in a base case market return of +42.0%. As at the close of trades in H1:2019, market realities have fallen shy of our prognosis though fundamentals aligned with our forecast. Although external developments should have been positive triggers for a market rebound, investor sentiment remained unattractively underwhelming despite compelling valuation multiples when juxtaposed with comparables.
Where then is the return for 2019? Our perspective is that short term investors have no business with equities in H2:2019 although technical traders are likely to cash in on enormous arbitraging opportunities in the phase of generally weak sentiment. From a fundamental perspective, company earnings are not expected to significantly improve; hence, we revise our EPS growth forecast to 5.0% while we imagine a median P/E multiple of 7.5x with a maximum and minimum levels of 6.5x and 8.5x respectively. This implies that the NSE ASI is expected to trade within a minimum and maximum level of 31,430.50 and 31,430.50 with a median index level and return of 31,430.50 and -1.9% by yearend.
Fixed Income Market Review and Outlook
The fixed income market performance in H1:2019 was in line with our forecast as monetary policy tightening took centre stage with regular OMO auctions by the CBN to keep system liquidity in check despite the unimpactful cut in MPR to 13.5% (from 14.0%) in Q1:2019 by the Monetary Policy Committee (MPC). The Committee had intended to boost economic growth by this action in her pro-growth effort. True to our projections of yield topping out at 16.0%, yields on treasury bills and bonds increased to 15.7% and 15.6% towards the general elections and took a slide post-election, shedding 254bps and 68bps to close at 12.5% and 14.5% in H1:2019 compared with H2:2018 (T-Bills: 15.0%; Bonds: 15.2%). Similarly, the Eurobonds space conformed with our bullish expectations as average yield on SSA and Nigerian Corporate instruments declined during the period under review on the back of the halt in policy normalization by globally systemic central banks.
In the bonds market, average yield across tenors as at H1:2019 stood at 13.2% which represents a 68bps drop in yields relative to FY: 2018. Average yield at the short end of the curve rose by 40bps to 14.4% in Q2:2019 compared to 14.0% in Q4:2018 stemming from pre-election pressures, despite MPR cut, and rate normalisation reversal in advanced economies. For medium and long-term instruments, average yield declined by 80bps and 90bps to 14.4% and 14.6% in that order. This implies there was bearish momentum on the short end of the curve, attributable to less demand for short-term instruments by investors - local and foreign investors including banks, HNIs and other institutional fund managers that drive trading activities in that space. On the other hand, high demand for medium to long-term instruments stimulated bullish performance in that segment particularly from Pension Funds Administrators (PFAs) that held approximately 50.4% of the total sovereign bonds outstanding as at June 2019.
As trade tensions in developed economies continue to wax stronger, coupled with downward revision of global growth by the IMF and the World Bank Group, global growth appears bleak and uncertain. The current easing momentum in developed economies is expected to route capital flows into emerging and frontier markets. Expectedly, the fixed income market is poised to enjoy the most interest considering its capital preservation feature as against the riskiness of the equity market. The SSA Eurobond instruments are anticipated to enjoy significant buy interest on the back of interest rate differential and attractive yield.
In the domestic front, yields should normally respond to movement in global policy rates, inflationary pressures and oil market dynamics. Rates in the global economy is expected to either remain at current levels or moderate, oil prices are not expected to fall significantly in the near term while we believe political expediency would prolong removal of subsidy on petroleum products and hike in electricity tariffs, thereby softening expectation of future inflationary pressures . Thus, the likelihood of the occurrence of these events in the next half of the year is slim and the attendant effect on interest rate is muted. In line with the above and current macroeconomic realities, we expect yield in the bonds and money market to moderate by at least 100bps and 50bps from current levels. We recommend investors ride the yield curve by taking advantage of short-term rates and lock in higher yields on long-term instruments. However, opportunities on the short end of the curve (where yields have shed c.260bps YTD) appears limited.
Investment Strategy for 2019 …Still in Search of Value
At the start of the year, we envisioned an investment climate that would be characterized by uncertainties amid domestic political risk and global concerns. These informed our investment strategy which we held was a blend of risky and less risky assets between the two halves of the year. We preached that, whilst there was a clear case of undervaluation of Nigerian equities and a relatively higher yield environment compared to frontier and emerging market peers, investor confidence in 2019 will be laced with caution in search of value. Hence, our strategy recommended significant overweight on fixed income securities for H1:2019 and a balance of play between equities and fixed income assets in H2:2019.
However, events of H1:2019 have cautioned that, although there is still value on the table, investment philosophy in H2:2019 must imbibe safety as a matter of necessity. Equities have to be a long-term play while fixed income investing should provide the room for safety. We had crafted four equity and two fixed income portfolios at the start of the year with performances of the former underwhelming benchmark while the latter fairly outperformed the market. Expectedly, taking a cue from H1:2019 events, we are more confident of an overweight fixed income strategy for the rest of the year.
A review of the performance of the portfolios indicate that, our fixed income portfolios posted positive returns averaging 12.5% in H1:2019 relative to comparable benchmark (S&P/FMDQ Sovereign Bond Index) of 12.1%. More specifically, our Modified Duration Bonds outperformed the comparable benchmark, returning14.5% while the Passive Eurobond also returned positive with 10.5% in dollar terms compared to return on US 10-year government bond (+7.1%) within the same period. Consequently, we maintain our recommendation of three investment portfolios for investors positioning in the fixed income market including Modified Duration Bond Portfolio, Smart Eurobond Portfolio and Passive Bond Portfolio.