Culled—Proshare
30/1/2017/ARM Research
Today’s portion of the cut-out from our core strategy document – the Nigeria Strategy Report—assesses movements in the equity markets over H2 2016 and posits our outlook for same over 2017.
In our H2 16 Nigerian Strategy Report, we projected a reversal of the positive run across Nigerian equities in the first half of 2016 which was fuelled by local investor confidence regarding more credible moves by policy makers, as persisting illiquidity in the newly floated interbank market deters FPI participation while rising FI yields dims local investor risk appetite. Our views largely played out as NSEASI posted two quarters of losses during the period (Q3 16: -4.3%, Q4 16: -5.2%)—which translated to negative returns in H2 16 (-9.2%) and 2016 (-6.2%). In a nutshell, across various sectors, investors’ expectations about feed-through of the deadbeat macro picture on earnings trajectory, which are hardly surprising given the recessionary economic climate, underpinned bearish dominance of NSEASI in H2 2016.
Fundamentals aside, parsing through the investing pattern across domestic and foreign fund managers over H2 16, sentiment was largely weak—foreign transactions declined 47% YoY to N204.32 billion while domestic transactions contracted 23% YoY to N226.77 billion. On an annual basis, faster moderation in FPI activity (-50% YoY to N473 billion) relative to domestic pull back (-29% YoY to N582 billion) implied that local investors accounted for the larger share of market transactions (55%) for the first time since 2010.
Going into 2017, we believe the key risk to performance are unchanged from last year—they include US interest rate normalization, global economic uncertainty, continued dollar strength, domestic macro concerns, FX challenges, and a drag in fiscal push to uplift the economy. Investors will continue to be especially sensitive to the state of the economy, a devaluation of the naira and any policy missteps by the monetary and fiscal authorities. On balance, the outlook for naira equities is more nuanced—low foreign and local appetite for equities combine with weak fundamental picture across most sectors underpins our muted outlook for naira equities in H1 2017.
Nigerian equities head south as local investor optimism retreats
In our H2 16 Nigerian Strategy Report, we projected a reversal of the positive run across Nigerian equities in the first half (+3.3%), which was fuelled by local investor confidence regarding more credible moves by policy makers, as persisting illiquidity in the newly floated interbank market deters FPI participation while rising FI yields dim local investor risk appetite. Our views largely played out as NSEASI posted two quarters of losses during the period (Q3 16: -4.3%, Q4 16: -5.2%)—which translated to negative returns in H2 16 (-9.2%) and 2016 (-6.2%).
Recasting performance monthly shows the bearing of these drivers more evidently, starting in July when crude oil prices recorded the steepest MoM decline over 2016 (-14.5%), net FPI flows declined by 50% MoM to N2.6 billion. Aided by CBN’s tightening which pushed returns on fixed income instruments higher, the local bourse slid 5.4% MoM. Though crude oil prices rebounded 10.8% MoM in August even as net FPI flows tracked four-fold higher relative to prior month to N13.3 billion after freer naira trading, domestic equity markets closed in August (-1.5% MoM) as investors reacted to feeble H1 16 corporate results particularly in banking (-2.8% MoM), cement (-1.9% MoM), and food (-2.8% MoM) segments. In September, amid sustained uptrend in crude oil prices (+4.3% MoM), MSCI’s decision to retain Nigeria on its frontier market index helped markets reverse the negative tide in September (+2.7% MoM). Nonetheless, a reversal in crude oil prices in October (-1.5% MoM) alongside disappointing Q3 16 earnings underpinned a 3.9% sell-off in October and November (-7.3% MoM). However, following crude oil supply cut agreement on November 30 which led to a 15.2% appreciation in crude oil prices, naira equities turned bullish in December with NSEASI posting a 6.5% MoM return.
Overall, despite the rally in crude oil prices over 2016, which ought to have boosted investors’ sentiment in line with historical trends, investors’ concern over the impact of the economic deterioration on earnings performance, persisting foreign apathy on account of FX illiquidity and local investors’ attraction to higher risk free rates combined to drive negative NSEASI performance over H2 16.
Figure 1: NSEASI half-yearly returns
Fundamental headwinds underpin bearish sectoral performance
Disaggregating NSEASI performance across the various sectors, starting with the cement sector which lost 15.1% over H2 16 as Q2 16 and Q3 16 corporate earnings which mostly came in July and October respectively showed earnings weakness due to several factors. First, the sector had to grapple with slowdown in volume growth (-5% YoY to 4.5 million MT) following the 47% hike in cement prices and depressed construction activity as revenue pressures forced moderation in FG and State governments capital spending. Furthermore, sizable input cost pressures, as gas supply shortages drove substitution to more expensive energy sources, resulted in the compression (-13pps YoY on average) of the sector’s gross margin. The foregoing combined with sizable currency losses on foreign loans at Lafarge (N38 billion), cement sector’s earnings slid 49% YoY to N98 billion which supported bearish bias on constituent stocks.
For defensive stocks, the tough operating environment drove mixed fortunes. Whilst cost pressures induced sector wide price increases which spurred robust revenue growth for Food producers (9M 16: +33% YoY) and HPC (+7% YoY), down trading by beer drinkers muted the impact of prices hikes by Brewers (9M 16: -1% YoY). Given the more inelastic nature of food products, price hikes more than compensated for cost pressures as gross margin tracked higher for Food producers (9M 16: +190bps YoY) which could not be said for Brewers (9M 16: -500ps YoY) and HPC (9M 16: -320bps YoY). Despite the varied responses to the cost pressures, earnings for consumer names declined (Food: -34% YoY, Brewers -54% YoY, HPC: -80% YoY) due to a mix of FX depreciation losses on foreign loans and feed-through from the earlier stated cost pressures which fed into weak share price performance for Food (-8.4%) and HPC (-6.4%) over the review period.
That said, agro-allied stocks proved to be an outlier to the negative earnings patterns as aided by CBN proscription of FX for CPO imports, sector revenues surged on higher prices (+39% YoY) and improved volumes (+5.5% YoY)1. In addition, the apex bank complemented the support for palm oil producers via various low-cost financing schemes. Largely reflecting the policy backing, CPO producers reported 33% increase in 9M 2016 earnings which informed the 26.9% appreciation in the sector’s share price for H2 16.
Elsewhere, though bank stocks delivered 17% YoY growth in PBT and PAT to N487 billion and N402 billion respectively2, headline reading masks earnings dispersion with only five banks reporting YoY expansion. Earnings growth across these banks stemmed from sizable FX revaluation gains on on-balance net long dollar positions which offset credit impairment charges. For the rest of the sector, asset quality concerns were central to earnings contraction as 9M 16 impairment more than doubled YoY to N270 billion across coverage. The asset quality issues offset feed-through from monetary policy tightening evident in asset yields (+160bps) pick-up across sector as banks repriced loans higher. In addition to asset quality issues, NGN depreciation triggered erosion in capital buffers with decline in sector’s CAR (-180bps). Overall, the cumulative impact of the aforementioned concerns heightened investors’ apathy resulting in an 8% decline in banking sector’s capitalisation over H2 16.
Lastly, despite production headaches which drove losses for upstream O&G heavyweight SEPLAT, sentiment about higher crude oil prices propped strong share price performance in H2 16 (2016: + 92.1%). However, things fared worse as solvency concerns following a qualified audit opinion and a string of losses drove adverse sentiment at upstream peer OANDO (H2 16: -27.7%, 2016: -20.34%). Though downstream players benefitted from the increase in fuel price (+68% to N145/liter), which supported top-line (+32.9% YoY) and earnings for selected downstream players, sharp pull back in FO (-71.3% 2016) and sell-offs in OANDO drove sector capitalisation decline by 8.6%. That said, in a sign that depressed valuations are attracting interest, M&A activity in the downstream segment continued in late November as NIPCO announced the $301 million acquisition of ExxonMobil’s 60% stake in Mobil.
In a nutshell, investors’ expectations about feed-through of the deadbeat macro picture on earnings trajectory, which are hardly surprising given the recessionary economic climate, underpinned bearish dominance of NSEASI in H2 2016.
FPI reluctance to naira equities hands baton to local investors
Fundamentals aside, parsing through the investing pattern across domestic and foreign fund managers over H2 16, sentiment was largely weak—foreign transactions declined 47% YoY to N204.32 billion while domestic transactions contracted 23% YoY to N226.77 billion3. Tracking patterns, following the recovery in Q2 16 which resulted in net long FPI positions (N7.3 billion) on naira equities—the first time in four quarters, foreign investors remained net long to the NSEASI over H2 16 to the tune of N27.3 billion. In the aftermath of the floating exchange rate in June, FPI sentiment towards Nigerian equities remained positive in July with net FPI flows of N2.4 billion though contracted 50% MoM following the steep drop in crude oil price and concerns over naira floatation after largely static interbank FX trading. Domestic investors also pulled back (-40% MoM to N45.9 billion) following the rise in fixed income yields after CBN hiked rates in July. Following CBN’s relaxation of FX trading and a rebound in oil prices over August (+10.8% MoM), foreign appetite for Nigerian equities recovered with net FPI flows jumping four-fold higher on a month ago basis to N13.3 billion even as domestic investors’ participation also expanded by 34.3% MoM to N61.6 billion.
Nonetheless, despite a continued rally in oil prices (+4.3% MoM), negative sentiment following increased CBN controls offset improvements to drive a 60.8% MoM contraction in net FPI flows to N5.2 billion in September. As in prior months, domestic investors likewise followed and scaled back from equities (17% MoM to N51.2 billion).
Though crude oil prices declined in October, MSCI decision in late September to retain Nigeria in its benchmark frontier-index, though tempered by potential reclassification4 supported an expansion in net FPI flows to N6.1 billion (+16.6% MoM). Nonetheless, this optimism was not shared by local investors who reduced equities exposures (-35.9% MoM to N32.8 billion) following a slew of weak Q3 16 earnings releases. The foregoing combined with a ‘forceful’ stability in the interbank and parallel FX market drove FPI apathy for Nigerian equities in November, though tempered by bullish crude oil prices to drive a mild net-short FPI position of N9 million in November while local investors increased exposure to equities (+7.5% MoM to N35.2 billion). Though data for December is not yet available, we believe the reinstatement of a hard peg in the interbank FX market and widened parallel market premiums combined with FPI exodus following rise in US interest rates likely kept FPI activity depressed.
On an annual basis, faster moderation in FPI activity (-50% YoY to N473 billion) relative to domestic pull back (-29% YoY to N582 billion) implied that local investors accounted for the larger share of market transactions (55%) for the first time since 2010.
Figure 3: Foreign and domestic share of transactions
Unsurprisingly, the drop-in investor participation implies softer market liquidity levels as average daily volume and value traded declined further in H2 16 by 28.0% and 6.3% to 250 million units and N2.1 billion respectively when compared to H1 16.
Over the course of 2016, the total volume and value traded fell 19.0% and 40.8% YoY to 298 million units and N2.1 billion accordingly on a year ago basis.
The creeping apathy to Nigerian equities by domestic and offshore investors which has led to negative market returns (YTD) has led to declining equity market liquidity as average daily volume slid 24.8% YoY to 252 million shares while average value traded contracted 33.7% to N2.1 billion over H2 16. Beyond leaving the market susceptible to further downtrend, the shrinking market depth and declining valuations made it difficult to raise equity or to list companies. For evidence, while H2 16 witnessed announcement of seasoned offerings, none of the proclamations came into effect as declining prices dampened optimism to follow-through5. With liquidity being a critical support for equities market over recent years, the drop over 2016 poses hurdles for fresh FPI inflows as on a dollar basis, the current liquidity levels are likely to break thresholds for investments in frontier markets.
Figure 4: Mean monthly volume and value traded
NSE continues to push through reforms
Following the deadbeat market performance, the NSE continued to roll-out initiatives aimed at boosting investor confidence in the domestic bourse—Rules for Filing of Accounts and Treatment of Default Filling—which was approved by the Council of the Exchange and SEC in March and August 2016 respectively sought to protect investors, ensure proper disclosure, and forestall market manipulations. The corporate action rule which places a watch on interim dividend declaration during a financial year, and thereafter record accumulated losses at the end of the financial year—to be fined up to 100% of the nominal value of the dividend declared6—ushers thorough scrutiny to corporate actions by issuers in a bid to avoid any false sense of strong earnings which may deter flows to the stock exchange. Besides, the NSE increased the fine paid by issuers as penalties for late filling of accounts, ranging from N100,000 to more than N100 million compared to sanctions within N5 million previously. Also, deficient issuers face threats of suspension and delisting in addition to the monetary fines.
Furthermore, the NSE—consistent with its commitment to broaden and deepen the Nigerian capital market—moved to expand the availability of equity instruments with the listing of ETFs on the NSE. ETFs which were introduced on the NSE in December 2011 with cross listing of New gold ETF with AUM of N287.5 million have recorded significant growth with total AUM of ~N4.24 billion on eight ETFs now listed and traded on the NSE. Following the strategic agreement between the NSE and the MSCI to develop and commercialize co-branded Indexes, the NSE fostered its move by training market participants on the dynamics and positives of the ETFs as it offers a direct and low-priced means to achieve diversified exposure to an index as well as offer additional benefits of low expense ratio, increased liquidity and can be used to execute different investment strategies.
In a related development, the African Securities Exchanges Association (ASEA) and the AfDB joined forces to deepen and connect African capital markets with the launch of the African Exchanges Linkage Project (AELP). The project is aimed at addressing the liquidity challenges in African capital markets by creating linkages across markets to allow cross-border visibility and open the markets for investors to trade in any of the linked markets. As a pilot, four exchanges namely the Casablanca Stock Exchange (CSE), Johannesburg Stock Exchange (JSE), Nairobi Securities Exchange (NSE) and the Nigerian Stock Exchange (NGSE) were selected to kick-start the initial run of the program. The partnership is expected to facilitate various projects of mutual interest to both the Association and the Bank targeting areas such as financial markets infrastructure development, introduction of new products in the market, improving market liquidity and market participation, information sharing and capacity building amongst other programs.
Will fundamental and sentiment improve to trigger a market recovery?
Going into 2017, events across the global landscape and the impact of domestic policy responses to these developments form the basis for our equities outlook. On the global front, the advent of Donald Trump as US president has changed the calculations — we now expect more fiscal stimulus, more inflationary pressures, and a potentially more hawkish Fed. The hike in US interest rates in December 2016 and guidance towards further rate hikes in 2017 now raises the opportunity cost for investing outside the US economy—markets have already started the adjustment, pushing up bond yields higher and strengthening the USD. Furthermore, the political surprises in 2016 (Brexit and Trump’s victory) raises high political risk in 2017, particularly across Europe7 to drive the hunt for safer haven. That said, following OPEC’s agreement to restrict output, in conjunction with key non-OPEC countries, prospects of a supply rebalancing confer a positive outlook for crude oil prices. Nonetheless, as in 2016, we think persisting investor concerns over the economy, which broke the long historical correlation between NSEASI and oil, implies less likelihood that our optimistic outlook for oil translates to Naira equities.
For the foreign investor class, the subsisting uncertainty of interbank USDNGN given the elevated parallel market premiums over the interbank, and more importantly, continuing dollar shortage at the official market should continue to deter investment.
Furthermore, shrinking equity market liquidity (in NGN and USD terms) and subtrend GDP growth picture stand as bulwarks against FPI participation in the domestic bourse. As a consequence, focus should remain on local investors and possibility of policy managers taking actions perceived to be credible in resolving the economic issues. On this wise, following its failed first step at economic reflation, local investors are less likely to look towards fiscal policy to drive sentiment. However, our views regarding a southward interest rate direction in H1 2017 raises the prospect that declining yields on FI instruments could reignite appetite for equities risk. That said, we think a quantum leap in equities demand by local investors would be underpinned by improved earnings performance.
From a sector-dimensioning fundamental perspective, across the NSEASI, our views about fiscal revenues struggles constraining capital expenditure at federal and state level translate to muted demand for construction materials. Further confounding the revenue picture is further pull back in expected demand following an over 47% increase in cement price. That said, margins should recover from battered 2016 levels as restoration of gas supplies and construction of coal plants result in less expensive energy mix. In addition, Lafarge’s restructuring of its dollar loan obligations, which shrinks its FX exposure 82% to $106 million should mitigate the risk of earnings compression from future NGN depreciation.
Undertaking a similar exercise for banks, following recent recovery in crude oil prices and a now more upbeat outlook, fears over the status of upstream Oil & Gas loans should now recede as following a wave of restructuring in 2016, breakeven prices are well below current levels. That said, dollar paucity and the over 50% exchange rate depreciation imply that asset quality fears now revolve over general commerce and manufacturing exposures. Furthermore, there remains the unresolved issue surrounding power sector loans. In addition to loan quality issues, capital adequacy worries remain on the horizon after the over 180bps shrinkage across our coverage banks which should drive muted organic loan growth (excluding NGN depreciation and CBN on-lending). Nonetheless, as in 2016, our prognosis about further naira weakness retains scope for FX revaluation gains for banks with net long positions.
Outside these banks, the underlying earnings picture is soft.
Elsewhere, for oil and gas, upstream names should benefit from sentimental buying associated with rising crude oil prices though production woes imply limited reprieve for battered earnings. Downstream, the dark side to the double-edged sword of the crude price rally should force upward adjustments to the retail pump price. That said, we think fears of a backlash from the populace would drive the FGN towards absorbing these increases for some time which holds negative portents for petroleum marketers’ margins.
Away from cyclical names, our deadbeat currency outlook implies that traditional defensive names in the food, brewery and personal care space offer scant downside protection as imported raw material requirements, foreign denominated loans and gas supply issues hurt sector earnings. That said, depressed valuations for basic food producers and strong pricing power implies this segment should come to pique investors’ interest. For more elastic sectors, negative real wage growth should continue to see price increases trail cost pressures leading to gross margin compression. Given currently elevated valuation levels, bearish bias should remain dominant for these names.
Lastly, palm oil producers should remain in the sweet spot of monetary and fiscal policy and given the fundamental demand-supply mismatch, as annual CPO production of 970,000 MT remains inadequate in the face of national consumption at 1.5million MT, we see more price upside over 2017 and expect stronger earnings performance.
Despite the broadly negative fundamental picture, NSEASI could still find respite from primary market activity in 2017 as telecommunication giant MTN lists as agreed under negotiations with FG8. Given that Nigeria accounts for 35% of MTN’s group operating profits and using JSE market capitalization of $18.6 billion, we estimate that the listing could account for 22.5% of NSE market capitalization at issue. For seasoned issues, though impact of the economic deterioration bolsters prospects for sizable capital raising activity9, thin market liquidity levels imply limited uptake by local investors and dilution concerns could yet stoke sell-offs in such names.
Overall, we believe the key risk to performance are unchanged from last year—they include US interest rate normalization, global economic uncertainty, continued dollar strength, domestic macro concerns, FX challenges, and a drag in fiscal push to uplift the economy. Investors will continue to be especially sensitive to the state of the economy, a devaluation of the naira and any policy missteps by the monetary and fiscal authorities. On balance, the outlook for naira equities is more nuanced—low foreign and local appetite for equities combine with weak fundamental picture across most sectors underpins our muted outlook for naira equities in H1 2017.
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