The Nigerian equities market has sustained a bearish run for most of 2015 as issues ranging from a fragile polity, foreign exchange restrictions, stifling monetary policy stance, weakening domestic growth and rising inflationary pressure have weighed in to weaken investor sentiment. While the victory of President Buhari at the polls boosted investor confidence between April and May, the five months of waiting before the eventual inauguration of cabinet on 11th November, 2015 has had a debilitating impact on the overall market.
Despite weaker macroeconomic fundamentals, the Nigerian equities market was undervalued compared to its emerging market peers before the new government was inaugurated. Market P/E as at 28 May, 2015 was at 12.8x relative to a peer multiple of 14.0x. However, with weak corporate earnings, as evident in the Q3:2015 earnings numbers, the deafening silence on fiscal policy direction and further monetary policy restrictions on FX, huge sell-offs across the sectors between May and December, saw the equities market shed 20.3% (04/12/2015). Despite this decline, the much weaker earnings recorded has caused the market P/E to shoot up to 18.2x compared to the average for emerging (12.7x) and frontier (10.4x) markets.
As noted above, we believe investors are wary of equities due to a number of macroeconomic concerns relating to FX restrictions and operational bottlenecks of companies which translated into weak corporate earnings and declining Foreign Portfolio Inflow (FPI) into equities (down from US$956.2m in July-2014 to US$433.7m in July-2015). In our view, there are five major signals that will herald the change in market sentiments and garner investor confidence for equities. In the following sections, we analyze each of these signs ranging from fiscal pronouncements, removal of subsidy on petrol, infrastructure spending, accommodative stance on FX policies and economically viable states.
Sign 1: A Well-Articulated Fiscal Plan to Reflate the Economy
After months of waiting, the installation of the cabinet members came with mixed reactions. Nonetheless, we are more interested in the ministers with portfolios that are strategic to the economy. We believe the ability of the cabinet to deliver a well-articulated fiscal plan will essentially rest on the Minister of Budget & National Planning (Sen. Udo Udoma), the Finance Minister (Mrs. Kemi Adeosun), the Minister for Industry, Trade and Investment (Dr. Okechukwu Enelamah), and the Minister of Power, Works and Housing (Mr. Babatunde Fashola). If well deployed, we expect the outputs of the combined experience of this team to reflate the economy going forward.
First, the success of the fiscal team will depend on the ability of the key actors to articulate an aggressive but credible plan to reflate the Nigerian economy which has been crippled by lower oil prices and foreign exchange restrictions so far in 2015. While the personalities, profiles and experiences of these individuals are key to performance, we think a major signal that may sway market sentiment from the fiscal space is the increasing indication of a large budget in 2016. A well-articulated Medium Term Expenditure Framework (MTEF) for the next three years may suggest an inflexion point for equities market as this will be indicative of a fiscal expansionary stance. With emphasis on investment in key infrastructure (transport, power, support for SMEs, domestic agriculture and agro-based industries) by the administration, we envision a light at the end of the tunnel for the economy.
The Minister of Budget and National Planning yesterday presented the MTEF for 2016-2018 to the Federal Executive Council (FEC) and was approved for onward transmission to the National Assembly. The document indicates a planned total budget of N6.0tn for 2016 (at a budget benchmark of US$38.0) with planned capital expenditure projected at N1.8tn (30.0% of the total budget) and N4.2tn on recurrent expenditure. However, this range of numbers immediately throws up a challenge on how the Government intends to fund such a budget. Given the depressed oil price environment, the huge proportion of government recurrent expenditure (including debt service) to its declining revenue receipts, it is apparent that any economic plan must incorporate a significant dose of financial re-engineering for such a plan to make sense. Indeed, the National Integrated Infrastructure Master Plan (NIIMP) has noted that Nigeria will need to spend US$25.0bn annually for the next three years in order to make material impact in developing its infrastructure.
While not dismissing the Government's option to borrow from the domestic and foreign debt markets to fund its speculated N5.0tn infrastructure fund, investors who are keenly aware of the fiscal challenges facing Nigeria today will definitely insist on a thorough credit analysis before parting with such a colossal amount. Hence, a well-articulated (and implementable) financial re-engineering plan can also support the Government's borrowing strategy in the years ahead. Also, increase in the tax base for the country through a proactive and actively deployed tax policy will help in the financing of the budget. This would likely improve government finances, free funds for more impactful fiscal spending and trigger positive market sentiments.
Sign 2: Removal of Petroleum Subsidy
A cursory look at the 2015 budget shows that total government revenue amounted to N3.5tn while total expenditure was estimated at N4.5tn for the year. Capital expenditure was projected at N0.6tn relative to the recurrent component of N3.9tn. Thus, recurrent expenditure was budgeted at 7.0x the size of capital expenditure. Nonetheless, fiscal deficit stood at N1.0tn. Going by data from the CBN, federally collected oil revenue (shared by the 3 tiers of government) dropped 43.1% Y-o-Y in H1:2015 to N2.0tn whilst expenditure declined by a lesser proportion of 21.1% in the same period. Capital expenditure has been the worst hit, as it fell 91.9% to a meagre N31.9bn in H1:2015 from N393.3bn in H1:2014. Recurrent spending has only declined by 6.6% to N1.7tn representing 91.0% of the government expenditure as at H1:2015. A further inspection of the components of recurrent spending indicated that subsidy payment (N159.0bn relative to N145.5bn in the budget) represents 8.9% of total recurrent spending as at H1:2015.
At the current run rate, we estimate government revenue to slow to N1.3tn by the end of H2:2015. However, based on data obtained from the recently approved supplementary budget, we estimate that total expenditure for the second half of the year, will close at N1.9tn, including capital expenditure of N25.8bn. Subsidy payment of N521.0bn which represents 91.0% of the supplementary budget, will account for 27.6% (from 8.9% in H1:2015) of recurrent spending in H2:2015. Consequently, we believe the argument for an outright removal of subsidy becomes compelling as it would have saved government a total of N680.0bn (20% of total expenditure) in 2015. In addition, without subsidy removal, fiscal deficit is estimated at N1.0tn (budgeted) or N829bn (FY:2015 projection).
Moreover, a removal of subsidy immediately puts government cash flow in a surplus position of N24.7bn and significantly strengthens the treasury's position before approaching the debt market for funding. In addition to the outright savings from subsidy removal, we have also assumed that non-debt recurrent expenditure (ex-subsidy) can also be managed downwards by 10.0% as a result of shutting down subsidy-related MDAs no longer required.
Sign 3: Investment in Infrastructure Spending
The dearth of infrastructure in Nigeria is monumental. Hence, investor expectation is heightening for investment in infrastructure spending to sway buy-sentiment for equities. With regards to the proposed 2016 budget, the implication of an increase in capital expenditure by the government will improve sentiments on the fundamentals of quoted companies. Poor road networks linking bellwether industrial and consumer goods companies' factories to the major cities and markets is a constraint on distribution and route to market. Investment in the power sector would undoubtedly have a positive impact on cost of production and efficiency of companies.
As a result of poor infrastructure viz a viz other constraining monetary and fiscal policy headwinds, the economy in 2015 has so far been indirectly and directly inhibited. We believe a change in growth momentum of the economy from 2016 which is likely to be triggered by expansive fiscal spending, possibility of a review of restrictive policy on FX rate and active regulatory oversight may redirect the trajectory of the benchmark index. Our expectation is anchored on the thinking that expansive fiscal spending will bode well for infrastructure and strengthen consumer spending whilst also boosting corporate revenue of companies (translating into profitability).
Against this backdrop, investor sentiment in the stock market is unequivocally expected to improve significantly once the move towards infrastructure project financing by government is made. In the long run, the improved enabling environment will trickle down into the earnings of listed companies and increase the overall return for investors. In essence, while the market is expected to stay depressed in the short term given poor economic performance, we see a change in market sentiment in the medium to long term as the economy is set on a stronger growth momentum in 2016.
Sign 4: FX Rate Adjustments - Key to Restoring Sentiment
The drop in global oil prices below the budget benchmark (US$53.0/pb) in 2015 has resulted in the underperformance of the 2015 budget relative to the Appropriation Act. Gross collected oil revenue estimated for H1:2015 in the Appropriation Act deviated from the actual by 24.5% (N2.0tn) according to CBN data. With the above in mind, we believe that Nigeria's economic managers must signal a constructive stance on value of the naira going forward. While Nigeria cannot control oil prices, it can determine its revenue funding structure simply by adjusting its exchange rate to reflect the new terms of trade.
The weakness of the external sector, heightened inflationary pressures and sub-optimal economic growth rate presented the monetary authorities with a policy dilemma. Against calls for a counter-cyclical policy to loosen policy variables and boost growth, external sector readings have also suggested a pro-cyclical action to tighten liquidity and devalue the currency to adjust for the deficit in current account and stabilize exchange rate.
The objective of price stability seems to have been jettisoned for competing objectives. The CBN first responded with liquidity tightening policies (increase in CRR and MPR) and a devaluation at the November 2014 MPC meeting but subsequently adopted a rather unconventional "third option" of using administrative measures to manage demand - resulting in a "contrived stability in the exchange rate market" - and easing liquidity in the financial system to stimulate credit growth and re-price market yields.
In its last meeting for the year (November 2015), the MPC also reduced MPR to 11% with asymmetric corridor of +2%/-7% while also reducing CRR to 20% thus increasing the financial system liquidity while also targeting lending to specific sectors of the economy. However, the low import cover of the external reserves, high unmet demand for FX and a bearish outlook for oil (which reduces CBN's capacity to defend the current exchange rate peg) have increased investors' expectation of a currency devaluation and stalled private capital inflows. See chart 4. Meanwhile, weakened demand for goods and services on low fiscal spending as well as the FX restrictions have taken its toll on trade and manufacturing sectors, which has ushered in a period of sub-optimal economic performance with GDP growth below 3.0% in the last two quarters.
The impact of the weakening macro-economic fundamentals has had a pass-through on corporate earnings; hence the negative sentiment that has pervaded the market. Although we believe earnings have to significantly improve to restore confidence in the market, the need to review the CBN's exchange rate demand-restrictive policy is critical in our view in the medium to long term. This would reduce uncertainty and investment risk of the Nigerian market while also potentially improving investor sentiment (domestic and foreign) and also stimulating growth in the economy.
The Federal Government can alleviate demand-side constraints in the economy while boosting fiscal spending by relaxing its current stance on exchange rate; a move that will nominally increase its revenue. In our analysis of the 2015 Appropriation Act vis-à-vis the actual budget performance, we found out that a 20.0% devaluation in exchange rate to N246.35/US$1.00 from N197.00/US$1.00, implemented together with the removal of subsidy payments, would have increased Federal Government revenue to N3.2tn from N2.9tn.
Simultaneously, total government expenditure would have fallen from N3.7tn to N2.9tn. Keeping all the variables constant, this would effectively convert N819bn fiscal deficit into a N358bn budget surplus. The combined effect of this strategy would be to send a very powerful signal to foreign investors that the Government is willing to do whatever it takes to stabilize the economy.
As a consequence, the market awaits a cautious reversal of the current outward direction of capital inflow which would help ameliorate the pressure on the Naira and stabilize external reserves for sentiment to upturn.
Sign 5: Economically Viable States
An analysis of the economic viability of the various states in the country has become increasingly important given the heavy dependence on federal allocation. This has become rather unsustainable given the declining government revenue consequent on the fall in crude oil prices, a situation that has necessitated persistent decline in the allocation to each of the states. Consequentially, State governments need to necessarily look inward and strengthen their internally generated revenue structure to substantially create a departure from heavy dependence on Federal government revenue.
Lagos State and Rivers State, are two of the few states in the country that can fulfill their economic obligations without necessarily depending on the allocation from the Federal government. The data for Internally Generated Revenue for each of the 36 states in the Country in 2014 released by the National Bureau of Statistics (NBS) indicated that Lagos State and Rivers State accounted for about 51.6% of total IGR in 2014. A further analysis showed that revenue from Personal Income Tax (PAYE) accounted for 55.6% and 76.7% of total IGR for Lagos State and Rivers State respectively.
Most of the states within the South-South region tend to be more economically viable than the states up North and this is greatly due to the Crude oil revenue in the states. Nevertheless, states in the Northern region have the opportunity to broaden the revenue base especially in the agricultural sector and this will lead to more taxable income for the government. In addition, State governments need to solidify their tax revenue framework given that it is a major contributor to realized revenue. These measures, will ultimately drive increased revenue generation for the States and make them more viable economically.
In effect, this will go a long way in driving influx of investments in the various states and also rub off positively on the Country as a whole. Most foreign investors await this signal of States viability to begin to re-price Nigerian equities. Hence, a move in this direction is necessary for upturning negative sentiments on equities.
Conclusion: Change in Market Sentiment/Valuation
Our analysis of the possible signs the market awaits suggests to us that the dragging factors of equities at the moment stem from a plethora of domestic macroeconomic concerns. While we have always argued that some of the issues are self-imposed from the monetary policy angle, the market awaits certain signals for a change in sentiments; some of which seem to be medium to long term in horizon. At the moment, foreign investors are staying on the sideline awaiting the appropriate time to make a re-entry into Nigerian equities market against the backdrop of unfriendly FX restrictions on funds flow.
For as long as the CBN remains inflexible with the contrived stability in FX rates, FPI inflow into equities will likely remain excluded while the market is denied of value seeking investors. Notwithstanding the CBN's stance on FX rate, a possible expansionary fiscal year (which will reinforce domestic growth momentum), critical infrastructure spending in strategic sectors, removal of fuel subsidy on petrol and State Governments' viability are some of the factors that the market anticipates for a change in sentiment.
We perceive that a number of these signals are not supportive of a short term phenomenal change in the current bearish equities dynamics. Consequently, it is our view that the current equities market condition may persist with pockets of opportunistic value seeking position-taking that may guarantee short term market gains which may not be sustained until any of the "5 Signs" comes into force. Nevertheless, a signal of any of these signs could potentially sway positive sentiments for investment in equities.