Opportunity in a Crisis?
In our 2020 Economic & Financial Markets Outlook, we noted that the second term of President Muhammadu Buhari began with fiscal reforms as the Finance Act and the amended PSC Act were signed into law in H2:2019. As the economy was yet to fully recover from the 2016 economic recession, we highlighted that the FG needed to mobilise more resources and attract investments in support of areas such as infrastructure and human capital development. With the 2020 fiscal strategy unconvincing in these areas, we forecasted the economy to grow by 2.4% from 2.3% in 2019.
Then COVID-19 struck, causing severe damage to the local economy through the transmission of external shocks and local containment measures. The ensuing risks to health systems and the economy have been unprecedented, with the downside economic risks worse than the 2008/9 global financial recession while the health risks have been described as the worst since the Spanish Flu of 1918. In Nigeria, COVID-19 has only further exposed the country’s structural weakness given economic and health system vulnerabilities prior to the pandemic. The sharp fall in oil prices to a 20-year low of $17.70/bbl. in April 2020, following the contraction in global oil demand, led to weaker prospects for government revenues and export earnings. Accordingly, there was a downward revision of 37.2% to FG’s 2020 revenue target to ₦5.3tn while the currency was devalued to enable the economy cope with external account pressures.
The heightened risks spooked investors, resulting in sizable foreign portfolio flow reversals that have only been limited by crippling capital controls. Unlike in previous episodes of economic shocks when remittances supported FX receipts, there would be little reprieve as the World Bank is projecting a 20.0% contraction in global remittances. Similarly, the health risks were significant and affected Nigeria’s response as lockdowns were implemented to avoid overwhelming the healthcare system. Prior to the pandemic, the country was already a hotbed of several health diseases that stretched health systems thin. The lockdown implemented to contain the virus in the major commercial cities of Lagos, Abuja, Port-Harcourt and Kano dealt a blow to economic activities. In a survey conducted by NBS to measure the impact of the pandemic on the local economy, about 43% of respondents reported losing jobs, over 50.0% found it difficult to support household consumption and social protection has been inadequate.
In our opinion, even though we admit that there is no escaping the devastating impact of COVID-19, decades of poor policy choices have elevated risks in Nigeria. The continued reliance on oil for FX receipts and government revenues, together with poor investment in the healthcare sector weakened the resilience of the economy. We believe the impact of this pandemic would reverse the marginal gains recorded since the 2016 economic recession, thereby hurting businesses and households. Beyond the initial response of removing fuel subsidies to support revenues, the upside is new priorities for the FG in the areas we have highlighted in the medium-term. We believe the economic crisis brought by COVID-19 presents an opportunity for policymakers to propose and implement reforms that would boost FG’s finances, enable a conducive business environment and attract investment into human capital development and infrastructure.
Global Macroeconomic Highlights
The Great Lockdown: Worst Economic Contraction since the 1930s
The International Monetary Fund (IMF), in its January World Economic Outlook (WEO), projected a 3.3% recovery in the global economy for 2020. The optimism was on the back of improved Sino-US relations, clarity on BREXIT and expected economic recovery in the Emerging Markets and Developing Economies (EMDEs). However, the unprecedented outbreak of coronavirus in the first half of 2020 dampened the prospects of a recovery in global growth. The total number of cases rose from 95,333 persons in early March to over 10.0 million in June, with 7.2 million recoveries and over 500,000 deaths, across 200 countries. The measures adopted by countries to contain the spread of the pandemic including border controls, social distancing and lockdowns resulted into significant disruption to global demand and supply chains. Global trade and investment activities also sharply deteriorated, with the associated risks and panic in the financial markets reported to be worse than during the 2008/9 Global Financial Crisis (GFC).
The IMF downgraded its 2020 global growth forecast to -3.0% in April following the lockdown measures. Furthermore, the IMF reviewed its forecast downwards to -4.9% in June as the impact of COVID-19 on the global economy became clearer. AEs are expected to see an estimated GDP decline of 8.0% in 2020 with recovery projected at 4.8% in 2021. The economy of the Euro Area is expected to contract 10.2% in 2020 but recover 6.0% in 2021. In the EMDEs, growth is estimated to print at -3.0% in 2020. Subsequently, EMDEs are expected to grow at 5.9% in 2021. In the SSA region, GDP contraction is forecasted at -3.2% in 2020 with a recovery of 3.4% in 2021.
Central Banks Come to the Rescue
To support the economy and smooth functioning of financial markets across the globe, many central banks adopted a dovish stance and introduced unconventional monetary and fiscal policy measures. Governments around the world also provided large emergency stimulus to individuals and firms at around $11.0tn. The US Fed lowered benchmark rate by 150bps to 0 - 0.25bps in March and adopted unpopular quantitative easing measures such as asset repurchases and credit swaps. The European Central Bank rolled out its cheapest ever loans for Eurozone banks and considered the expansion of its €750.0bn ($815.0bn) bond-buying program, to contain the economic fallout from the coronavirus pandemic. The developing economies also followed the same pattern with aggressive rate cuts and adoption of unconventional monetary policy measures. Given uncertainties on the direction of the global economy, weak inflation and low business confidence, we expect central banks to maintain the dovish approach and provide further monetary policy support to the economy.
Domestic Macroeconomic Highlights
Real GDP: Nigeria amid COVID-19… Another Devastating Setback
We were optimistic about a slow but sustained recovery in the economy as we forecasted a 2.4% y/y real GDP growth rate in our Economic and Financial Markets Outlook published in January 2020. However, the NBS has since published Q4:2019 and Q1:2020 GDP numbers, which indicated that the pace of growth remained slow and uneven. Real GDP growth in Q4:2019 was faster at 2.6% y/y, driven mainly by the non-oil sector which rose 2.3% y/y. Overall, the economy grew 2.3% in 2019, below our expectation of 2.4% but an improvement from 1.9% in 2018. In 2020, we believe the ongoing recovery from the 2016 recession would suffer a setback. The growth performance in Q1:2020 was slower but positive at 1.9% y/y – the weakest since Q3:2018 – as the COVID-19 pandemic had yet to significantly affect trade, investment and local economic activities. Oil sector growth moderated to 5.1% y/y and non-oil sector growth slowed sharply to 1.6% y/y.
We revise our growth forecast downwards to –6.2% in 2020 from 2.4% earlier in the year as we believe subsequent quarters would reveal the scale of the economic impact of COVID-19. Our expectation is mainly driven by external shocks brought by the pandemic through weaker oil prices and the lockdown as well as social distancing measures adopted to contain the spread of the virus. While we expect the weakest performance in Q2:2020 given the full lockdown in April, we anticipate a partial recovery in H2:2020 as the containment measures are relaxed with the reopening of major cities in Nigeria and external trade partners.
Inflation Outlook: Coping with FX Constraints and Supply Chain Disruptions
In our January 2020 outlook, we explored the path of inflation for the year using three scenarios. However, our base case has been the more realistic outcome following the suspension of the proposed new electricity tariff due to the impact of the pandemic on disposable incomes, although the exchange rate has been devalued by 15.0%. Since the turn of the year, consumer prices have seen a slow but steady rise with headline inflation increasing from 12.0% in December 2019 to 12.3% in March 2020 before reaching a 25-month high of 12.4% in May 2020, bringing average inflation in H1:2020 to c.12.3%.
Looking ahead, with the onset of COVID-19 and high FX volatility, inflationary pressures have intensified. The disruption in the agriculture value chain due to the pandemic, which has affected planting activities and distribution, is expected to result in weaker food supplies. The impact of exchange rate devaluation from ₦307.00/$1.00 to ₦360.00/$1.00 in the spot market and ₦360.00/$1.00 to ₦380.00/$1.00 at the I&E FX window, FX scarcity and the VAT increase should drive consumer prices higher. Consequently, we project an average monthly inflation of 12.8% in 2020.
FGN 2020 Budget: COVID-19 Compels Sharp Fiscal Adjustments
Fiscal authorities revised the 2020 budget in the wake of the COVID-19 pandemic which had caused an oil price shock and weakened prospects for non-oil revenue. The oil price assumption was reduced by 50.9% to $28.00/bbl. while oil production was cut 17.4% to 1.8mb/d following output cuts agreement reached to support oil prices. Meanwhile, the CBN devalued the official exchange rate by 15.3% to ₦360.00/$1.00, reflecting the deterioration in external accounts and falling external reserves. The revision made to the assumptions translated to projected revenues of ₦5.4tn, which is 36.3% weaker than initial expectations. Projected oil revenue has been revised downwards by 60.3% to ₦1.1tn while non-oil revenue was reduced by 10.0% to ₦1.6tn. Independent revenue was increased 9.7% to ₦932.8bn while other revenues including asset sales & renewals, fines, domestic recoveries and donor grants were cut 43.0% to ₦1.7tn. Despite the much weaker revenue expectations, projected expenditure was increased to ₦10.0tn (excluding GOEs) from ₦9.7tn following provisions made for COVID-19 interventions.
While the FG expects a total fiscal deficit of ₦4.6tn in 2020, we expect it to be higher at ₦5.5tn. This would translate to a fiscal deficit to GDP of 4.2% compared to the budgeted 3.5% of GDP. Although this would breach the 3.0% threshold set by the Fiscal Responsibility Act (2007), the FG is protected by the clause that allows borrowings to overshoot this target during a crisis. With the significant increase in borrowings in 2020, we expect FG’s debt sustainability indicators to deteriorate. We estimate a debt (including CBN overdrafts) to GDP ratio of 27.5% in 2020 from 21.7% in 2019. Meanwhile, we estimate a debt service to revenue ratio of 87.8% in 2020 from 59.6% in 2019.
Financial Market Highlights
Equities Market Review and Outlook: COVID-19 Throttles Positive Return
The equities market kicked off the year amid stronger optimism propelled in part by the unattractive fixed income yield environment and the hunt for high dividend yielding stocks by investors. However, the outbreak of the COVID-19 pandemic and the economic fallout swiftly put an end to the early optimism, with the resulting fear and uncertainty dictating market sentiment for the rest of the first half. As the pandemic continued to spread with Nigeria recording its first case, stocks lost 9.1% and 18.8% in February and March due to lockdown and elevated external risks. In early April, sentiment worsened on the back of weaker oil prices, fueling exits that dragged the YTD return to a low of -23.0%. However, interests from local bargain hunters mostly drove the market performance in April (+8.1%) and May (+9.8%) into positive territory. The benchmark index settled at a YTD return of -8.8% in H1:2020.
Events of the first half of the year caution against an overly optimistic outlook for the second half. We envisage that the recovery pattern in late H1:2020 would be sustained due to an improvement in risk appetite mostly from the locals and an improvement in external conditions. That said, we note that the downside risks to our expectation include tightening of the partial economic reopening due to new wave of the COVID-19 spread, lower oil prices, MSCI’s classification of the Nigerian market as a standalone, continued FX illiquidity and weaker than anticipated economic and earnings growth. Based on the listed drivers, we foresee three possible scenarios in H2: Pessimistic Case - 11.8%, Base Case -2.8% and Optimistic Case - 6.2%.
Fixed Income Market Review… Accommodative Monetary Policy Takes Centre Stage
In our outlook for FY:2020, we had envisaged that short term yields would be driven by monetary policy while movement in long term yields was expected to be influenced by the activities of long term investors. We also expected attractive carry trade to continue, especially in Emerging Markets (EMs) with improving macroeconomic outlook, due to higher yields compared with yields in Advanced Economies (AEs).
In 2020, policy rate cuts along with other measures became the new norm for most central banks as the novel Coronavirus rattled major markets and economies. The US Fed cut interest rates by 150bps to a range of 0%-0.25% and also commenced asset purchases, buying back $3.0tn worth of instruments amid other fiscal policy measures to lessen the economic impact of the pandemic. These developments would ordinarily imply more funds to Emerging Markets (EMs) as investors hunt for higher yields but the pandemic and its related uncertainties have necessitated ‘flight’ to safety, with investors exiting EM assets. Contrary to our expectations of a sustained bullish performance in the SSA sovereign and corporate Eurobonds, both the sovereign and corporate Eurobond instruments under our coverage reported sell-offs as yields rose 186bps and 120bps respectively.
To fund the revised budget deficit of ₦4.6tn, FG is sourcing about ₦2.1tn ($5.9bn) from multi-lateral lenders with an additional ₦2.2tn expected to be borrowed in the domestic market. While it is cheaper for the FG to borrow locally at current yields, we do not rule out the possibility of ‘Ways & Means’ funding by the CBN, especially when fiscal deficit overshoots target. Already, ₦510.9bn has been borrowed market in H1:2020, with ₦1.7tn outstanding in H2:2020 which may be raised in the fixed income market and/or borrowed from the CBN through ‘Ways & Means’. On the demand side, we expect inflows of maturities worth ₦8.1tn from treasury bills, OMO and bonds in H2:2020. Although this is lower compared with the maturities of ₦11.3tn in H1, it remains sufficient to push yields lower. We believe that if the CBN decides to tighten liquidity significantly by issuing OMO bills to prevent sharp portfolio outflows as FX demand backlogs are met, there could be significant improvement in yields.
Investment Strategy for 2020
At the start of the year, we had expected accommodative monetary policy in AEs to drive funds flow to EMs assets in search of yields. However, with the outbreak of COVID-19, investors initially panicked and retrieve funds from EMs to safety, resulting in massive rise in yields`. On the back of gradual resumption of economic activities, we have seen investors return to EMs assets as yields remain attractive.
A review of the performance of the portfolios we recommended for 2020 reveals positive performance from both the Modified Duration Portfolio and the Passive Bond Portfolio. Our Modified Duration Portfolio performed best in H1 with an average return of 18.9%, outperforming the benchmark – S&P/FMDQ Sovereign Bond Index – with a 17.0% return in H1. Similarly, our Passive Bond Portfolio, comprising domestic corporate bonds reported an impressive 14.9% return. The effect of the pandemic was mostly felt in our Smart Eurobond Portfolio which returned -3.5% with all instruments recording losses during this period.
For H2:2020, we maintain our recommendation for the Smart Eurobonds portfolio due to improving prospects for commodity prices. We also believe that the Passive Bond Portfolio remains attractive for investors buying to hold due to its high yield and illiquidity. For the Modified Duration Bonds, we made adjustment to the selection to balance the interest-rate risks in the portfolio.