The Virtuous Cycle… Again!

Executive Summary: Nigerian Economic and Financial Market: 2017 Review & 2018 Outlook By Afrinvest

Global Macroeconomic Highlights
The global economy continued to record synchronised expansion across regions in 2017. This has been supported by sustained momentum in Advanced Economies (AEs), brought about by favourable financial conditions and cyclical recovery in the Euro Area, resilient growth in China and rebound in frontier markets propped by increase in commodity prices. The strong and synchronised global growth upswing is expected to continue into 2018, with the IMF revising 2018 forecast upward by 0.1% to 3.7% in October 2017 and 0.2% to 3.9% in January 2018. Nevertheless, while near term global growth prospects remains broadly positive, increasing geo-political risk, trade protectionism and policy normalization by systemic central banks are downside risks to forecasts.

Likewise, as the move towards normalization strengthens in 2018, supported by favourable labour market conditions and increased momentum in global growth, systemic central banks in developed markets would be more willing to begin monetary policy tightening despite sticky inflation. As central banks gradually normalize monetary policy from the extraordinary measures taken at the peak of the global economic and financial crisis, associated downside risks of tightening global liquidity and capital flow reversals from emerging & frontier markets and currency volatility will become more prominent headwinds to near term growth and financial market stability.

Domestic Macroeconomic Highlights
The year 2017, in many respects, was a year of recovery for the Nigerian economy and financial market compared to the sharp business cycle contraction witnessed in 2016 alongside weak market returns. Consequent on the upturn in commodity prices, cessation of attacks on oil & gas infrastructure in the Niger Delta region (which had a positive knock-on impact on domestic crude oil production volume) and adoption of pro-market FX reforms by the Central Bank of Nigeria (CBN), economic activity rebounded while investor and consumer confidence as well as business sentiments strengthened.

The Nigerian economy returned to growth in Q2:2017, exiting a 4-Quarter long recession - its first in 25 years – which lasted between Q2:2016 and Q1:2017. Propped by higher oil exports and administrative flexibility in FX management structure, reflected in increased CBN FX Interventions and opening of the Investors’ and Exporters’ (I&E) FX Window in April 2017, external sector indicators also turned positive with the Current Account Surplus jumping nearly four times from US$2.5bn in 2016 to US$9.5bn in 2017 while cumulative Capital Importation as of 9M:2017 rose 91.5% Y-o-Y to a 2-year high of US$6.8bn. The favourable Balance of Payment dynamics led to accumulation in External Reserves which climbed to a 3-year high of US$38.7bn (29/12/2017) and stabilized the Naira at the official window with a consequential impact on the parallel market which gained 35.0% Y-o-Y against the greenback to close at N363.00/US$1.00 by yearend. Supported by improved growth prospects and FX liquidity, business sentiment, gauged by the CBN’s Manufacturing and Non-Manufacturing Purchasing Managers’ Indices (PMI), indicated expansion in activity from April 2017 till date. Consumer Confidence has also been on the rise, with the NOI (Ngozi Okonjo Iweala) Polls survey showing a 4.8 points increase in its Consumer Confidence Index from 62.7 points in Q1:2017 to 67.5 points in Q3:2017.

Although price level growth disappointed for much of the year, persistently falling below Analysts’ estimates, due to pressure on food prices, Y-o-Y Headline Inflation moderated 3.2ppts to 15.4% in December 2017 while the Core Inflation fell 6.0ppts within the same period to 12.1%. Labour market slack was the only blot on the strong improvement in core macro variables as the economy struggled to create jobs for the expanding labour force, forcing Unemployment and Underemployment rates to rise 4.6ppts and 0.2ppts to 18.8% and 21.2% respectively in Q3:2017. On the back of the strong oil price tailwind, our near term prognoses for macroeconomic indicators are broadly positive as we expect the economy to consolidate on recent recovery.

Price Level… Benign Outlook as Policy Makers Hold-off on Supply Side Reforms
Unlike 2016 when the spike in food prices pressured the Consumer Price Index (CPI), the major risk-factor for Consumer Prices in 2018 will be coming from the Core Index where delayed supply-side reforms in regulated markets for Power and Fuel could destabilize prices. The Power sector is currently facing a liquidity crunch due to non-cost reflective tariffs and lack of investment in the value chain to ease high Aggregate Technical, Commercial and Collection (ATC&C) losses, resulting in demand for increase in tariff by value chain operators. Furthermore, the “Price-Modulation” template for pricing of PMS (Petroleum Motor Spirit) introduced by the Petroleum Products Pricing Regulatory Agency (PPPRA) in May 2016, in retrospect, is akin to putting Band-Aid on a bleeding artery rather than a landmark reform to liberalise the downstream industry as earlier guided. Already, assumptions included in the template are urgently due for upward review on the back of the increase in the landing cost of PMS – following the oil price rally and the June-2016 naira devaluation.

Despite these risk factors, our near-term inflation outlook remains benign due to constrained political will to implement supply side reforms ahead of the 2019 elections. Supportive oil earnings tailwind will also buy the federal government more time to contemplate the reforms. Hence, our base-case scenario projects Headline Inflation moderating further to 12.3% by yearend 2018.

Near Term Growth Outlook … Oil Sector Low Base Effect Will Remain Key Driver
The economy’s return to growth in Q2:2017 and acceleration in momentum in Q3 were largely driven by Oil sector GDP which grew 3.5% and 25.9% Y-o-Y in Q2:2017 and Q3:2017 respectively. The sizeable expansion in the Oil sector, particularly in Q3:2017, was due to the low base effect of oil sector production which reached a 6-Quarter high of 2.0mb/d during the period. The Non-Oil sector however remains a pressure point, as it relapsed to negative growth in Q3 after showing positive signs in Q1 and Q2. The disappointing performance of the Non-Oil sector - which was unexpected given the positive readings from leading variables such as the PMI - is evident in virtually all the main Non-Oil categories including Services and Manufacturing which contracted 2.7% and 2.9% Y-o-Y respectively in Q3:2017. The slow recovery of the Non-Oil sector has both cyclical and structural explanations. Cyclical factors include tight monetary policy, subsisting weak fiscal spending – particularly at sub-national level - low real household consumption growth (due to high inflation rate) and benign corporate investment spending consequent on the damaging impact of large FX rate movements in the last 3 years on corporates’ balance sheet.

Whilst the structural issues remain headwinds, we note that the cyclical challenges should start to abate from 2018 and buoy Non-Oil sector growth against the backdrop of 1) anticipated expansion in fiscal spending as fiscal balance stabilizes and political parties spend ahead of the election, 2) further deceleration of inflation rate which will directly affect GDP price deflator and support real growth, and 3) Increase in private investments due to favourable aggregate demand outlook and stable FX rate. Similar to 2017, we also expect Oil sector low-base push to remain a key driver of growth until Q2:2018 before the effect wears off as base normalizes. The expected take-off of oil production from Total’s offshore Egina field project in Q4:2018 will possibly add approximately 200,000 barrels  to daily crude production, but with oil production capped by OPEC at 1.8mb/d (ex- condensates), we do not foresee aggregate oil production (including condensate) breaking its peak of 2.2mb/d.

Thus, against the backdrop of expected rebound in Non-Oil sector and Oil sector low base push, we forecast GDP growth to accelerate to 2.1% in 2018 from our full year estimate of 0.7% for 2017. Major downside risks to our forecast include OPEC/Non-OPEC decision on Nigeria’s production cap, development in the oil market and stability in the Niger-Delta.

Monetary Policy Outlook… Easing Cycle to Enter Full Gear despite Stable Benchmark Rate
As we projected in our 2017 Outlook, the CBN successfully guided short and long-term rates downward in the fixed income market despite retaining benchmark policy rate at 14.0%. Although price level growth disappointed in 2017, with Inflation rate still above MPR, the CBN began an easing cycle with the use of clearing rates at OMO auctions and frequency of auctions as policy instruments to achieve its easing objective. Typically, what should follow the moderation in market rates and signify the full take-off of the easing cycle is a benchmark interest rate cut. However, we believe the CBN would stick to utilizing its recently favoured OMO strategy – which is more flexible - to achieve the same easing objective without tweaking the MPR. Despite our conviction, we do not rule out the possibility of a politically induced benchmark rate reduction in the second half of 2018, in order to make credit available to the real sector. If economic conditions improve further, this could potentially be done in order to score political points with the populace ahead of the 2019 election.

Our forecast is based on downside risks considerations relating to 1) anticipated fiscal spending in the run up to the general elections and expected volatility in domestic assets market in H2:2018 which will pose a threat to price and exchange rate stability; 2) expected monetary policy tightening by systemic central banks in Europe and North America which could spur capital outflows from emerging and frontier markets and constitute downside risk to domestic exchange rate stability; and 3) benign but double-digit inflation rate which may not necessarily go below MPR but would support a hold on the rate as the CBN tries to consolidate gains on price levels. Hence, our monetary policy outlook favours continued downward repricing of fixed income yields, albeit with a stable MPR.

Fiscal Policy Outlook… Focus on Reducing Debt Service Obligations amidst Rising Expenditure Pattern
Nigeria’s increasing debt burden and rising servicing cost have come under focus in recent times for justifiable reasons. Whilst current debt to GDP ratio (18.2% ) appears non-threatening, rising servicing cost relative to revenue (47.0% in FY:2016) and slow growth of non-oil revenue post-crisis have increased debt sustainability risk – a key consideration of Moody’s  in recent sovereign downgrade. The FGN responded by changing its 10-year long conservative debt strategy of relying more on domestic market for debt to tilting towards cheaper external sources in the global market to reduce servicing costs. Thus, the FGN returned to the Eurobond market after a 4-year hiatus in 2017, raising US$1.5bn in Q1:2017 and US$3.0bn out of a US$5.5bn approved Medium Term Note Project in Q4:2017. Despite the steep decline in domestic market rates, we expect the FGN to stick to the new strategy in the near term due to the favourable global market environment and its ambitious expenditure plan.

As with prior years, the 2018 Budget projects a reflationary spending of N8.6tn, a 16.2% increase relative to the N7.4tn of 2017, with a focus on consolidating on gains recorded in the previous year whilst also prioritizing the need to bridge the investment deficits in the Infrastructure, Agriculture and Health sectors amongst others. While the budget’s macroeconomic variables assumptions are not far off from current realities, perhaps even prudent with regards to crude oil prices, we are of the view that achieving >70.0% implementation of capital component will be difficult due to the ambitious non-oil and independent revenue assumptions. As of 9M:2017, performance of the “Budget of Recovery and Growth” had been rather underwhelming with fiscal authorities falling short of revenue targets, especially Non-oil revenue (N0.7tn actual vs. N1.0tn pro-rated projection) and Independent Revenue (N155.1bn vs. N605.9bn pro-rated projection). Thus, the Non-core revenue lines which contain non-recurring items such as Exchange Rate difference and Paris Club over-deduction refund were leveraged to finance the budget. While the Presidency hopes to improve on existing tax reforms to boost income from the Non-oil sector as well as enhance activities in other sectors of the economy, the odds of a significant increase in tax revenue in the short term remains low as Non-oil sector growth remains below historical trend.

Polity Stability: Security Concerns and Ethnic Divide Setting Stage for Volatile Election Cycle
One of the major downside risks to asset prices or capital markets and polity stability in 2018 is politicking ahead of the General Elections holding in February 2019. President Muhammadu Buhari of the All Progressives Congress (APC) is widely expected to seek re-election in what would potentially be a keenly contested poll due to the waning popularity of the incumbent in Southern Nigeria (see NOI polls) and divisions in the ruling party which has already led to the defection of Former Vice-President Atiku Abubabar to the opposition People’s Democratic Party (PDP).

Typical of election cycles in frontier markets, we expect to see some volatility in financial assets in the period leading up to the polls whilst policymaking will take a shorter-term perspective. Key issues we expect to dominate debates include Job Creation, Security and Political Restructuring. Slacking labour force despite improving growth profile has led to an increase in Unemployment and Underemployment rate with 34.0m people either without jobs or underemployed. Whilst secession agitation in the South East appears to have lost momentum and government’s efforts to placate Niger Delta militants has largely succeeded, the impact of climate change – which has ravaged grazing fields in Northern Nigeria – has increased incidences of trespassing in farmlands in North Central and Southern Nigeria by nomadic Fulani cattle herdsmen searching for greener pasture. This, perhaps appears to be the prime near-term security risk, setting the stage for a potentially volatile election cycle in 2019.

Nigerian Financial Markets
The Nigerian equities market posted its first positive annual return in four years (+42.3%) in 2017, ranking the benchmark All Share Index (ASI) as  the 11th best performer in the world and 2nd in Africa. The launch of the Investors’ and Exporters’ FX window in April,2017, was a turning point for the market during the year while a rebound in economic activities, supported by rising oil prices above US$60.0/b and improvements in company earnings kept investors vested in the market all through the year.

With the market now at an all-time high in terms of market capitalisation and the NSE All Share Index at a 9-year high, there are justifiable fears of overvaluation of the market which raises concerns with regards to a near term correction. Our approach is to diagnose and probe the fundamental as well as technical merits and demerits of the overvaluation hypothesis.

From our analysis, average Trailing P/E and P/BV for the Nigerian equities market in the last one month as at 17/08/2018 stood at 13.1x and 1.7x, which are lower than 15.1x and 2.0x respectively for the MSCI Frontier markets index. Looking back to the last 2-year bull market run Nigeria experienced between 2012 and 2013, the Nigerian equities market was priced at a premium to its frontier markets peers in the late cycle of the run, as shown in the average P/E and P/BV multiples of the MSCI Frontier Markets index of 12.5x and 1.6x in 2013 relative to 13.5x and 2.2x of the Nigerian market in the same period. This implies that despite the rally in the market in 2017 and early trading in 2018, the current market boom has a bit more space to run. Hence, against the backdrop of improving macroeconomic conditions as well as positive outlook for corporate earnings, we believe there is a compelling case for investors to sustain interest in the Nigerian equities market as already noticed in the YTD return of 17.4% (17/01/2018). Our base case scenario forecasts the All Share Index at 45,811.73 points by year-end 2018, which is a 19.8% appreciation from 38,243.19 points in 2017.  Our bear case (+7.7% to 41,189.9 points) and bull case (+32.7% to 50,749.10 points) also follow the same trend and further buttresses the consensus view of positive market performance in 2018.

Prior to 2017, the Nigerian Yield curve maintained a Humped or Bell-Shaped slope since Dec-2016 – indicating the broadly recessionary environment. However, by the turn of 2017, we observed a bull flattening pattern as investors aggressively positioned in longer-dated bills. Notwithstanding the sustained hawkish monetary policy stance, pressure on general price levels, improved investor appetite for safety and the weak start of domestic equities market amongst others shaped the direction of yields in 2017 as well as the overall level of activities in the fixed income market. Investors displayed overriding interest for shorter term fixed income securities compared to bonds as the supply of T-bills and OMO (Open Market Operations) from the CBN propped up activity levels. While the activity dominance of most institutional investors – PFAs, DMBs and Insurance companies - remained prevalent in the year, the attractive interest rate environment strengthened by the CBN’s tight monetary policy stance also attracted retail and HNI investors to the market. Average T-bills yields on 91-day, 182-day and 364-day benchmarks settled at 17.3%, 18.7% and 20.3% in 2017 relative to 12.5%, 14.3% and 15.0% respectively in 2016.

On the medium to long term end of the market, the dominance of the Federal Government of Nigeria as the largest supplier of fixed income became entrenched in 2017 with a total sovereign bond issuance value of N1.5tn compared to N1.3tn in 2016. In addition, the FGN explored alternative long term borrowing windows within the domestic market including the launch of the Quarterly Coupon Paying Savings Bonds (N7.0bn, 13.5%), N100.0bn Sukuk bond issued at 16.5% rental yield and the Green Bond worth N10.7bn issued in December 2017 at 13.5% yield. Also, the Debt Management Office (DMO) successfully raised a total of US$4.5bn (in four tranches) from the Eurobond market at an average marginal coupon rate of 7.3% while also successfully completing a US$300.0m Diaspora bond at 5.6%.

We believe the yield environment in 2018 will be largely determined by market activities as already being noticed since the last quarter of 2017. Nevertheless, we do discountenance the possibility of a benchmark rate reduction in H2:2018 to align with market movement. We are of the view that the demand for safer sovereign instruments by Institutional Fund Managers (notably PFAs, Insurance Companies, DMBs as well as HNIs will propel market activities towards yield moderation. We highlight some of the revelations from gazing at our crystal ball to include:

  • Yield Moderation on Long Term Instruments
  • Undissipated Inflationary Pressures may Keep Short Term Rates Upbeat
  • Flurry of Commercial Paper Issuance as Government Participation Reduces
  • Higher Modified Duration Bonds will Support Long Term Fixed Income Strategy
  • Eurobonds Market will Favour Active Fixed Income Strategy
  • Corporates will Explore Domestic Market Options for Long Term Financing

Our optimism for the Nigerian markets in 2018 hinges on the slow but steady recovery in the general macroeconomic conditions following the upturn in global oil prices. Stable oil price outlook puts less strain on monetary and fiscal policies given the significant dependence of government revenue on oil exports as well as the umbilical reliance of the CBN on the sector’s foreign exchange earnings in optimizing FX allocation. As the economy gradually regains its growth momentum, we are confident that improved fundamentals, coupled with enhanced investor sentiment – currently at all-time highs, will continue to drive equity asset prices. Correspondingly, our prognosis on interest rate proposes a market driven moderation in 2018 as the government shifts its focus from short term domestic borrowing to long term foreign debt while investors explore alternative high yielding domestic short/long term securities.

Recovery Driven Fundamentals to Shape Investment Strategy
Against the backdrop of macroeconomic headwinds, our investment strategy in 2017 had advised a cautious strategy focused on capital preservation whilst recommending investors stay overweight on fixed income securities over equities with an advised mix of 80:20 allocation. Looking back, all our crafted portfolios outperformed market benchmarks by significant margins with our equity dividend portfolio returning 77.8% (vs. NSE ASI 42.3%) and the worst performing bond portfolio gaining 16.6% (vs. market benchmark of 11.6%).

Having survived the policy misalignment that enveloped and weakened equities market return in 2016, we are of the view that the recent recovery momentum, which began in 2017, will be sustained in the near term. On the back of a 42.3% return in 2017, the NSE All Share Index is set for another bullish year, in what looks like a repeat of 2013, having gained 17.9% as at 19/01/2018. Similarly, the bull run in the fixed income market in Q4:2017 resulted in a 10.5% return in the Access Bank Bond index in 2017 relative to a 4.5% loss in 2016; yet, expectation of lower yields in 2018 will shape performance on fixed income securities. Consequently, we reason that for the investment strategy in 2018 to be optimal, it will necessarily have to hinge on fundamentals of investible asset classes. However, contrary to our 2016 and 2017 investment strategy that suggested overweight on fixed income securities over equities, we believe 2018 will be more skewed towards a balance of play between the two traditional asset classes.

Whilst we are more cautious about equity market valuations inching beyond its fundamental value threshold, we are also assured that, barring a dysfunctional foreign exchange market, equities are possibly set for appropriately timed entry and exit opportunities in 2018. Fundamentally backed sentiments will conceivably propel the equities market on a volatile but upward trending trajectory which informs our Equity Strategy that is skewed towards five (5) major portfolios. Contrariwise, Long Term play defines our overall strategy in the fixed income market for 2018. We expect the easing of the crowding out effect of the federal government in the domestic debt market to create incentives for sub-national and corporate debt issuances as rates on sovereign instruments moderate towards long term average levels. Importantly, our four (4) portfolios for smart fixed income investing in 2018 is themed: “Active “and “Liquid”.

The Virtuous Cycle… Again!
To investors familiar with frontier markets, the almost 360-degree turnaround in Nigeria’s economic fundamentals and investor sentiment is not surprising, given the strong correlation of the business cycle and capital market with foreign  currency earnings for commodity exporting countries. In our 2017 outlook titled “Reform or Be Relegated”, we had reflected that;

“A return to 2015 level of crude oil production (2.1mb/d) would comfortably lift oil sector GDP (which accounts for c.9.0% of aggregate real GDP) by an estimated 15.0% Y-o-Y in 2017 and may pull the economy out of recession… On this basis, Nigeria’s business cycle would be highly dependent on the ability of policy makers to deliver incremental oil output in 2017, restore macroeconomic stability by rebuilding confidence in monetary policy and the administrative side of the FX market structure as well as showing commitments to structural reforms. These would be necessary to stabilize external account, rebuild external reserves, improve liquidity in the FX market and achieve lower inflation as well as lower long term interest rates.”

Events in the last 12 months have justified our prognoses as policymakers were able to deliver on:
1.    Increase in domestic crude oil production from a low of 1.6mb/d in Q3:2016 to 2.0mb/d in Q3:2017.

2.    Restoration of FX market stability following the increased volume of FX interventions, particularly to BDCs, and eventual opening of a market-oriented FX segment (the I&E FX window), which allowed for flexibility in pricing of FX as well as efficiency and transparency in allocation. The CBN spent US$15.4bn in the first nine months of 2017 intervening in the FX market via Spot and Forward Interbank FX auctions and spot sales to BDCs, relative to US$9.6bn spent in the same period of 2016, while the I&E window recorded US$27.8bn in turnover in 2017.

3.    Release of the Economic Recovery and Growth Plan (ERGP) in Feb-2017 - arguably the most ambitious development plan by the FGN since the National Economic Empowerment and Development Strategy (NEEDS) document published in 2004. The ERGP is a medium-term plan (2017-2020) which focuses on five key priority areas: 1) Stabilizing the macroeconomic environment, 2) Ensuring energy sufficiency (power & petroleum products), 3) Achieving agriculture and food security, 4) Improving transportation, and 5) Driving industrialization by focusing on small and medium scale enterprises. An implementation and performance measurement management process was set up to drive execution of the plan.

4.    Tackling some of Nigeria’s deep-seated structural constraints by surpassing Ease of Doing Business reform target of moving up 20 places in World Bank’s Ease of Doing Business ranking in 2018. Nigeria moved up 24 places to 145th and ranked in the top 10 most improved countries.

Fate also smiled on Nigeria as faster than expected rebalancing in the oil market buoyed oil prices and complemented the reform by policymakers to restore macroeconomic stability. Due to the high level of compliance of OPEC/Non-OPEC countries to the deal reached in November 2016 (extended for six months in December 2017) to cut oil production by 1.8mb/d and supply disruptions in the US, UK, Nigeria and Libya, Brent Crude averaged US$54.74/b in 2017 compared to US$45.13/b in 2016.

These reinforcing factors, some due to happy accidents or providence and others, a result of deliberate government efforts, have aided Nigeria’s exit from the “vicious cycle” of macroeconomic instability and weak capital market returns and ushered in, once again, a “virtuous cycle” of stability in external sector indicators and fiscal balance, declining inflationary pressures, improving growth profile, increasingly accommodative monetary policy and strong capital market returns.

Yet, despite the oil price tailwind driving asset prices and short-term growth outlook, Nigeria’s recurrent energy crisis, high unemployment rate, fiscal insolvency of sub-national governments, high dependence on oil earnings for fiscal revenue & current account stability as well as several unforced administrative errors by the ruling political class are constant reminders of unresolved structural fault lines. Thus, even as we are positive on short term growth prospect as revealed in our report title “ The Virtuous Cycle… Again!”, we continue to emphasize on our 2-year long theme calling for structural reforms from policymakers to build long term macroeconomic resilience. As the country nears two decades of uninterrupted democracy, by far its longest run post-independence in 1960, we believe issues to top the reform agenda over the next year should include: the liberalisation of the downstream petroleum sector, total deregulation of the power sector to enthrone a more cost reflective electricity tariff, Governance Reforms echoing some of the major themes of much talked about restructuring, Infrastructure Investing, Economic Restructuring to aid Fiscal Viability of Sub-Nationals and Creation of Job Opportunities for  the galloping population.