Culled—Proshare

March 12, 2020

By CardinalStone Research

Executive Summary

The rapid spread of COVID-19 has clearly altered global economic outlook for 2020. Recently, the World Health Organisation (WHO) classified COVID-19 as a pandemic, suggesting a possibility of further shutdown across economies with knock-on effects likely to negatively distort global trade and mobility. This risk is further accentuated by the ongoing oil price war stoked by the failed OPEC+ resolution on oil production cuts.

The domestic economy is not immune to the impact of deteriorating global macros and collapse of major commodity prices. As it stands, global crude oil price is now c.38.3% lower than Nigeria’s budget benchmark crude price of $57.00/barrel. While the country is currently reeling from the second-order effect of the ongoing crises, we highlight the risk that a graver first-order effect can be unleashed by further spread of Coronavirus in the country. In this report, we expatiate on the likely implications of these developments on Nigeria, vis-a-vis:

• Weaker dollar earnings for the government
• Wider than expected fiscal deficit and a possible upward revision of planned borrowings
• Possible upward revision of the rate on OMOs
• Increased risks of dollar shortage, slow implementation of capital expenditure in 2020, and weaker-than-expected growth
• Likely repricing of Nigerian risks by FDIs and FPIs
• Increased risk of devaluation due to more aggressive FPI outflows, weaker balance of payment position, and reduced CBN’s ability to maintain currency defense
  

COVID-19: Global growth on the balance

The unexpected outbreak of the Corona Virus Disease (COVID-19) has adversely impacted the world order, with China (the second largest economy) on course to record its worst growth in a decade. Major central banks are now enacting looser monetary policies as global equities reverse earlier gains and safe haven assets rally amid investors’ flight to safety. Partly justifying the panic is the reduction in global economic activities as businesses and consumers pull back on consumption and investment. Commodity prices have not been left out in the downturn as prices of energy, industrial metals, and agricultural commodities succumbed to a COVID-19-induced demand dip. The prices of crude oil, gasoline, natural gas, copper, crude palm oil, and wheat have heavily declined, adversely impacting revenue generation in producing countries.

COVID-19 and Oil shocks: Domestic economy to reel from impact

As it stands, global crude oil price is now materially lower than Nigeria’s budget benchmark crude price of $57.00/barrel. The impact of COVID-19 on demand outlook and fresh oil price wars, stoked by the failed OPEC+ resolution on production cut, have also led to material reviews of oil price projections. By our estimates, a base case average oil price projection of $42.50/barrel could result in a N726.68 billion loss in projected oil revenue for 2020 even if government successfully meets its oil production target of 2.18mbpd. This, alongside a possible reduction in capex intensity to 17.0% (vs. over 35.0% in the approved budget), and 90.0% realization of non-oil revenue target could result in a fiscal deficit of c.N2.73 trillion in 2020 (vs. N1.91 trillion in annualized 9M’19 figures).

FX: Weaker fundamentals may force currency repricing in 2020

The fundamental case for the naira is now materially weaker, with twin deficits across current account and fiscal balances combining with higher inflation expectations to bolster the argument for a currency repricing. Clearly, Nigeria’s external buffers are lower, with reserves and excess crude accounts now at $36.2 billion and $71.0 million apiece compared to $62.0 billion and $20.0 billion, respectively, before the 2008 global economic crisis.

This comes with significantly higher vulnerability to external shocks as foreign portfolio flows into the apex bank’s Open Market Operations (OMO) now constitutes c.32.7% of reserves amidst, arguably, one of the worst oil market crises since the Gulf war of 1990/1991. Aided by marked deterioration in oil economics, we expect the CBN’s unorthodox currency management to capitulate before the end of 2020 if oil prices continue to go south.

By our base case projection, the naira is likely to be repriced closer to its fair value of c.N437.20, which reflects an average inflation of c.13.0% for Nigeria and 2.0% for USA, in 2020. We also note that a delayed response by the CBN (which is likely) could stoke further panic buying and hoarding in the black markets. The CBN may eventually adopt a stepwise approach to naira repricing in 2020 in view of the politically hot nature of devaluation discourse and the potential knock-on effect on the populace, who are also bracing up for electricity tariff adjustments.

Equities: Brace up for another negative close; but strategic positioning could rescue the proactive

Nigeria’s equity market has been adversely affected by concerns about the quick spread of the coronavirus since mid-January, mirroring sentiments in other global markets. The bourse has since eroded earlier gains recorded after a startling start to the year which saw it standout as one of the best performing equity markets globally. In addition to health-related concerns, a failed OPEC+ attempt to extend production cut agreement cascaded to an oil price war and the worst Nigerian daily equity market performance in 2020. Clearly, our revision of Nigeria’s growth and inflation expectations for 2020 suggest that the equities market may be set to close in the negative for a third straight year. Considering the negative crude oil price outlook for Q2’20 and Q3’20, we again bring to the fore the strong correlation between the ASI performance and crude oil prices in the last four years.

Given our base case expectations for naira devaluation and a slowdown in CAPEX in 2020, we note that brewers, other manufacturers reliant on imported raw materials, and cement producers are likely to be directly impacted. Notably, following the 2016 devaluation and recession, these set of producers experienced the sharpest contraction in operating profits in Nigeria. Elsewhere, we see scope for FX gains in banks with net-long dollar positions. These gains may however be capped by impairments on oil & gas and other associated loans. In the downstream oil & gas sector, operators are likely to book higher lubricant margins (on falling crude oil price) that could slightly offset cost of importation. Real value could, however, be unlocked by a proper deregulation.

Overall, we believe the market will likely remain bearish in the short term as investors remain cautious amidst coronavirus concerns and depressed oil prices. However, the sell-offs present bargain hunting opportunities for mid-to-long term investors who look to take position in fundamentally justified counters ahead of an inevitable change in tide. To this point, we highlight the stock market rebound in 2017 following the 2015/2016 crisis.

Fixed Income: External shocks to drive yields higher

In the fixed income market, domestic sovereign yields are likely to climb in near term (quicker than our previous forecast of Q3’20) driven by a combination of recent external shocks and prevailing domestic macros. The sizeable reduction in OMO maturities (N618 billion on average in Q2’20 and Q3’20 pales in comparison to average OMO inflows of N1.5 trillion since the OMO ban in October 2019), the likelihood of higher fiscal borrowing (as oil revenues shrink), increased pressure/speculation on FX, and heightened credit risk & inflation concerns are likely to place upwards pressure on yields in the short term.

For OMO bills, which are exclusively traded by foreign portfolio investors and banks, we also see legroom for an uptick in yields as the CBN is likely to reprice rates higher to compensate for the heightened risk. In addition to the recent oil price war, the increased probability of a ratings downgrade, following previous revisions from ‘stable’ to ‘negative’, is a key risk to yield outlook. FPI’s have largely been on the sell side in recent months, trimming their holdings in OMO bills from $17.7 billion in August 2019 to $12.7 billion in November 2019 as the CBN faces an uphill task of convincing investors to stick as reserves continue to slide.

Asset Allocation

Given the heightened risk environment, we think 75% and 25% weightings in favour of fixed income and equity exposures, respectively, are ideal. We expect investors to stay short in relatively safe fixed income instruments in anticipation of an upward repricing of yields. While domestic fixed income instruments may provide predictable returns if held to maturity, we believe that investments in dollar-denominated fixed income assets provide both a return and a currency hedge.

Long term investors could also seize the opportunity to take advantage of low valuations on fundamentally sound equity counters. Importantly, equity purchases should be staggered to avoid ‘catching a falling knife’ as broad based sell-offs may persist amid uncertainty over oil prices and COVID-19 outbreak in the near term.