Favourable external conditions save the day

The Nigerian fixed income and FX markets performed well in April, after a period of pronounced weakness, as these asset classes finally benefited from a lagged multi-week rally in emerging markets. Having re-priced to the upside between May 2013 and Jan 2014, emerging market currencies and interest rates were positively supported between Feb and early April. Against this backdrop, it was a matter of time before the bullish positioning spilled over to less mainstream markets, including Nigeria.

Yet there were signs that the rally in emerging local markets started to run out of steam from mid-April. Most emerging market currencies (including the South African ZAR, Brazilian BRL, Turkish TRY, Russian RUB) traded either slightly weaker or at least sideways against the USD over the past couple of weeks, while the downward trend in domestic market yields appeared to slow or even reverse marginally (Turkey being the main exception given the expectation of lower interest rates).

Earlier in April, international investors returned to the short end of the Nigerian yield curve in decent size for the first time in several months which contributed to an initial rally in T-bills. Even though offshore demand subsequently subsided, the continued downtrend in T-bill rates reflects the substantial build-up of excess liquidity in the market that the CBN has allowed (around N700bn on 29 April). Having printed at a yearly high of 15.7 percent in the primary market on 19 March, the 364-d T-bill yielded 13.9 percent at the 23 April auction, while secondary market rates for this tenor collapsed to 12.2 percent on 30 April.

In a sense favourable external conditions and their positive lagged effect on Nigerian assets eased the urgency to tighten formal and effective monetary conditions in the country. While we had recommended a hike in the MPR at the 24/25 March MPC and advocated an increase in both the CRR on private and public sector deposits (currently 75 percent), the Committee decided to hold the policy rate unchanged at 12 percent by five votes to four, and only raised the CRR on private sector deposits to 15 percent from 12 percent. Our argument at the time was that Nigeria needed to restore the competitiveness of its fixed income assets vs emerging market peers that experienced a stronger FX and interest rate re-pricing since last year.

Granted, the relative valuations of Nigerian fixed income assets became moderately more attractive as emerging market debt continued to gain in late Q1:14, and the premium that offshore investors required for purchasing NGN instruments contracted, especially as FX reserves concomitantly stabilised around $38bn in recent weeks. That said, we feel that secondary market T-bill yields are now certainly well below levels that would anchor foreign investor interest in the Nigerian curve. However, we will look for re-entry points into the T-bill trade in the high 13 percent or 14 percent area when the market corrects.

The foreign bid for Nigerian T-bills earlier last month and the subsequent improvement in domestic confidence contributed to a decent move lower in USD/NGN (a low of 160.6 on 30 April), after a 164-165 range prevailed in March. The turn in the FX market is certainly a relief after two previous months of significant upward pressure on USD/NGN, and will ease immediate concerns about the sustainability of the exchange rate. Yet further USD/NGN downside is constrained by the lack of more qualitative and sustained portfolio inflows, and the pair will continue to track global risk cycles.

On the policy front, two recent key events suggest that a devaluation of the NGN is not likely in the medium term. First, the MPC meeting held on 24/25 March reiterated its commitment to exchange rate stability, in line with the FX stance that has prevailed in recent years. Second, CBN Governor designate Godwin Emefiele indicated that a devaluation of the currency would be devastating for the import dependent economy, adding that the CBN FX policy approach was correct during his screening and confirmation by the Senate (26 March). In other words senior CBN officials continue to hold the view that a weaker currency would not improve external competitiveness and boost import substitution given that oil accounts for 95 percent of exports and considering Nigeria’s persistent infrastructure and energy bottlenecks. Yet they believe this would most likely result in a spike in imported inflation and weigh negatively on investment.

Given the above mentioned structural distortions in the Nigerian economy, we still feel that arguing about the fair value of the NGN is somewhat an esoteric discussion. In a related matter, a policy-induced move higher in the mid-point of the RDAS +/-3% band around 155 will not help the exchange rate find a more sustainable new equilibrium. If anything, the interbank FX rate will also trend higher and the upward pressure on the currency will resume at the upper end of the new trading range. After all, the core issue here is that we have a major oil producer that is unable to accumulate any meaningful fiscal savings (a mere $3.5bn in the ECA in March [0.7 percent  of GDP] and $1.5bn in the SWF [0.3 percent of GDP]) despite the robust oil price in recent years and a consistent current account surplus. As long as oil revenue leakages and a loose federally consolidated fiscal stance persist, ensuring a stable USD/NGN will remain an arduous task for the CBN, and this will prolong the overdependence on capital flows to support the exchange rate.

Bonds have also rallied aggressively, with the benchmark Jan 22s trading as low as 13.1 percent on 30 April, from levels exceeding 14 percent in March. At first, this was primarily the product of short covering, as domestic market players initially expected a new round of aggressive monetary tightening at the 24/25 March MPC. Bonds have since benefited from excess liquidity in the market and lower T-bill yields, but pension funds have not been active buyers in recent weeks. As expected, there is also barely any foreign bid at the long end.

Bonds appear to offer limited value for a number of reasons. First, the 10-yr bond in a more liquid market such as Brazil currently trades around 12.5 percent which places a floor on how much yield downside for FGN issues is acceptable from an offshore investor perspective. Second, it remains to be seen whether the more neutral-to-cautious risk environment in late April is a short-term deviation from the multi-week trend in emerging market assets or if it will continue for a longer period of time. The other concern is that we are getting gradually closer to May-June, a period when offshore accounts usually tend to lighten up their positions, which in turn is conducive for market corrections. Third, Nigeria’s weight in the GBI-EM will be modestly reduced to 1.70 percent by Sep from 1.92 percent as the index is rebalanced and the weight of Colombia increases. Fourth, investors are likely to prefer the short end as Nigeria moves closer to the 2015 general elections and reduce their exposure to duration.

Nevertheless, the trend in bond yields is unlikely to reverse sharply as long as T-bill yields remain supported by ample system liquidity and there is no new leg of capital outflows at the short end. Additionally, the DMO has so far managed to contain the issuance volumes at the long end, even reducing the size of the 23 April auction to N50bn (N25bn of Aug 16s and N25bn of March 24s), although it remains to be seen whether the benign supply will remain sustainable closer to the 2015 polls. Meanwhile, we suspect the bid from domestic pension funds will cap the upside for bonds yields should they move higher, as has been the case in the past, as these institutions need to match long term assets and liabilities, do not mark-to-market and see favourably the elevated real rates in the market (a stationary single-digit inflation path has persisted for some time [7.8 percent  y/y in March]).

The equity market lost ground in Q1:14, but recovered in late March and advanced in April. While the NSE All-Share Index is down 4.8 percent and 5.9 percent YTD in NGN and USD terms, it gained 3.6 percent and 6.2 percent, respectively, between 20 March and 30 April. The recent performance broadly tracked that of the MSCI FM index which gained 6.8 percent post-20 March (the MSCI EM rose 6.3 percent). Besides, the stronger NGN and improved confidence in the sustainability of the exchange rate weighed positively on the NSE trend. The correction earlier this year revealed some value in Nigerian equities, but the strongest names (GTB, Zenith, Nestle) seem to have predominantly benefited from the recent rebound. This suggests that investors will probably want to play it safe amid an uncertain institutional, political and economic outlook for the next year. Meanwhile, secondary market liquidity has remained modest, around $20m per day on average. Still, the downside for the NSE is probably constrained by the likely support from the growing frontier market investor community and Africa-focused accounts which cannot really ignore Nigeria and the already modest domestic pension fund exposure to equities. Interestingly, there was decent onshore and offshore investor appetite (albeit not so much from accounts specialised in oil stocks) for the Seplat Petroleum Development Company IPO which raised $500m from both the NSE and LSE (stock price up 9.2 percent and 13.6 percent, respectively). This dual listing actually represents the largest IPO for a Sub-Sahara African company since South Africa’s Life Healthcare deal in 2010, despite the subdued interest among Nigerian companies in tapping primary equity capital markets post-2008.

Nigerian Eurobonds remained well supported by the favourable risk metrics in the credit market, with their spreads over UST narrowing to new lows in April, in line with a pronounced compression in emerging market spreads since Feb and benign US Treasury rates (10-yr at 2.7 percent on 30 April). That said, the uncertainty surrounding the political situation in Ukraine weighed somewhat on emerging market Eurobonds lately, and more generally, further contraction in the EMBI+ spread (314 bps on 30 April) will be hard won after such a sharp rally. In any case, the valuations of the Nigerian Eurobonds look expensive (spreads over UST ranging between 291 and 307 bps), especially considering the institutional and political risks ahead, which reinforces our underweight recommendation. Meanwhile, Zenith Bank took advantage of this window of opportunity and issued 5-yr senior unsecured Eurobonds at 6.5 percent (coupon of 6.25 percent). The bank raised $500m, but the order book amounted to $1.3bn, pointing to decent investor appetite for the bond. Yet the share of domestic accounts in the allocation only stood at 6 percent, which is unusual in Nigerian corporate Eurobond issuances.

Samir Gadio