Nigeria has emerging-market rally to thank for thinning risk premium in election year

Since a return to democracy in 1999, Nigeria’s risk premium has widened in an election year, as investors priced in political uncertainties into Africa’s biggest democracy.

This year, there’s a difference.

A risk premium is an extra return that investors demand to hold a relatively risky asset. An asset’s risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment.

For example, high-quality government bonds issued by a developed country like the United States typically have very little risk of default, therefore offering lower yields than bonds issued by developing and emerging market economies where there is a higher risk of default.

The spread between a developed market’s bond and that of the developing market is the risk premium.

For Nigeria, yields on the benchmark government bond, a ten-year paper, closed at 14.68 percent Friday, while the US ten-year bond returned 2.67 percent as at market close. That effectively equates to a risk premium of 12.01 percent, being the spread between both assets.

At 12.01 percent, Nigeria’s risk premium is down from 13.03 percent as at the beginning of 2019. At that time the yields on the Nigerian bond was 15.57 while the US bond yielded 2.54 percent.

The safe bet would have been to predict a widening risk premium as investors price in political risks associated with the general elections Feb 16. That bet would have backfired.

The unusual thinning risk premium doesn’t necessarily mean investors are unconcerned with the elections, instead the rally is driven more by broader fund flows into emerging markets.

Once the United States Federal Reserve, the US equivalent of the Central Bank of Nigeria (CBN), announced it would slow down the rate of monetary tightening, funds that had rushed out of emerging markets found their way back.

The market had earlier expected the US to pick up from where it left off last year, by hiking interest rates three times this year.  That had initially sparked a sell-off in emerging market assets until the US Fed reversed its rate outlook and guided towards a dovish approach this year.

The Fed has turned dovish since December’s ninth, and quite possibly last, rate rise of the cycle, which started in late 2015.

Emerging market debt has enjoyed a stellar start to 2019 as a result. JPMorgan’s main index of hard currency sovereign bonds has surged 4.7 per cent as spreads over Treasuries have tumbled 55 basis points — the largest year-to-date tightening on record, according to Morgan Stanley.

Since the late-November low, the index has rallied 7.1 per cent.

Local currency denominated paper has been somewhat outshone, but has still accrued a solid 2 per cent gain.

As emerging markets increasingly become awash with cash, Nigeria has somewhat benefitted, albeit to a lesser extent.

Funds have poured into naira assets recently.

The stock market has had a mini-rally in the last two weeks following a tepid January, boosting the 2019 year to date performance of the NSE ASI to 3.1 percent.

Ahead of the elections, it was expected that investors will take positions in order to benefit from a post-election rally, with the level of momentum dependent on who the eventual winner might be.

Foreign Portfolio Inflows have poured in through the I&E window, which went from a year low of $460 million in December to $1.3 billion in January.

About 60 percent of the inflow went to money market securities while the balance went into equities.

“The emerging market rally has overshadowed any negative investor perception about Nigeria amid the elections,” said Wale Okunrinboye, head of research at Lagos-based fund manager, Sigma Pensions Ltd.

“Eurobond yields have largely collapsed this year and equities have found a renewed momentum in the past week as investors take positions in cheap stocks now to avoid crowded trade later,” Okunrinboye said.

Nigerian stocks are indeed cheap. At a price to earnings ratio of 9 times, they are one of the world’s cheapest.

Technical factors are also supportive of naira assets, particularly equities.

The performance of the equities market during the last general election in 2015 reflected a pre-election rally.

That helps explain why investors are taking early positions, according to Lanre Buluro, a director of sales at Lagos-based investment bank, Chapel Hill Denham.

Stocks rallied 30 percent between February 14 (ASI level 0f 27,585) and April 4 (ASI level of 35,728).

On the first day of trading after the election, the NSE was up 8% intraday alone.

Subsequently, post the election excitement, the stock market ended the year down -17.4% (-24.3% in USD) on the back of weak macros, foreign currency illiquidity, falling oil prices, removal of Nigeria from the JP Morgan emerging market bond index, and slow transition of the new government (late selection of key cabinet members).

That said, Buluro goes on to provide a number of stocks on his watch list that could be set for a post-election rally.

“To play the election rally, we will stick to the blue chip names with strong fundamentals,” Buluro said.

“These names can ride out the volatility in the market in the event of a protracted election process.

“Also note that earnings are around the corner, so you can play for the dividend yield,” Buluro added.

From a technical standpoint, a scan of the 52 week high and lows of some of these names suggest there is upside from current levels.