ARM Research Today’s portion of the cut-out from our core strategy document – the Nigeria Strategy Report—assesses movements in the equity markets over H2 2016 and posits our outlook for same over 2017. In our H2 16 Nigerian Strategy Report, we projected a reversal of the positive run across Nigerian equities in the first half of 2016 which was fuelled by local investor confidence regarding more credible moves by policy makers, as persisting illiquidity in the newly floated interbank market deters FPI participation while rising FI yields dims local investor risk appetite. Our views largely played out as NSEASI posted two quarters of losses during the period (Q3 16: -4.3%, Q4 16: -5.2%)—which translated to negative returns in H2 16 (-9.2%) and 2016 (-6.2%). In a nutshell, across various sectors, investors’ expectations about feed-through of the deadbeat macro picture on earnings trajectory, which are hardly surprising given the recessionary economic climate, underpinned bearish dominance of NSEASI in H2 2016. Fundamentals aside, parsing through the investing pattern across domestic and foreign fund managers over H2 16, sentiment was largely weak—foreign transactions declined 47% YoY to N204.32 billion while domestic transactions contracted 23% YoY to N226.77 billion. On an annual basis, faster moderation in FPI activity (-50% YoY to N473 billion) relative to domestic pull back (-29% YoY to N582 billion) implied that local investors accounted for the larger share of market transactions (55%) for the first time since 2010. Going into 2017, we believe the key risk to performance are unchanged from last year—they include US interest rate normalization, global economic uncertainty, continued dollar strength, domestic macro concerns, FX challenges, and a drag in fiscal push to uplift the economy. Investors will continue to be especially sensitive to the state of the economy, a devaluation of the naira and any policy missteps by the monetary and fiscal authorities. On balance, the outlook for naira equities is more nuanced—low foreign and local appetite for equities combine with weak fundamental picture across most sectors underpins our muted outlook for naira equities in H1 2017. Nigerian equities head south as local investor optimism retreats In our H2 16 Nigerian Strategy Report, we projected a reversal of the positive run across Nigerian equities in the first half (+3.3%), which was fuelled by local investor confidence regarding more credible moves by policy makers, as persisting illiquidity in the newly floated interbank market deters FPI participation while rising FI yields dim local investor risk appetite. Our views largely played out as NSEASI posted two quarters of losses during the period (Q3 16: -4.3%, Q4 16: -5.2%)—which translated to negative returns in H2 16 (-9.2%) and 2016 (-6.2%). Recasting performance monthly shows the bearing of these drivers more evidently, starting in July when crude oil prices recorded the steepest MoM decline over 2016 (-14.5%), net FPI flows declined by 50% MoM to N2.6 billion. Aided by CBN’s tightening which pushed returns on fixed income instruments higher, the local bourse slid 5.4% MoM. Though crude oil prices rebounded 10.8% MoM in August even as net FPI flows tracked four-fold higher relative to prior month to N13.3 billion after freer naira trading, domestic equity markets closed in August (-1.5% MoM) as investors reacted to feeble H1 16 corporate results particularly in banking (-2.8% MoM), cement (-1.9% MoM), and food (-2.8% MoM) segments. In September, amid sustained uptrend in crude oil prices (+4.3% MoM), MSCI’s decision to retain Nigeria on its frontier market index helped markets reverse the negative tide in September (+2.7% MoM). Nonetheless, a reversal in crude oil prices in October (-1.5% MoM) alongside disappointing Q3 16 earnings underpinned a 3.9% sell-off in October and November (-7.3% MoM). However, following crude oil supply cut agreement on November 30 which led to a 15.2% appreciation in crude oil prices, naira equities turned bullish in December with NSEASI posting a 6.5% MoM return. Overall, despite the rally in crude oil prices over 2016, which ought to have boosted investors’ sentiment in line with historical trends, investors’ concern over the impact of the economic deterioration on earnings performance, persisting foreign apathy on account of FX illiquidity and local investors’ attraction to higher risk free rates combined to drive negative NSEASI performance over H2 16. Figure 1: NSEASI half-yearly returns   Fundamental headwinds underpin bearish sectoral performance Disaggregating NSEASI performance across the various sectors, starting with the cement sector which lost 15.1% over H2 16 as Q2 16 and Q3 16 corporate earnings which mostly came in July and October respectively showed earnings weakness due to several factors. First, the sector had to grapple with slowdown in volume growth (-5% YoY to 4.5 million MT) following the 47% hike in cement prices and depressed construction activity as revenue pressures forced moderation in FG and State governments capital spending. Furthermore, sizable input cost pressures, as gas supply shortages drove substitution to more expensive energy sources, resulted in the compression (-13pps YoY on average) of the sector’s gross margin. The foregoing combined with sizable currency losses on foreign loans at Lafarge (N38 billion), cement sector’s earnings slid 49% YoY to N98 billion which supported bearish bias on constituent stocks. For defensive stocks, the tough operating environment drove mixed fortunes. Whilst cost pressures induced sector wide price increases which spurred robust revenue growth for Food producers (9M 16: +33% YoY) and HPC (+7% YoY), down trading by beer drinkers muted the impact of prices hikes by Brewers (9M 16: -1% YoY). Given the more inelastic nature of food products, price hikes more than compensated for cost pressures as gross margin tracked higher for Food producers (9M 16: +190bps YoY) which could not be said for Brewers (9M 16: -500ps YoY) and HPC (9M 16: -320bps YoY). Despite the varied responses to the cost pressures, earnings for consumer names declined (Food: -34% YoY, Brewers -54% YoY, HPC: -80% YoY) due to a mix of FX depreciation losses on foreign loans and feed-through from the earlier stated cost pressures which fed into weak share price performance for Food (-8.4%) and HPC (-6.4%) over the review period. That said, agro-allied stocks proved to be an outlier to the negative earnings patterns as aided by CBN proscription of FX for CPO imports, sector revenues surged on higher prices (+39% YoY) and improved volumes (+5.5% YoY)1. In addition, the apex bank complemented the support for palm oil producers via various low-cost financing schemes. Largely reflecting the policy backing, CPO producers reported 33% increase in 9M 2016 earnings which informed the 26.9% appreciation in the sector’s share price for H2 16. Elsewhere, though bank stocks delivered 17% YoY growth in PBT and PAT to N487 billion and N402 billion respectively2, headline reading masks earnings dispersion with only five banks reporting YoY expansion. Earnings growth across these banks stemmed from sizable FX revaluation gains on on-balance net long dollar positions which offset credit impairment charges. For the rest of the sector, asset quality concerns were central to earnings contraction as 9M 16 impairment more than doubled YoY to N270 billion across coverage. The asset quality issues offset feed-through from monetary policy tightening evident in asset yields (+160bps) pick-up across sector as banks repriced loans higher. In addition to asset quality issues, NGN depreciation triggered erosion in capital buffers with decline in sector’s CAR (-180bps). Overall, the cumulative impact of the aforementioned concerns heightened investors’ apathy resulting in an 8% decline in banking sector’s capitalisation over H2 16. Lastly, despite production headaches which drove losses for upstream O&G heavyweight SEPLAT, sentiment about higher crude oil prices propped strong share price performance in H2 16 (2016: + 92.1%). However, things fared worse as solvency concerns following a qualified audit opinion and a string of losses drove adverse sentiment at upstream peer OANDO (H2 16: -27.7%, 2016: -20.34%). Though downstream players benefitted from the increase in fuel price (+68% to N145/liter), which supported top-line (+32.9% YoY) and earnings for selected downstream players, sharp pull back in FO (-71.3% 2016) and sell-offs in OANDO drove sector capitalisation decline by 8.6%. That said, in a sign that depressed valuations are attracting interest, M&A activity in the downstream segment continued in late November as NIPCO announced the $301 million acquisition of ExxonMobil’s 60% stake in Mobil. In a nutshell, investors’ expectations about feed-through of the deadbeat macro picture on earnings trajectory, which are hardly surprising given the recessionary economic climate, underpinned bearish dominance of NSEASI in H2 2016. Figure 2: Disaggregation of NSEASI by sector FPI reluctance to naira equities hands baton to local investors Fundamentals aside, parsing through the investing pattern across domestic and foreign fund managers over H2 16, sentiment was largely weak—foreign transactions declined 47% YoY to N204.32 billion while domestic transactions contracted 23% YoY to N226.77 billion3. Tracking patterns, following the recovery in Q2 16 which resulted in net long FPI positions (N7.3 billion) on naira equities—the first time in four quarters, foreign investors remained net long to the NSEASI over H2 16 to the tune of N27.3 billion. In the aftermath of the floating exchange rate in June, FPI sentiment towards Nigerian equities remained positive in July with net FPI flows of N2.4 billion though contracted 50% MoM following the steep drop in crude oil price and concerns over naira floatation after largely static interbank FX trading. Domestic investors also pulled back (-40% MoM to N45.9 billion) following the rise in fixed income yields after CBN hiked rates in July. Following CBN’s relaxation of FX trading and a rebound in oil prices over August (+10.8% MoM), foreign appetite for Nigerian equities recovered with net FPI flows jumping four-fold higher on a month ago basis to N13.3 billion even as domestic investors’ participation also expanded by 34.3% MoM to N61.6 billion. Nonetheless, despite a continued rally in oil prices (+4.3% MoM), negative sentiment following increased CBN controls offset improvements to drive a 60.8% MoM contraction in net FPI flows to N5.2 billion in September. As in prior months, domesticinvestors likewise followed and scaled back from equities (17% MoM to N51.2 billion). Though crude oil prices declined in October, MSCI decision in late September to retain Nigeria in its benchmark frontier-index, though tempered by potential reclassification4 supported an expansion in net FPI flows to N6.1 billion (+16.6% MoM). Nonetheless, this optimism was not shared by local investors who reduced equities exposures (-35.9% MoM to N32.8 billion) following a slew of weak Q3 16 earnings releases. The foregoing combined with a ‘forceful’ stability in the interbank and parallel FX market drove FPI apathy for Nigerian equities in November, though tempered by bullish crude oil prices to drive a mild net-short FPI position of N9 million in November while local investors increased exposure to equities (+7.5% MoM to N35.2 billion). Though data for December is not yet available, we believe the reinstatement of a hard peg in the interbank FX market and widened parallel market premiums combined with FPI exodus following rise in US interest rates likely kept FPI activity depressed. On an annual basis, faster moderation in FPI activity (-50% YoY to N473 billion) relative to domestic pull back (-29% YoY to N582 billion) implied that local investors accounted for the larger share of market transactions (55%) for the first time since 2010. Figure 3: Foreign and domestic share of transactions