African market outlook for 2017: Opportunities and challenges
Tuesday, 14 Feb 2017
The global risk backdrop has been relatively supportive for emerging market (EM) FX and fixed income in early January 2017, as investors downplayed previous concerns about fiscal stimulus in the US under a Trump administration. This has underpinned the South African rand and local bonds and reinforced a receiving bias in swaps. However, there is a risk that upward pressure on UST yields and a bull USD cycle may re-emerge, for example on renewed worries about fiscal expansion in the US, expectations of further Fed interest-rate normalisation and threats to global trade. In this case, the stronger USD could erode local market bond returns, which may possibly push fixed income investors to opportunistically increase hedge ratios in their mostly unhedged GBI-EM fixed income holdings. A paying bias in long-dated South African swaps may potentially offer value in the medium term if the FX and external risk backdrop deteriorate, while short-dated swaps could be supported by a neutral policy rate stance, weak growth, and subdued inflation.
In the frontier Sub-Saharan African countries, market stakeholders will be on the lookout for investment opportunities likely to deliver significant value in 2017. Given the high base in fixed income yields, improving interbank liquidity, the prospects of an IMF programme and likely monetary policy easing, Zambia’s bonds may offer large duration gains this year. Portfolio flows into Zambian debt have picked up in recent months, as investors position for future bond price appreciation. Although the Zambian kwacha (ZMW) has so far been supported by corporate left-hand side FX flows and portfolio inflows, foreign investors will be closely monitoring any signs of renewed ZMW weakness, especially if the IMF pushes for greater FX flexibility.
Foreign investors remain constructive on Ghana’s local bonds, as evidenced by a significant pick-up in foreign participation in local debt over the past year. Given the magnitude of the rally in long-dated bonds since Q3-2016 in expectation of further formal monetary easing and a downtrend in inflation, it is likely that bond carry - rather than duration gains - will now be the main driver of fixed income returns. The authorities have managed to stabilise the USD-Ghanaian cedi (GHS) rate following moderate upward pressure around the December 2016 elections. Yet renewed fiscal consolidation efforts and commitment to IMF reforms will be key to managing market expectations and preventing a build-up of USD-GHS longs.
Elsewhere in West Africa, limited portfolio flows into T-bills, hedged in Nigerian naira (NGN) futures, have largely dried up in recent months, given limited visibility on the potential for a more liquid FX market. The wide parallel market premium reflects significant FX shortages, while investors generally perceive the current FX regime as unsustainable in the medium term in the absence of much higher oil prices and a rebound in production. However, the authorities have indicated that they would not devalue the NGN. Thus, foreign flows into Nigerian debt look unlikely in the foreseeable future. Foreign investors will probably continue to express their views on the currency via the offshore non-deliverable forward (NDF) market. NDF outrights have compressed in recent weeks, but the long end of the NDF curve may prove vulnerable to a wider parallel market premium.
Meanwhile, a heavily-managed FX regime in Nigeria makes it less relevant to maintain elevated domestic fixed income rates via high-yielding open market operations and tight liquidity conditions. The sovereign yield curve is still inverted, but bond yields have backed up to historical highs over the past month, mainly on supply concerns. Yet, a partial relaxation of liquidity conditions and a slowdown in inflation on high base effects would contribute to duration gains for onshore institutional investors, at least until FX market flexibility is back in focus later this year.
In East Africa, investors will probably be waiting for more attractive entry points into local debt to reassess the investment case for Kenyan bonds. So far the yield curve has remained relatively sticky despite recent FX re-pricing. A still-supportive interbank liquidity environment has anchored low Treasury yields, as a more broad-based tightening of liquidity conditions is constrained by a weaker backdrop for selected small financial institutions. But we think some upside risks for Kenyan fixed income yields will likely materialise from current levels.
Uganda’s fixed income yields shifted higher in late 2016, albeit moderately, as the currency came under pressure; increased domestic demand has pushed bond rates marginally lower lately. The yield curve re-pricing in Q4-2016 may have been insufficient to trigger renewed portfolio inflows or compensate foreign investors for the perceived sensitivity of the Ugandan shilling to global risk factors. Yet, if UST yields and the USD eventually find new levels that look better anchored, the investment case for a carry trade in Ugandan rates may turn more appealing. In Tanzania, foreign investors are still awaiting the delayed opening of the debt market to non-East African residents; should global offshore investors be allowed to purchase local bonds, portfolio inflows will likely pick up, but their scale could be constrained by limited secondary market liquidity.
On the credit side, African Eurobonds performed strongly in 2016 supported by attractive entry points early last year, a broadly favourable risk profile in EM and limited issuance in the SSA region. The tighter valuations of African Eurobonds and the uncertain global risk environment will probably push investors to be more selective in 2017 and may support the case for a shorter duration. Eurobond investors will likely still reward issuers that have seen an improvement in fundamentals and displayed good policy-making such as Cote d’Ivoire and Senegal. They could also remain constructive on credits offering a mix of robust carry and idiosyncratic catalysts for outperformance, including IMF-sponsored reform programmes.