The tight money stance of the Central Bank of Nigeria (CBN) poses a bearish risk for stocks as investors may begin to look to asset rotation into fixed income from equities.
In the debut monetary policy committee (MPC) meeting of Governor Olayemi Cardoso and the other committee members, policy rates were aggressively tightened to curtail liquidity surfeit and rein in stubbornly elevated inflation.
“The equity market would likely take a breather, as portfolio managers begin to realign asset allocation strategies towards higher yield fixed income instruments, at the expense of equities,” Abiola Rasaq, economist and former head investor relations at United Bank for Africa (UBA) Plc, said.
The transitory monetary policy measures reflect the inflation targeting orientation of the new leadership at the CBN and overall monetary policy committee.
Expectedly, this would increase the cost of funds of banks and shrink net interest margin, according to Rasaq.
Decisions reached by the MPC include: monetary policy rate or MPR was increased by 400 basis points (bps) to 22.75%, the asymmetric corridor was adjusted to +100bps/-700bps from +100bps/-300bpns, increase in Cash Reserve Ratio (CRR) to 45.0% from 32.5%, and retaining the Liquidity Ratio at 30.00%.
Rasaq said Bank stocks will likely take the most hit, especially as dividend payments may not likely reflect 2023FY profitability given the rational need to maintain higher retention ratio to shore up capital positions ahead of CBN announcement of new capital requirements and the immediate capital need to absorb higher risk weighted assets arising from impact of Naira depreciation on dollar-denominated assets.
Nigerian Stocks are up 34.52% year-to-date, however the banking index has gone down in the same period, returning -4.19%. In January 2024, the headline inflation rate increased to 29.90% relative to the December 2023 headline inflation rate which was 28.92%.
For non-financial companies, those with relatively high leverage ratios would likely see a spike in finance cost and ultimately lower profitability.
“In our view, the strong hawkish actions of the CBN are likely to cartelize higher yields in the fixed-income market in the near term. For the equities market, the higher interest rate is less compelling for valuation and could further stoke bearish sentiment in the market,” said analysts at Cardinal Stone Partners.
Higher yields are often negative for equities for a number of reasons. As bond yields go up the opportunity cost or risk premium of investing in equities goes up and therefore equities become less attractive.
The yield on bonds is also normally used as the risk-free rate when calculating cost of capital. So when bond yields go up then the cost of capital goes up. That means that future cash flows get discounted at a higher rate, which compresses the valuations of stocks.
For foreign investors, when yields go up, they may find Nigerian debt more attractive in relation to developed market debt (the so called carry trade). This may lead to capital outflows from equities and inflows into debt.
The hike in cash reserve ratio (CRR) to 45%, one of the highest in the world, would lead to banks profitability being challenged.
Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank.
A central bank increases this portion of cash reserves when it aspires to limit the use of funds to be lent out or invested. On the other hand, it lowers the cash reserve ratio if it desires to encourage lending and investment in the market.
“Sell-offs may present decent entry opportunities in fundamentally sound stocks, such as those with positive interest sensitivities to their margins, robust cash and low leverage. Savvy investors may also look for tactical opportunities to earn dividend income as full-year numbers begin trickly in March/April and onwards,” Cardinal Stone Partners analysts said.
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