Africa: on the frontier

Managed commodity currencies will face dual headwinds from a sustained period of low oil prices and a rising US dollar. But those countries that have floating exchange rates and have already adjusted should prove more resilient, including Egypt and South Africa. Several countries in Africa have issued hard currency government bonds in recent years, and Nigeria’s US dollar-denominated debt in particular looks attractive. Overall, we expect GDP growth to accelerate across the continent as the shock from weak commodities prices unwinds and China ‘doubles down’.

Refresh the chart in your browser | Edit chart in Datastream

In the current environment, with risk tolerance elevated, adventurous investors are seeking pastures new. Emerging markets (EMs) have been a notable beneficiary, with EM equities gaining 12% year to date, outperforming benchmarks in Europe, Japan and the US. More daring types will look further afield, to frontier markets, where the returns are potentially high, as are the risks. The MSCI Frontier index has increased by 8% since January.

Within the diverse frontier landscape, Africa stands out as a potentially attractive investment destination. Economic performance since 2000 has been strong. This is due, in part, to improved policymaking as we have previously highlighted. Admittedly, economic growth in the region has weakened over the past couple of years on the back of slumping commodities prices and a slowing in Chinese growth.

In the near term, the outlook for the continent is a mixed bag: with a new normal of weaker commodities prices on the one hand and accelerating global growth in the world’s largest economies on the other. The uptick in China’s economic activity since last year has been driven by increased credit; it is unbalanced and unsustainable. Nevertheless, over the next couple of years, it is likely to act as a tailwind for Africa. We expect GDP growth on the continent to pick up from 1.8% last year to 2.9% and 3.6% in 2017 and 2018, respectively. So while an upturn lies ahead, as elsewhere, growth rates will remain below pre-crisis norms.

Financial vulnerability indicator

We use our proprietary Financial Vulnerability Indicator (FVI) to assess 181 countries on their vulnerability to four types of crises: banking, currency, sovereign and sudden stop. It combines our macroeconomic forecasts with financial market pricing to monitor economic risks, and it is particularly useful in assessing developments in frontier markets. With the banking sector relatively underdeveloped in many African countries, the currency and sovereign FVI are particularly telling. Both have demonstrated strong predictive power.

Currencies: floating beats fixed

When assessing the outlook for African exchange rates, we make a clear distinction between floating currencies, such as Egypt and South Africa, and those that remain pegged or fixed. In the latter camp, we would place Angola and Nigeria. The gap between ‘shadow’ and official exchange rates in both economies points to a scarcity of US dollar reserves. If the greenback strengthens further this year, as we expect, these managed pegs may prove to be untenable.

Indeed, our FVI suggests that five out of the top ten riskiest currencies are the legal tender of African countries. As the table below shows, Angola ranks top on this measure. Despite reassurance from the central bank governor that the current exchange rate policy is appropriate, we think the dual headwinds of low oil prices and a stronger US dollar may force policymakers’ hand.

Despite a more than 50% devaluation of the naira last year, Nigeria ranks as the 8th most likely country to suffer a currency crisis. Mention of a floating exchange rate was conspicuously absent from a recently introduced reform plan, but we see some devaluation as inevitable.

Currencies in Egypt and South Africa have undergone significant depreciation in recent years. The Egyptian pound has depreciated by 51% since its float last year, while the rand has lost almost half its value versus the US dollar since the end of 2010. Having already adjusted, and with domestic interest rates relatively high, both should outperform their peers.

Sovereign debt: worth the yield?

Following substantial debt relief at the turn of the millennium, which was then followed by an extended period of strong economic growth, many African sovereigns now enjoy historic fiscal space. Most have decided to use it. While government debt-to-GDP ratios remain well below levels at the turn of the century, they have risen across the board since 2010. This increase has been particularly marked in Egypt and Mozambique – two countries that were forced to request IMF assistance last year.

Refresh the chart in your browser | Edit chart in Datastream

Frontier countries took advantage of the global low interest rate environment, and consequent search for yield, to tap international markets for US dollars with a string of eurobond issuances. These range from net oil exporters, such as Nigeria, to net importers such as Kenya and Ethiopia. These hard currency liabilities have become more difficult to service following dollar appreciation over the past couple of years but this has had only a modest impact on prices.

So while we expect the yield on these African eurobonds to increase, we think that US Treasury yields will rise too. In particular, we believe that Nigeria’s hard currency debt remains attractive, reflecting both its low level of government borrowing and institutionalised debt management framework. Yields have declined in recent weeks but continue to look favourable, particularly versus Brazil, with the latter ranking some 50 positions higher on our FVI’s measure of sovereign vulnerability.

Refresh the chart in your browser | Edit chart in Datastream

What is the upshot?

While predictions that this would be Africa’s century appear overblown so far, the economic outlook is at least brighter than it was a year ago. In the near term, we expect economic activity to accelerate, driven primarily by a stabilisation of commodities prices alongside export growth on the back of increased foreign demand, particularly from China. We are bearish managed petrocurrencies but attracted to the carry on floating exchange rates that have already adjusted. Hard debt issued by countries with well-managed public finances, such as Nigeria, also appear to offer value. Equity markets in the region have underperformed in recent years. Our risk scenario — to which we attach a 30% weight — envisages a global veer towards isolationism and protectionism. In that world, African equities, which are relatively less trade exposed, perform less poorly than other EMs.

_______________________________________________________________________________________

Thomson Reuters Datastream

Financial time series database which allows you to identify and examine trends, generate and test ideas and develop view points on the market.

Thomson Reuters offers the world’s most comprehensive historical database for numerical macroeconomic and cross-asset financial data which started in the 1950s and has grown into an indispensable resource for financial professionals.