x Abu Dhabi, UAEFriday 19 January 2018

Heady mix of interests drives Middle East equities

Oil price volatility, political transitions and foreign investments will all influence the direction of markets. However, local investor activity remains the key determinant.

Reliance on higher oil prices to balance government books in the oil exporters, greater dependence on volatile foreign investment flows for oil importers, continuing internal political transition pains and cross-border tension in some countries all point to a challenging outlook for equities in the Middle East and North Africa (Mena).

However, it is worth noting that the region has demonstrated its resilience in overcoming the biggest risks of the 2008-09 period, namely an oil price collapse, large-scale corporate debt defaults and paralysis in property and construction markets.

Some of Mena's structural challenges no longer appear so glaring alongside those of developed and emerging markets, namely government economic policy implementation, corporate governance and political tension. With the global economy still saddled with too much debt, parts of Mena remain endowed with surplus capital.

Within this mixed context, the era of blanket calls across the region's markets (bullish in 2006-07 and bearish in 2008-09) has probably passed. This is a natural evolution for any equity market as it begins to mature, not as a growth story, but as a better understood asset class.

At a regional level, valuation is not that instructive with a broad regional index, such as the S&P Pan Arab Composite, trading on about the same 2013 price to book and price to earnings as a broad emerging market index, MSCI EM.

Below is an outline of some of the deeper digging needed on liquidity (trading volumes or activity) and on country and sector fundamentals.

Despite a start of year spike in foreign participation, local investor activity remains the key determinant. Locals account for more than 90 per cent of daily activity in the Saudi market and Saudi accounts for more than 80 per cent of the region's activity.

Even in those markets fully accessible for foreigners, local investors drive 60 to 70 per cent of activity. MSCI index changes (potential upgrades for UAE and Qatar to emerging markets) or greater liberalisation of Saudi to foreigners will change the mix but are unlikely to tilt the balance away from locals. And there is very little visibility on the timing of these changes anyway.

The gradual recovery in regional bank lending, corporate profitability and property prices should augur well for local investor risk appetite. Heightened political risks obviously pull in the opposite direction.

Nevertheless, the largest local investors arguably run Mena public equity positions as a small portion of a fairly global, multi-asset portfolio. Global contagion in Mena equities may be far more powerful than is generally credited. The direct economic link of oil prices and changes in global expectations are probably key for the outlook of Mena equities. Identifying pockets of potential outperformance may depend, above all, on making the correct assumption about global economic growth.

For those who believe global growth expectations (and associated risk appetite) are likely to improve as the year progresses because, for example, developed countries' sovereign debt or China's slowdown will be managed better than feared, Mena offers a number of publicly listed companies with gearing to global commodity prices in the petrochemicals, fertilizer and metals sectors in Saudi Arabia, Qatar, Egypt, Jordan and Bahrain. Better-than-expected global trade should also drive recovery in some of the regional hub activities of trade, logistics and tourism. There is public equity exposure to this, particularly in Dubai.

For those who believe that global growth expectations (and risk appetite) are likely to worsen as the year progresses, the relatively defensive plays in Mena equities are probably found in those companies most central to the strategic development goals of rich sovereigns. These are, arguably, companies that enjoyed the strongest balance sheet and operational support during or in the aftermath of the financial crisis. They include utilities, banks and government property developers in the hydrocarbon-rich part of the Arabian Gulf.

For those with an agnostic view on global growth, companies exposed to consumption growth by Mena's large population arguably offer investors the strongest intra-regional structural growth. Price controls on socially sensitive products and rising costs because of labour localisation requirements are no doubt a constraint. But this should be outweighed by revenue growth for a number of businesses with competitively proven brands, opportunity for expansion into adjacent products and geographies and scale economies in manufacturing, procurement or distribution. Driven by the size of domestic population and the growth of disposable income there are a number of publicly listed plays on this theme in Saudi.

The experience of 2011-12 also demonstrates that equity market performance may be swayed above all by changes in perception of political risk. Last year, despite stuttering corporate earnings performance and deteriorating economic data, Egyptian stocks, measured by MSCI Egypt, were up about 50 per cent, way ahead of Mena peers.

Arguably, the overlap of interests between foreign powers, the military and moderate Islamists all drove a more stable political outcome than most feared.

Amid the ongoing presidential-judiciary wrangle, uncertainty heading into parliamentary elections, cracks in the currency and delays to formal international assistance from the likes of the IMF, we are seeing a repeat of the same fears that Egypt's politics and economics are on a downwards spiral.

We may yet see the same overlap of vested interests drive a more stable transition than expected as the year progresses.

It is worth noting, that, along with the UAE, Egypt remains one of the only markets at a material discount (close to 20 per cent) to the broader region on this year's price to book.

Hasnain Malik is the founder of Frontier Alpha Research and a board member of the Middle East Investor Relations Society