Markaz: Mr. GCC Market-Manic Depressive; 5 Questions-No Answers


“Remember that the stock market is manic-depressive. Sometimes it is wildly excited about future prospects and at other times it is unreasonably depressed” Warren Buffet Things have really turned for the worse during the current month of September when GCC stock markets lost 17%, highest monthly loss noticed in recent times. And the month is just half way! In this confused environment, there are many reasons that are being touted behind this precipitous fall all attributed to liquidity crisis or lack of liquidity in the system, aided and abetted by the housing burst in US.

Crisis is not something new to global economy. However, crisis shares the feature of a Russian doll, where the latest crisis always seems bigger than the earlier. The so-called negative correlation play of GCC markets seems to have broken down (at least for the moment) with GCC markets falling alongside global markets. While US meltdown may be justified on the back of problems emanating from within their economy, the GCC region is clearly taking the brunt on the back of emotional fear. GCC stock markets are punished on the back of extremely strong fundamentals and reasonable valuations. GCC economies are growing at least 3x to 4x than the US and Europe, driven by strong government spending based on budgetary assumption of less than $40/bbl for oil price. The current crisis within Gulf stock markets is believed to have been triggered by lack of liquidity. Central banks in the region are curbing credit growth in order to reign in inflation. In order to achieve steady economic growth, clearer coordination between monetary and fiscal policy is the call of the day.

The inflation control policy needs to be reviewed looking at current and budgeted growth, as inflation can be a minor issue (and therefore a small price to pay) if it can come about in the midst of steady growth supported by fiscal spending on fruitful projects. In this research note, we raise the following questions that are plaguing the minds of our clients. 1. How bad is the situation? 2. What went wrong? 3. What role “Economics” play in this? 4. Why are fundamentals ignored & 5. What can change the situation? While we attempt to answer them as much as possible, the reality remains that there are more questions for which there are no answers at the moment. 1. How bad is the Situation? Market MTD(%)* YTD (%) * 2007 (%) Saudi Arabia -18% -36% 41% Kuwait -13% -13% 34% Dubai -15% -32% 44% Abu Dhabi -15% -18% 52% Qatar -22% -15% 34% Oman -14% -9% 62% Bahrain -6% -9% 24% GCC -17% -28% 36% MSCI Emerging Markets -10% -31% 36% China -13% -61% 162% India -10% -37% 47% S&P 500 -2.5% -15% 4% MSCI World -5% -19% 7% Source: Markaz Research * As of 15th September, 2008 What a turnaround during 2008 compared to 2007?

Global markets melted down on a string of bad news that started with the sub prime issue in US. Big bulge investment banks are filing for bankruptcy one after another with the latest one being from Lehman Brothers.

Merrill Lynch has offered itself to Bank of America in what can be appearing to be a massive integration of two giants. The broad market index S&P 500 is down 15% for the year. When US catches a cold, the rest of the world sneezes especially emerging markets. They have so far melted down 30% with China leading the pack with a fall of over 60%. And India is no exception (-38%). A third of the loss to emerging markets came about during the half month of September alone!

The screenshot for GCC markets is exactly on par with emerging markets with a yearly loss of 36%. The largest market, Saudi Arabia, was also the largest loser with YTD losses of 36% closely followed by Dubai (-32%) and Abu Dhabi (-18%). Curiously enough, bulk of the losses accrued during the current month of September, which is yet to go another half way. Very notable among the GCC peers is Saudi Arabian stock market that lost about 18% during the month so far. However, what proved to be a solid least volatile market among the gulf countries i.e., Kuwait also cracked up during the month with a loss of 13%. In other words, gains made during the previous eight months of the year have been wiped out in just half a month. Qatar is especially note worthy in that it was performing solidly for most parts of the year. However, during the current month it lost 22% bringing its yearly losses to 15%. In a nutshell, the situation is really bad.. 2. What went wrong? There is a confluence of several factors that are behind this precipitous fall. Exit of Foreign Investors This is cited to be predominant reason for the GCC market fall.

It is said that foreign investors, mostly hedge funds, took a bet at the beginning of 2008 on two things i.e., dollar depeg and strong oil price. While they were proved right till recently on oil price bet, their bet on dollar depeg failed to materialize right from the beginning. GCC governments, expect Kuwait, have pegged their currency to USD and are paying the price in the form of inflation (due to dollar weakness). However, GCC governments have made it clear that they are in no mood to depeg. Also, in line with the correction in commodity prices, oil prices came off from their peak $146/bbl to currently about $95/bbl. With neither short-term nor long-term interest in the region, it is rumored that many foreign investors decided to exit the GCC markets in search of opportunities elsewhere. It should be noted here that foreign investors continue to be marginal players at the moment and only in select markets like Dubai. They may have started the panic and it could have caught on with domestic investors. Falling Liquidity In the absence of depegging, the only way to control inflation is to slow down liquidity growth. Inflation has reached an inflection point here as well as globally. Allowing it to spiral beyond this point may have political repercussions. Hence, central banks do not have any choice but to control liquidity growth. They started enforcing strict lending measures and imposed curbs for consumer lending (which normally finds its way to stock market). Also, a spate of high-profile IPO’s and rights issues also drained liquidity from the system. Earnings Fear After years of fabulous growth, GCC companies may be bracing for a slowing of earnings during 2008. Corporate earnings growth averaged only 7% during first half 2008 compared to 28% for 2007. Our current assessment about Kuwait points to a 0% growth against 86% registered for 2007. The slowing down in earnings is triggered by banks triggered by losses due to sub-prime, higher provision on loan books as well as fall in fee income due to stock market decline. Also, telecom sector is facing lack of organic growth (and hence are mostly buying growth through acquisitions outside the region). Petrochemicals may fall in line with oil price movement. Hence, the expectation for the third and fourth quarter of the year is at best a flat if not negative growth. Oil Price Fall in oil price from the peak of $146/bbl to the present $95/bbl is a sure dampener in terms of sentiment.

While this will have hardly any impact on the macro economic soundness of the system, it is more of an emotional shock regarding the shape of things to come. In a nutshell, it was a confluence of factors all coming together at the same time… 3. What role “Economics” play in this? At the heart of the problem is the lack of liquidity in the system. Availability of easy money on easy terms has been central to the bullish phase of the stock markets. Customers borrow from the banking systems (albeit in the form of consumer loans) in order to invest in stock markets. Liquidity is primarily driven by oil price. Monetary policy makers are confronted with a heated up economy (thanks to oil price) that is driving the credit growth. While deposits grew at a compounded growth rate of 17% during the last six years, credit grew at 21% for Kuwait. It must be noted that there has been a significant pick up in the credit growth during the last three years relative to the earlier period. Apart from others reasons, excessive credit growth has been an important contributor for inflation. Inflation has galloped from low single digits a few years ago to high teens in most of the GCC economies thus causing public distrust and resentment. Inflation is contributed by domestic and imported factors (due to dollar peg).

While imported inflation cannot be controlled as authorities do not want to risk depegging (in what they think is temporary weakness of dollar), they are now on a mission to control domestically induced inflation, contributed by credit growth and government spending. While the former would come under the monetary policy purview, the second factor comes under the fiscal policy purview. Since domestic inflation is brought about by demand-supply gap (leading to increased prices of commodities), a restraint on credit will control the demand. Also, slowing of government spending (on projects and infrastructure) can also reduce the demand. However, both of these actions will be anti-growth to the economy. GCC economies are acutely depending on one commodity (i.e., oil) for their growth. If for some reason oil price drops steeply, then growth will certainly take a beating as has been proved in the past. Contrary to what US is experiencing in the form of stagflation (Inflation + stagnant economic growth), GCC is faced with a situation of very strong growth albeit with inflation. While inflation shapes current concerns, growth is a strategic long-term choice. A string of strong economic growth is a pre-requirement for improved infrastructure and living standards of citizens. Growth is precious especially when it is rendered difficult by volatile oil prices. So the dilemma is between Economic Growth Vs. Inflation Control. Policy makers (read central banks) have opted for the second by curbing credit growth and halting liquidity. The first casualty of this process is the stock market for which liquidity is the lifeline.. In a nutshell, economics (both monetary and fiscal) plays a huge role in this mess… 4. Why are Fundamentals Ignored? Global Economic Outlook Kuwait Economic Outlook (August 29, 2008) Saudi Arabia Economic Outlook (September 3, 2008) In the process of weakening quite sharply Near-term economic prospects remain strong Near-term economic outlook remains favorable. Recession will be avoided in 2008 but remain cautious Fiscal and current account surplus will remain substantial due to robust oil revenues and growth in external asset earnings A massive public investment program is under way, including new cities, ports, and expansion of oil production capacity. What lies ahead is a period of sub par global growth triggered by difficult credit market and high inflation Near-term economic prospects remain strong The external current and fiscal accounts surpluses will widen to record highs, leading to substantial accumulation of foreign assets and further decline in public debt. The weakening in global growth and the rise in inflation present a challenging environment for policymakers These surpluses will be transformed into high levels of government spending, which will continue to drive growth for the foreseeable future Limited public debt, ample foreign exchange assets, and continued structural reforms imply no slowdown in the pace of economic activity even if oil prices were to drop sharply.

Source: IIF A rush to sell GCC stocks as if there is no tomorrow is akin to ignoring strong fundamentals that completely differentiates the region from the rest of the world. (See table) Backed by strong oil prices, GCC countries are on their course to post yet another year of high nominal growth. The petrodollar bounty is creating a liquidity wave never seen before. Of course, there were oil booms during 1970’s and 1980’s but there are many things that differentiate that oil boom with the current one.

During the previous booms, the excess money that was generated was mostly stashed away in US Treasuries and Eurodollar deposits. However, this time around the story is very different for the following reasons: ? GCC countries are more strategic on how they place their petrodollar bets ? Multibillion-dollar investments in infrastructure across the board ? Massive financial investments in developed world ? GCC Investments in China, India and especially Africa at unprecedented levels ? GCC countries are among the main financiers for US current account deficit The high level of government backed spending is happening on the backdrop of conservative budget assumptions for oil price.

In most cases, the average price assumed for budgetary purposes is no more than $40/bbl while the actual price is now close to $95/bbl. The huge surplus built over the past few years can see them through even if oil prices were to fall back to 1998 levels of $10/bbl. In a nutshell, fundamentals are extremely strong but completely ignored…. 5. What can change the situation? Is this all doom and gloom? Well, not really. A sudden change of sentiment and reversal of course is not something the region has not seen before.

As recent as in 2007, we did witness a dramatic change in course. As can be seen in the graph, the last quarter of 2007 marked a significant spike in the market resulting in very strong yearly performance. GCC stock markets appreciated by nearly 24% during the fourth quarter which is nearly half of full year performance. What can change this course? Stability in Oil price Purely from a sentiment factor, if oil prices stabilizes at the current level then it can bring back the positive confidence very much required in the market Earnings surprises Banks may start surprising the markets through good numbers for Q-3 and Q-4 and so can be other sectors.

The growth may come in from Islamic banks that have shown very strong performance during the first half of the year. Dollar Strength A continued strength in dollar would be a welcome relief to policy makers as it lowers the impact of imported inflation. Support from SWF’s Sovereign wealth funds may be prodded to support the market as valuations are very attractive. They are flush with liquidity.

Monetary Relief And finally, monetary authorities may abandon their inflation control chase for a while. Analyst Certification Each research analyst(s), strategist(s) or research associate(s) responsible for the preparation and content of this research report hereby certifies that, with respect to each issuer or security that the research analyst, strategist or research associate covers in this research report, all of the views expressed in this research report accurately reflect their personal views about those issuer(s) or securities.

Each research analyst(s) strategist(s) or research associate(s) also certify that no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendation(s) or view(s) expressed by that research analyst, strategist or research associate in this research report. M.R. Raghu CFA, FRM Head of Research +965 224 8280 [email protected]