The maxim not to fight the Fed has proved sound so it’s no surprise that investors have been agonizing over the apparent end to easy money and, by implication, the era of central bank-led asset inflation.
The Fed’s action to hike its key interest rate in December is perhaps understandable in the context of U.S. data but is inconsistent with a world economy that appears to be struggling with anaemic growth and volatility in currencies and asset values.
The relentless decline in commodity prices is positive for developed economies and represents a huge tax cut to consumers but it also sends a chilling warning about the overall health of the global economy. The unwavering faith in the capacity of central banks to continuously administer monetary medication to support asset prices is likely to be repeatedly tested.
There is optimism at the dawn of each new year but no reason to change the established scenario for low growth, inflation and interest rates that will limit any upside to international stock markets once again. The world today is more fragile, more volatile, more unpredictable and offers lots of risk for low returns.
No Way Out
The GCC had a year to forget, local investor sentiment is poor and the news flow is likely to remain grim. Fiscal austerity and monetary tightening are unavoidable and the markets are braced for the expected pain. Monetary tightening can be observed through the one-year Saudi Riyal interbank rate that has more than doubled over the past year and the strength of the dollar-pegged regional currencies. Fiscal tightening is also underway with government spending declining, business investment moderating and households spending flagging due to higher taxation, lower subsidies and worsening employment prospects. The anecdotal and statistical evidence for a slowdown in regional activity is mounting and irrefutable. According to the UAE Banks Federation, hundreds of small and mid-sized business owners absconded last year leaving behind unpaid debts estimated at over $1.4 billion.
Real estate prices have dipped, agencies have closed and jobs are being shed in sectors including media, energy and financial services. A regional construction survey by Pinsent Masons revealed that 32 percent of respondents were optimistic about the year ahead compared to 77 percent last year. These developments are not surprising given the widespread concerns over lower energy prices, deteriorating sovereign credit ratings and statistical indicators of sluggish activity. Unfortunately the currency marriage to the U.S. dollar has limited regional monetary policy, and pro-cyclical fiscal policies have exposed governments to the necessity to increase spending just when they have become constrained—it is predicament that underpins the prevailing bearish consensus.
In spite of the gloom, there is a contrarian case for turning tactically positive into further market weakness on the basis that stock prices are in the process of discounting a slowdown that is already in progress. The market caution over the past year had been a function of (i) valuations that ran at elevated levels (ii) alarm over oil prices, and (iii) anxiety over the lack of structural reforms, but these concerns are diminishing.
Although corporate profits across the GCC will continue to decline over the next year, equity valuations have improved and are now broadly comparable to other emerging markets. Indeed valuations on a price to book value basis are now reasonable by historical standards and at a small discount to the MSCI World index average. Stock markets are not yet in deep distress although the markets in Oman and Bahrain, which are perceived to hold some systemic risk, are particularly cheap. The dispersion of valuations across the markets, however, remains high and for every attractive opportunity there is a potential value trap or an absurdly valued stock that has no hope of a decent payback.
Disequilibrium in Oil
For all the talk of diversification oil remains critical to the health of the regional economies and an expected reduction in supply combined with demand that will grow moderately hints at higher equilibrium prices. In the short term supply cuts are expected from oil sands and shale where the prospects for new investments are poor especially given the withdrawal of cheap capital that had been available for speculative drilling.
Over the medium term the cancellation of billions of dollars in capital investments will limit the ability of producers, particularly high-cost non-OPEC members, to raise production as older fields deplete. The International Energy Agency’s central scenario is for a tightening oil balance to lead prices back up toward the $60-$80 range by 2020 but this may be reflected in the markets much sooner than currently anticipated.
Walking the Talking
Nearly 18 months after oil began its precipitous decline there are belated signs of fiscal reforms across the region with a focus on cutting non-essential spending and raising taxes, often by stealth. Budget proposals this year have been sensible but their impact will depend on whether, and how quickly, the reductions in subsidies and increases in taxation are offset by demand boosting measures. Taxation without sweeping economic reforms and market deregulation risks suffocating households and damaging consumer confidence, business sentiment and private capital investment. The latest spin on value added taxes, for example, is that they will have minimal inflationary impact when the reality is that they reduce disposable income and render economies increasingly uncompetitive.
Governments appear to have acknowledged the conundrum but their actions so far have focused largely on raising revenues and only vaguely at addressing the other side of the equation. The worry is that cash cushions will be used to see through the next twelve months in the hope that oil prices will rebound and that tough decisions on structural reforms can be avoided altogether. A report by McKinsey in December warned that Saudi Arabia can’t afford to wait for oil prices to recover and needs to accelerate economic measures to avoid rising unemployment, deficits and debt.
Whether the well-intentioned proposals under consideration across the region are sufficiently ambitious to fundamentally reshape and revitalize the local economies remains to be seen. Investors might be willing to give governments the benefit of the doubt on the basis that they have talked the talk but this generosity of spirit will be limited if they don’t walk the walk.
Foreign investors in particular have become wary of buying the hype after being repeatedly frustrated by the allure of gold only to find their portfolios filled with broken promises. Nonetheless, it is possible that the stock markets will want to trend higher on the prospect that the bad news is largely discounted.
The Bottom Line
Uncertainty remains for the Arabian markets as they gaze into a year of fiscal austerity and a tightening monetary cycle under the shadow of global instability and the specter of widening regional conflict. Receding global growth, stalling corporate earnings, currency wars and a possible hard landing in China are potential headwinds that will make for an interesting journey. The preoccupation of the financial community at the beginning of each year is with the scope for profit but our hope this year must be for peace and security across the Middle East.
The writer is CEO, Nomura Asset Management Middle East. The views expressed herein are the author’s own and do not necessarily represent those of the Nomura group.