Gulf Business: Rewarding Risk

Analysts believe the Saudi strategy of destroying its weakest competitors in the oil sector appears to be working. REUTERS/Faisal Al Nasser

Gulf stocks might be showing weakness, but there’s no need to panic

BY Tarek Fadlallah

Fortune favors the bold; and the Arab Gulf is no different. The past few months have seen an inclination on the part of investors to bargain-hunt Arab Gulf stocks into technical weakness (a proactive trading strategy in which a trader makes profit by buying into a long position) that has proved both fortuitous and rewarding. Profits from regional markets are now up between 15 percent and 25 percent in March from January’s lows.

And although the upper bounds of the trading range are yet to be determined, the lower end is expected to hold due to the meeting of several supportive factors, including the price of oil among others.

As traders see it, the price of oil has essentially bottomed out, and will now trend gently higher. The Saudi strategy of destroying its weakest competitors in the oil sector, such as shale oil producers, took much longer than expected—but nonetheless appears to be working, as high-cost producers have shuttered their rigs elsewhere in the world. In the United States, half of the shale oil producers might go bankrupt, Oppenheimer & Co believe if oil prices remain well under their survival rate of $70 per barrel, and it is not only shale. About a third of the publicly-traded oil companies worldwide are at risk of going bankrupt this year, according to Deloitte.

Saudi Arabia may not admit that this is the case publicly, but it is under tremendous pressure to revive its own revenues as it faces increasing expenses and significantly larger than expected deficit. The kingdom’s net foreign assets have fallen to their lowest level since July 2012, and its willingness to freeze oil output is perhaps an indication that it is drawing a line in the sand.

Unfortunately, oil prices are unlikely to rise to a proper level where Saudi Arabia would disregard the need to impose new taxes. This includes a possible Value Added Tax (VAT), which Riyadh and its Arab Gulf counterparts are looking at implementing by 2018, and deep structural reforms that are needed to promote competition and encourage entrepreneurship.

Regional economies are operating under a largely archaic structure and must shake off their rentier aspects in order to prosper. This is even more so the case given the expected introduction of taxes that will increase prices, reduce economic competitiveness and depress consumption.

Although there has been some effort to talk up recent fiscal developments and the removal of certain subsidies, the rhetoric about structural adjustment and economic diversification is only just getting translated into action.

With business activity slowing down across the region, it is not surprising that combined profits of the listed companies in the Gulf Cooperation Council fell by 7.3 percent, last year and are forecast to drop by a further 2.9 percent this year.

These falls are fairly modest. They reflect an evolution in the makeup of corporate profits wherein nearly two-thirds of aggregated income is now derived from just three sectors—telecom, banking and financial services—that are expected to maintain a relatively stable level of profits.

Income from the volatile commodity (petrochemical and mining) sector that accounted for nearly a quarter of the aggregate total in 2011, was slashed by more than half to just 10 percent of profits.

Other sectors that are likely to feel the impact of the economic slowdown, such as construction, real estate and consumer discretionary, have a relatively modest weighing in the stock market. Meanwhile, it remains to be seen whether banks can maintain margins in a challenging funding environment and amid rising non-performing loans, but comparisons with 2008, when banks were caught off guard by the global financial crisis, are too pessimistic.

It is likely that there will be some downward revisions to earnings, but that the scale will be limited so as not to seriously undermine stock prices at current valuations.

Global Strategies

Global equity markets have rebounded nicely in the past months, but a glance at the performance of the MSCI World index in the 21st century shows that it has risen by 18 percent—an annualized return of around 1 percent. Excluding the U.S. stock market, the index is only marginally higher but down 30 percent from its 2007 peak.

With G7 sovereign bonds yielding just 0.75 percent for an average holding period of eight years, the return prospects for a traditional balanced portfolio consisting of bonds and equities appear miserable. Indeed an equally weighted representative multi–asset portfolio shows that returns in 2014 were 1 percent, 2015 was down by  7 percent, and so far this year has been poor being down by 1 percent.

The inability to generate positive returns over an extended period is a huge problem for investors, such as pension funds, that rely on compounding real returns. An alternative strategy may now be necessary to navigate this prolonged period of uncertainty and substandard returns.

One idea is to consider an investment strategy in which a traditional balanced portfolio is complemented by standalone strategies that focus on absolute returns; thematic secular trends that are likely to deliver growth over the long term; and opportunistic trading strategies that combine fundamental valuations and technical analysis. Making money hasn’t been easy over the past couple of years—so don’t expect that to change.

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