The Gulf’s forthcoming reforms bode well for the future
BY Tarek Fadlallah
The contrarian case for making tactically positive trades during Gulf Cooperation Council (GCC) market weakness earlier this year has been sound. It remains on track to deliver further modest gains once Ramadan is over and the traditionally slow summer season has passed. The supportive elements are higher oil, ongoing reforms and reasonable valuations.
Firstly, oil prices have rebounded but remain inexpensive by historical standards, and outside Organization of the Petroleum Exporting Countries, there is little supply that can be added profitably at current levels.
Indeed, oil companies around the world are halting production of less efficient rigs and waiting for higher prices to make new investments viable again. Working through the inventories will take time but prices should stabilize this year in a new range with a $60 ceiling.
Secondly, expectations for reform have been building and Saudi Arabia’s Vision 2030 is encouraging in terms of setting the framework while the announcement of the National Transformation Plan is keenly awaited.
The euphoria will dissipate as the honeymoon period ends and investors acknowledge the minimal short term impact of these ambitious plans, but the downside should be limited by hope that long standing structural issues are finally being addressed.
Thirdly, GCC price to book valuations have risen modestly and price to earnings ratios have expanded due to a combination of rising prices and profits that have fallen. However, earnings are not expected to decline by nearly enough to dent valuations drastically and the principal risks to the local stock markets this year are expected to be external or geopolitical.
The International Monetary Fund predicts that GCC oil revenues this year will be $500 billion lower than in 2014—a gap that cannot be closed just by reductions in fuel subsidies or higher duties on cigarettes and soft drinks.
In this regard, Saudi Arabia’s Vision 2030 is bold, ambitious and absolutely necessary even if the odds appear stacked against its outright success. Vision 2030 needs to overcome prevailing biases, deep seated institutional inertia, and operate within relatively rigid societal constraints.
Consultants have calculated that Saudi Arabia requires $4 trillion in additional investments to create jobs in mining, petrochemicals, manufacturing, tourism, retail, healthcare, finance, and construction.
Even with the proceeds of an Aramco public offering and proposals for the world’s largest sovereign wealth fund, that’s a lot of money to find in a neighborhood where the competition for international capital is intensifying among candidates with equal need and abundant commercial opportunities.
The past decade has provided a generally favorable economic environment for GCC companies with high oil prices, growing government spending and low interest rates.
The rising economic tide has lifted all boats but as the waters recede, there will be increasing differentiation among the operating performance of individual companies that will need to grapple with harsh realities.
The removal of subsidies and rising costs has already started to hurt profits, forcing firms to reconsider their operational strategies and seek alternative solutions.
More generally, in a low growth environment the competition for customers can become a zero sum game with a loser for every winner in a costly war of attrition within each sector.
There has long been a need for restructuring across most industries but a reluctance to do so for various reasons that are unrelated to profit maximization, operational efficiency or pragmatic strategies.
Companies that refuse to restructure or submit to consolidation going forward could survive but probably as zombies operating sub-optimally and struggling to justify their cost of capital.
Bahrain, the smallest member of the GCC, has fourteen commercial banks listed on its stock exchange.
For comparison the UK’s FTSE100 has just five including international giants HSBC and Barclays.
Alas, it’s wishful thinking to imagine that there will be a spurt in mergers and acquisition in banking or other sectors. This will provide huge opportunities for investors to discriminate between winners and losers.
As a general rule GCC governments remain far too involved in their respective economies and there is scope for the private sector to provide certain services and fill voids more efficiently.
Meanwhile the monetization of oil reserves through IPOs can be a sensible way to reduce reliance on a single source of income and to seek more balanced revenues.
Selling strategic assets, however, is a one-off event and the proceeds should be used in a sustainable and profitable manner—an increasingly difficult task in this challenging environment.
Diversification of investments should reduce the volatility of income but it won’t guarantee higher financial returns.
Nonetheless, and over the long term, the strategy could turn out to be a smart hedge against the inexorable rise of clean energy and electric vehicles.
Lastly, the currency peg has been underwritten by dollar denominated oil exports but it will inevitably come under increasing scrutiny as the economy diversifies. But speculators that believe this provides a green light to bet against the riyal or the dirham prematurely may be disappointed.
Tarek Fadlallah is the CEO of Nomura Asset Management Middle East.