In mid-June, global index provider MSCI announced the United Arab Emirates and Qatar would be reclassified as emerging markets, moving up from the frontier market classification. MSCI’s long-awaited decision (three years in the making) marks an important milestone in the capital markets’ development in the MENA (Middle East and North Africa) region and could provide a successful template for other countries in the region to follow. The investable MENA universe encompasses 11 diverse countries, extending from Oman to Morocco, and also including Bahrain, Egypt, Jordan, Kuwait, Lebanon, Qatar, Saudi Arabia, Tunisia and the United Arab Emirates (UAE).
To further understand this fast-growing region, it helps to think of each of the MENA countries as part of two main economic sub-regions: oil importers (North Africa and the Levant) and oil exporters (the Gulf Cooperation Council, or GCC, a political and economic alliance).The GCC countries generally enjoy similar characteristics, such as low debt-to-GDP ratios, high government spending and large capital reserves. North African and Levantine countries are generally consumption-driven, and have large, young and fast-growing populations. For more perspective on this dynamic region and what the new MSCI classifications mean for investors, we hear from two members of our Local Asset Management Team in Dubai, Salah Shamma and Bassel Khatoun.
Salah Shamma, Co-Head MENA Equity, Local Asset Management
Bassel Khatoun, Co-Head MENA Equity, Local Asset Management
The reclassifications of Qatar and the UAE have created much excitement, but they will only take effect officially with the MSCI’s May 2014 semi-annual index review. It is expected that Qatar will have a 0.45% weight and the UAE a 0.40% weight in the MSCI Emerging Market Index.1
The most significant potential benefits of reclassifications include an increase in portfolio flows with the entry of foreign institutional investors and passive or index-tracking investors. In fact, many market participants are anticipating windfall investment flows due to these reclassifications, and several research houses have been quick to calculate the expected flows into both the UAE and Qatari exchanges. We believe it is still premature to quantify the immediate effects, as they are subject to several variables. However, we are encouraged by the longer-term prospects and expected institutionalization of these markets.
Hopes for the MSCI upgrades and the entry of new investors helped boost stocks in both Qatar and the UAE, currently among the world’s top performers year-to-date. We believe the long-term implications are even more meaningful. The upgrades could attract additional liquidity going forward, and provide policymakers with an ongoing impetus to reform their markets.
It’s All About Reform
Typically, reclassification has followed or been accompanied by economic and financial policy reforms, including improvements in market infrastructure. As with any reclassified market, both Qatar and the UAE have already undertaken several market reforms to adhere to MSCI EM listing guidelines: the former by raising the limits on foreign ownership of companies and the latter by improving the trade settlement systems. More encouragingly, since its reclassification, the UAE has revived a proposal to merge its two main stock exchanges, Abu Dhabi Securities Exchange Market (ADX) and Dubai Financial Market (DFM), in a state-backed deal that could boost trade in the local market, while attracting more foreign investment to the Gulf state. The proposed merger would also deepen the equity market of the Arab world’s second biggest economy, encouraging more companies to list their shares and international institutions to buy them.
We believe that GCC governments, including Qatar and the UAE, will push ahead and further liberalize access to their markets by raising foreign ownership limits for investors and adopting flexible legislative and regulatory frameworks. Regulators have already started showing serious signs of commitment to further develop their markets to properly reflect the underlying economies. Governments are pushing for increased private sector participation and encouraging local family businesses to turn into public shareholding companies listed on the different exchanges.
Listed companies, for their part, are taking active measures to improve corporate governance in accordance with international standards. Meaningful steps are being taken to improve current disclosure and transparency practices. We are encouraged by these positive actions, which, we believe, would improve overall market competiveness and promote further investment.
Saudi Arabia: The Final Frontier
We believe MSCI’s decision to upgrade the UAE and Qatar could motivate Saudi Arabia to accelerate foreign ownership plans for its own bourse. The potential opening up of Saudi Arabia to foreign investors remains one of the most anticipated events in the MENA region. Lately, market chatter surrounding the imminent approval of a foreign investment law by the council of ministers has increased. [perfect_quotes id=”1694″]
Although the general consensus seems to make this a question of “when” and not “if,” the actual timing of such a development occurring remains unclear. However, we highlight that the recent appointment of a new Capital Market Authority (CMA) head and the realignment of the Saudi weekend with other markets in the region as clear and positive developments in the potential opening up of the market.
With a market capitalization of US$400 billion2 and average daily traded value US$2 billion in 20123, Saudi Arabia’s equity market is the largest in the MENA region, and would be the largest in customary frontier markets indices as well if it were included. Increasing foreign ownership to 10% of the market would imply an approximate US$38 billion in new equity purchases, according to our estimates.
Over the medium term, we would expect foreign investor interest to rise steadily in preparation for Saudi Arabia’s eventual inclusion in global indices. In our opinion, this could prove to be the single largest event in the development of capital markets in the MENA region in recent history.
EM Inclusion: Great News, Bad Timing
While this all sounds like good news, MSCI’s decision couldn’t have come at a more delicate juncture for emerging markets, which have experienced some volatility of late. The recent announcement by US Federal Reserve Chairman, Ben Bernanke, to taper bond purchases has sparked a sizable rally in the dollar and a sell-off in the US Treasury market, sending bond yields to their highest levels in over a year. Emerging markets, a main beneficiary of the Fed’s quantitative easing policy, saw fund outflows intensify following the spike in yields as investors rushed to sell emerging market bonds, foreign exchange and equities. Against this backdrop of higher yields coupled with weaker currencies and lower growth prospects, emerging market central banks have their work cut out formulating appropriate policy responses.
Unlike typical emerging market economies, GCC countries that are pegged to the USD could actually benefit from a stronger greenback. These economies enjoy considerable account surpluses on the back of higher oil prices and increased production. Government debt to GDP ratios in the GCC region are very low and range from 5% to 36%.4 Consequently, GCC countries have generally enjoyed strong credit ratings and healthy external balances. The windfall from increased oil revenues has allowed GCC countries to reduce their debt profile considerably and build ample foreign currency reserves.
As such, GCC governments have been committed to supporting their economies through record budgets and massive infrastructure spending plans. Non-oil real GDP is expected to grow by close to 5% in 2013, according to latest IMF forecasts.
In our view, valuations remain historically cheap. GCC Markets are trading at about 12.5 times 2013 earnings estimates with a strong growth outlook, and dividend yields remain high at 3.8% with low payout ratios that have room to grow.5
We believe the positive liquidity boost following MSCI’s decision coupled with attractive valuations will support the GCC markets over the medium term. The economic outlook—at least in the majority of GCC countries—remains positive. Huge stimulus efforts in GCC countries that have none of the fiscal constraints of the developed world could earn MENA equities renewed attention, especially if global economic prospects for 2013 remain subdued. Overall, the decision sends a very strong positive message for the MENA region as a whole and for the UAE and Qatar in particular, as these markets will now be firmly entrenched in the minds of emerging markets investors.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
1. Source: MSCI press release June 11 2013 “MSCI Announces the Results of the 2013 Annual Market Classification Review.” All MSCI data is provided “as is.” MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. Past performance is not indicative of future results. Indexes are unmanaged. One cannot directly invest in an index.
2. Source: Bloomberg LP, as of June 30, 2013.
3. Source: Bloomberg LP, as of December 31, 2012.
4. Source: IMF World Economic Outlook, October 2012. Copyright © 2013. By International Monetary Fund. All Rights Reserved.
5. As of July 7, 2013. Source: S&P GCC Composite LargeCap, June 26, 2013. Copyright © 2013, S&P Dow Jones Indices LLC. All rights reserved. Reproduction of the S&P index Index Data Services in any form is prohibited except with the prior written permission of S&P. S&P does not guarantee the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions, regardless of the cause or for the results obtained from the use of such information. S&P DISCLAIMS ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OR MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. In no event shall S&P be liable for any direct, indirect, special or consequential damages, costs, expenses, legal fees or losses (including lost income or lost profit and opportunity costs) in connection with subscriber’s or others’ use of the S&P Index Data Services. Indexes are unmanaged and one cannot directly invest in an index.