Plunging oil prices and whipsawing emerging markets have taken a toll on the recently liberalized Saudi Arabian stock market (otherwise known as Tadawul) pushing it into bear market territory in late August after hitting a peak in April 2015. On the surface, the reasons for the selloff look easy to discern. Questions about whether lower oil prices will continue to provide the government with the flexibility to spend heavily on promoting growth in the non-oil sectors of the economy and whether its currency peg is sustainable have helped drive the market lower right alongside its clearly more challenged commodity-exposed emerging-market peers.
Certainly, oil prices are important for the Saudi economy, comprising about 45% of the overall economy and 90% of total government revenues.1 However, we think Saudi Arabia looks likely to emerge from the current volatility in a relatively strong position regardless of the dropoff in oil prices in recent months. Saudi Arabia’s population is young and growing, with some 60% under the age of 302—and their spending benefits a wide range of industries from telecommunication services to financial services. Although lower oil prices have meant Saudi Arabia must dip into its still-massive US$664 billion in reserves and raise debt to continue its widespread counter-cyclical fiscal spending, we believe the country remains committed to promoting growth in the non-oil sectors of the economy. Even recently discussed spending cuts are relatively small considering the US$105 billion capital spending plan the country has in place.3 With energy comprising only a small portion of Tadawul relative to the broader economy, Saudi Arabia’s stock market can provide investors with exposure to these faster-growing areas, which we believe makes it a standout among its commodity-heavy emerging-market peers over the longer term.
Although Tadawul has largely been closed to foreign direct investment until just recently, within regional investment circles, it has long been recognized as the largest, most liquid stock exchange in the Middle East, offering the broadest range of sector opportunities, and comparable in size and influence to well-established emerging markets such as Russia and South Africa. Now that Saudi Arabia has become the last G20 country to open its stock market to foreign investors—albeit with restrictions—global investors have access to what we view as one of the more attractive long-term investment stories in the emerging world and an essential gateway to the biggest economy in the Middle East.
We believe favorable demographics and still-strong government spending are key tenets of the Saudi investment case. The need to provide for a growing middle class represents an attractive backdrop for demand growth across many areas of the economy—from consumer products and health care to telecommunication services.
Saudi Arabia’s government also plans to spend heavily this year, despite falling oil prices, demonstrating its eagerness to diversify away from a reliance on oil and provide fiscal stimulus for the broader economy. In fact, the 2015 budget stands out as a record budget in spite of being set amid falling oil prices. This policy may cause Saudi Arabia to register its first double-digit budget deficit in 2015, but given its still-low debt levels and massive reserves, we believe the country can manage the gap.
Recent debt offerings to plug some of the budget shortfall also underscore that Saudi Arabia remains committed to promoting growth in spite of tumbling oil prices and the impact that has had on its reserves. But as a percentage of gross domestic product (GDP), public debt in Saudi Arabia is exceptionally low at just 1.6% (as of 2014), according to the Saudi Arabia Monetary Agency. Indeed, its spending policies have shown some evidence of success. The economy continues to grow with non-oil sectors growing more robustly than the large oil economy—2015 non-oil GDP growth is estimated at 4.6% compared to 0.9% growth estimated for oil GDP, according to International Monetary Fund estimates.4 And unlike its oil-exporting peers (Russia, Iran, Venezuela and Nigeria), the Saudi economy appears to be on very sound footing, according to our analysis.
Additionally, with Saudi Arabia undoubtedly facing important challenges in the years ahead, ongoing Tadawul reform could help to lessen the burden on the state as it continues its efforts to diversify the economy away from an overreliance on oil.
Moreover, unlike other commodity-heavy emerging equity markets, Tadawul provides investors with greater exposure to what we view as the more attractive non-energy areas of the Saudi economy. The energy sector is underrepresented (1% of Tadawul) relative to its position in the overall economy. Instead, financials comprise about 28% of the market value, according to data from Tadawul, followed by petrochemicals (23%) and telecom and consumer-related companies (20%).5
We think each of these sectors has its own attractions. Saudi banks are among the best capitalized in the world, Saudi infrastructure companies have benefited from massive government spending projects in areas such as education, energy and health, and consumer-related companies are being supported by the rise in Saudi Arabia’s consumer society and government efforts to bolster disposable income. Just as importantly, companies in a range of sectors command profit margins that are the envy of emerging-market peers and operate in an economy benefiting from favorable underlying demographic trends.
In our view, higher US interest rates may also not affect the Saudi economy and stock market quite as much as some other emerging markets. The US Federal Reserve’s slow and steady move toward higher interest rates supports a stronger US dollar, and we would note that the peg between the Saudi riyal and the US dollar has helped equities avoid much of the past currency volatility experienced by some other emerging-market economies with higher external vulnerabilities. While the peg does limit Saudi Arabia’s flexibility—and was called into question in the wake of China’s currency devaluation—it has been in place since 1986. We believe it is likely to be well defended, largely because oil is priced in US dollars and has allowed the country to take advantage of a stable and fixed foreign exchange rate.
Following the August selloff when Tadawul declined by 15%, the Saudi equity market now trades at what we view as an attractive 11.2 times 2016 earnings and offers earnings growth and dividend yield prospects that are better than those in both the developed and emerging stock markets.6 Moreover, while Tadawul has fallen 33% over the past year, it has not fallen nearly as sharply as the 48% drop in oil prices.
Indeed, based on our analysis, the historical correlation between Saudi stocks and oil prices has been much weaker historically. The five-year correlation of daily returns stood at only 0.09,7 reflecting not just the diversity of sectors within Tadawul and minimal energy exposure, but also the government’s ability to use its sound finances and ample reserves to undertake countercyclical spending measures, as and when necessary, to support growth.
A Chance to Improve Market Discipline and Transparency
Over time, we believe allowing international investors greater access to Tadawul could have the added benefits of dampening volatility in a market traditionally dominated by local retail investors and providing technical know-how to the Saudi financial markets. Moreover, Saudi Arabia’s Capital Markets Authority (CMA) believes the opening of listed firms to foreign shareholders may encourage internationalization and improve management by exposing local companies to much greater market discipline. In addition, allowing institutional investors direct access to Saudi stocks will likely add liquidity and could add to the sophistication and maturity of the market, leading to a greater number of initial public offerings (IPOs) over time and deepening the market.
We expect the eventual inclusion of Saudi Arabia in equity indexes around the world to attract substantial quantities of new foreign capital over time. Index provider MSCI could start evaluating Saudi Arabia’s eligibility through consultation with investors as early as June 2016, with Tadawul targeting inclusion in the MSCI Emerging Market (EM) Index in 2017.
If included, the country’s weight in the MSCI EM Index is estimated at 1.7%.8 Our research leads us to believe that the opening up of Tadawul alone could create a potential US$45 billion opportunity for new foreign funds or an incremental fund flow of US$40 billion from today’s levels—and for investors, a chance to widen and deepen their exposure to the strong growth prospects of the Saudi economy. Such an inflow would boost the Saudi economy as it copes with the impact of lower oil revenues and more limited fiscal flexibility.
However, we think foreign inflows are likely to be muted in the short term. Gaining access to the enormous opportunities flowing through this market remains a challenge for outside investors, with participants requiring extensive resources to meet stringent licensing criteria. The evolving nature of the market warrants careful selection of an investment partner capable of identifying local risks as well as the abundant opportunities that we believe will finally be available to outside investors as a result of this historic capital markets development.
Nonetheless, given the size, growth and rising sophistication of the Saudi Arabian economy and stock market in the MENA region, we think the expected foreign inflows into Tadawul will undoubtedly be a major catalyst in raising the profile of regional markets in general, especially if and when access is liberalized further. As such, once calm returns to the emerging-market equity asset class, we believe global investors will come to realize that the opening up of Saudi Arabia’s equity market provides a singular opportunity for institutional investors to participate in the increasing sophistication of the country, the MENA region and its markets.
Bassel Khatoun’s comments, opinions and analyses are personal views and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region, market or investment.
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What Are the Risks?
All investments involve risk, 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. Special risks are associated with foreign investing, including currency rate fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to risks associated with these markets’ smaller size, lesser liquidity and the potential lack of established legal, political, business and social frameworks to support securities markets. Currency rates may fluctuate significantly over short periods of time, and can reduce returns.
7. Source: Bloomberg, as at 1 September, 2015. Correlation measures the degree to which investments move in tandem. Correlation will range between 1 (perfect positive correlation, moving in the same direction) to -1 (perfect negative correlation, moving in opposite directions).
8. Source: HSBC Global Research report “Saudi Arabia Revisited—Implications for Global Index Benchmarks,” 6 February, 2015. The actual weight of Saudi Arabia at the time of inclusion would depend on a number of factors, including foreign ownership limits and the liquidity of individual stocks. Indexes are unmanaged, and one cannot directly invest in an index.