AMMAN, 22 September 2003 — In the past when US stocks were having a bad year, stock markets in Europe and Japan would perform better. The rule was that if you have a globally diversified portfolio, you will be better off in terms of risk/return profile than having all your investments in one market. However, in the past four years, US stocks have moved in tandem with European stocks, and so did stocks in nearly all developed countries. After dropping across the board in 2000, 2001, 2002 and the first quarter 2003, share prices invariably rose with the S&P 500 index of the US stock market up 16 percent since the beginning of the year, Nikkei of Japan up 24 percent and FTSE of the UK up 8 percent.
In technical terms, the relationship between US stocks and non-US stocks has increased from 50 percent at the start of the 1990s to 90 percent in 2002 and 2003. In other words, stock prices in markets from Australia to Italy to United States have all been moving nearly in lockstep. No longer can the investor reduce the volatility of his holdings simply by owning a diversified portfolio of shares in the major stock markets of the world.
On the other hand, several Arab stock markets did quite well in the past three years, especially those of Jordan and the Gulf countries. So far this year, the stock markets of Saudi Arabia, Kuwait, Qatar, Oman, UAE and Bahrain have all recorded impressive performances with the major indices up by 80 percent, 74 percent, 65 percent, 31 percent, 27 percent and 18 percent respectively, on top of their strong performance in 2002. Jordan, Morocco, Tunisia and Palestine rose as well by 40 percent, 22 percent, 8.8 percent and 17 percent respectively, so far this year, reversing last year’s negative performances.
There are various reasons for the surge of the regional stock markets. The most important is the region’s strong economic performance fueled by higher oil prices, lower interest rates and a general decline in regional uncertainty following the end of the war on Iraq. Average oil prices so far this year come to $28.8 a barrel for Brent crude, compared to an average of $25 a barrel in 2002 and $24.5 a barrel in 2001. Average prices for 2003 are likely to exceed the record highs achieved in 2000 of $28.4 a barrel. Higher prices and larger oil production levels will boost revenues and overall government expenditures this year, which in turn will filter down onto the income statements of local companies. In addition, strong oil revenues in the Gulf usually lead to a rise in the level of regional liquidity, through higher remittances, better export opportunities to the GCC markets and a surge in direct investment flows to the non-oil Arab countries.
In the past, most of the excess liquidity in the region used to seek investment opportunities in the international stock and bond markets. But with the high volatility and generally negative performances of these markets in the past three years up till March 2003, much of this wealth have looked for opportunities closer to home. Some evidence of this can be seen in the growing levels of turnover especially in the Gulf stock markets, where the average daily trading turnover have almost doubled compared to levels recorded in 2000 and 2001. In Jordan, the value of shares traded in the Amman stock exchange rose by 24 percent in the first eight months of this year. Being uncorrelated to global markets, and considerably less volatile than most other emerging markets, the argument for placing a portion of a portfolio in Arab equities as an effective diversification play has become more compelling.
The Gulf currencies and the Jordanian dinar are pegged to the dollar which means that interest rates in the US are largely followed by rates in Jordan and the GCC countries. Domestic interest rates in these countries have been trending lower in the past three years in line with the lower dollar rates. Lower rates would make borrowing cheaper, thus reducing the cost of operations to companies and render time deposits less rewarding compared to investing in the stock market. Arab equity markets are characterized by high yields. For investors seeking cash returns and dividend payouts, the Middle East average yield of almost 4.5 percent is quite compelling in a low interest rate environment.
Perhaps the most important attraction of Arab stock markets is their valuation. Whether measured by price/earning ratio (PE), price/book value, or dividend yield, Arab equities look attractive compared with both developed and other emerging markets. With the surge in share prices recorded so far this year, the average PE ratios in the various Arab stock markets have risen to levels considered to be historically quite high, nevertheless, they are still lower than the more volatile S&P 500 of 22, the UK or the German benchmark indices of 18 and 20 respectively. Even with an average PE ratio of 13 for Oman, 15 for Bahrain, 18.5 for Jordan, 17 for the UAE, 20 for Kuwait and Qatar, and 25 for the Saudi stock market, these ratios are not considered to be exceptionally high. A company with a PE of 20 has an earning yield of 1/20 or 5 percent. When interest rates were at 7 percent-8 percent, a PE of 20 would clearly be high. But with deposit rates below 3 percent, a PE of 18 to 20 would still be acceptable.
Many headlines have been dedicated to the “Return of Arab Capital to Arab markets”, but evidence of the mass liquidation of Arab investments in the US and their reinvestment in the region is limited. For example, last year the aggregate increase in customer deposits throughout the entire banking sector in Saudi Arabia amounted to only SR20,000 million ($5,333 million), which, with a growth rate of 7.7 percent, was in line with organic domestic expansion.
Whatever liquidation has taken place was related more to market developments than to fear of confiscation of Arab investments. Concerns about the American economy and distrust of corporate America have prompted investors to reassess their exposures. Latest data from the Bank for International Settlement on global bank deposits show that some Saudi citizens have begun moving part of their funds out of all international banking centers, not just the US, starting mid-2001. Arab investors, like many wealthy investors around the world, have been diversifying in response to falling interest rates and the tumbling of equity markets. With the profit and security elements missing in the US markets, it is a golden opportunity to do all what is needed to attract some of the money invested abroad back to the local markets.
But for capital to be attracted back to the home front, returns will have to be commensurate with the risks associated with greater market immaturity and lack of sufficient liquidity and transparency. Institutional investors and high net worth individuals judge the attraction of a stock first of all on its own merits and then on the basis of both size (i.e. market capitalization) and liquidity (i.e. daily trading volume). A stock has to have more than a $50 million market capitalization and a minimum daily turnover of $1 million for it to be considered liquid and for sophisticated investors to be able to get in and out of it quickly enough. If this rule is applied to the Arab stock markets only few stocks in Saudi Arabia, and one or two in the other Arab markets would stand the test of size and liquidity.
Some progress has already been made illustrated by the successful initial public offering (IPO) of a 20 percent stake in Saudi Telecom, 10 percent of Jordan Telecom, and the sale of a major government stake in Bank of Kuwait & the Middle East. In Saudi Arabia alone, heavyweights such as Saudi Railways Organization, National Commercial Bank and possibly even Saudi Arabian Airlines are all likely to be privatized in the coming few years.
On the regulatory front, Jordan’s Securities Commission supervising the Amman stock exchange is leading the way on regulatory development of capital markets in the region, while Bahrain had developed a niche market in Islamic products and services. Saudi Arabia with its capital market law, Qatar with its mutual fund bill and the UAE with the Dubai International Financial Center are all steps taken to further deepen the region’s capital markets.