Asked which single asset class would provide the best returns, 47.2 percent of business executives ranked real estate above equities, bonds or holding cash — down from 59.4 percent in Q4 survey.

Real estate lost some favor to hard currency and equities — the second and third most-appealing investment prospects for business leaders. Some 26.6 percent of respondents (against 21.5 percent in Q4) ranked cash the best medium-term investment opportunity, while 21 percent said equities (against 12.7 percent in Q4) and 5 percent answered bonds.

The sentiment among companies is that real estate prices in the Kingdom have likely bottomed out; 65.5 percent of respondents said they expected real estate prices in the Kingdom would either rise or stay the same in the next two quarters. A substantial 43.4 percent of surveyed business executives saw property prices going up, compared with 23.9 percent who expect prices would fall over the period.

The sentiment toward real estate prices has warmed up since Q4 — when a greater proportion of respondents, 26.7 percent, saw prices falling.

Strong interest in real estate investments comes as executives express uncertainty about the future direction of the stock market, which rose almost 14 percent between September and the end of January, largely underpinned by a petrochemicals rally. The most-common response to a question about how equity markets would perform in the next two quarters was “not sure.” Some 42.4 percent of executives gave that answer, while 22.7 percent think shares will rise and 19.7 percent assume they would decline. Among equity sectors, 47.7 percent of businesspeople listed petrochemicals as their most-preferred sector, followed by 34 percent who said banking was their best pick.

Inflation, currency

The question of rising prices has resurfaced on the minds of business executives, the index showed, although only a minority — 43.4 percent — expect inflation would rise in the coming two quarters, on par with levels recorded in Q4. Some 23.9 percent of respondents expected inflation levels would decline, while another 22.1 percent saw inflation staying the same.

A dramatic 83 percent of respondents, meanwhile, expected no change in the value of the riyal currency over the period under projection, according to the survey. The riyal is pegged to the US dollar at a fixed rate of 3.75, and policymakers have reiterated on many occasions that the peg is a source of stability for investors that they will continue to maintain. We hold the view that there will be no change in currency policy for the foreseeable future.

Analysis

The perspectives offered by business executives in the Q1, 2010, BSF Business Confidence Index signals that while optimism is surely on an upward curve, managers think it could take some time before the better economic climate filters down to their bottom line. Companies are, in general, certain that the worst of last year’s slowdown has passed; what they are divided on is when business activity and demand will pick up substantially.

It is certainly difficult for businesses to forecast when a downward business cycle will end to pave the way for the start of a new one — this is not unique to Saudi Arabia. The global picture, particularly in Europe and the United States, shows us that the path to full recovery is going to be a long and bumpy one, fraught with unemployment.

Despite the 5.7 percent (annualized) Q4 GDP figure in the US economy, record low interest rates and equities still holding their relative gains, confidence is dismal. There is little in the recent US GDP data that to change our view that the American economy, as the boosts from inventories and the fiscal stimulus fade, faces downside risks. Markets are tempted to believe that things have returned to normal, but BSF expects the global environment will be a challenging one to operate in during 2010, which could make investors more conservative.

Average 2010 oil prices should be higher than 2009 but BSF may not witness a sustainable rally, above $78 per barrel (WTI), as some forecast. BSF is beginning to observe some downside risks to oil prices. While the year kicked off with oil above $80 per barrel, demand and physical stocks are placing downward pressure on prices. In 2009, oil started the year around $40 per barrel and gradually averaged up. This year BSF could be seeing the reverse: Oil starting at a higher level and averaging down. Economic recessions are having an asymmetrical impact on oil demand, affecting gasoil demand more than gasoline demand. Refiners striving to meet gasoline demand have produced gasoil in excess, which has been put into stocks.

In BSF’s view, Saudi Arabia has weathered the global financial crisis better than many other G20 member countries. At 3.3 percent of GDP, Saudi Arabia’s budget deficit was more than two times smaller than the expected deficit as a percentage of GDP for all other G20 economies in 2009. Spain, Ireland and Greece face budget deficit ratios this year of around 12 percent, creating obvious downside macroeconomic risks. As G20 economies’ debt-to-GDP ratio is set to increase above 105 percent, Saudi Arabia’s government to GDP should fall to around 13 percent this year. The US Congressional Budget Office estimates a 2050 US debt ratio of 300 percent and Europe of 250-300 percent as a worst-case scenario. Hence, BSF continues to take a very sanguine view on Saudi Arabia’s public finances even as the global economic recovery picture looks hazy.

In the recent past, equity investments have fallen out of favor with Saudi investors, who have opted instead to park money in real estate and keep it in their bank accounts. Some regulatory developments could have a positive effect on sentiment in the coming months. The upcoming mortgage law — which is likely to be enacted within the first half of the year — will take time to provide a renewed momentum to the property sector.

Saudi Arabia’s real estate sector suffers from a shortage in supply, which has kept rental inflation at exceptionally high levels in the past two years. The property sector has been somewhat immune from the sharp drops suffered in neighboring countries such as the United Arab Emirates and Qatar, primarily due to the comparatively large population of Saudi nationals and a sustained supply-demand gap. Inflation is not a key worry in most of the Gulf where some countries, including the UAE and Qatar, are still on a deflationary path. Inflation is likely to average 4.3 percent in 2010, with domestic economic activity and demand keeping price pressures intact. The dollar, which is on an appreciation path, and low inflationary environment in the euro zone are contributing to lower imported inflationary pressures in the Kingdom.

BSF expects 3.9 percent growth in real GDP this year, compared with 0.2 percent last year, as government and private sectors accelerate.

But encouraging banks to boost their credit portfolios remains one of the biggest hurdles standing before a full recovery in the Saudi economy. While they have been awash with liquidity for some time now, lenders in the Kingdom are cautious about taking risks with their money. Private sector appetite for project expansion, meanwhile, is subdued compared with previous years, especially prior to 2008.

These circumstances cut into banks’ profitability during 2009 and prompted the widespread adoption of risk-aversion policies. The contraction in bank lending to the private and public sectors last year was a key factor behind the slowdown in economic growth. The government has largely picked up the slack with a stimulatory state spending program that draws on its stores of foreign assets. The state announced its largest ever budget for 2010, which could go some way toward improving business sentiment in the coming months. Government spending will remain high.

Banks’ reluctance to extend credit is not a question of liquidity; their deposits of cash at the central bank have doubled and their foreign assets rose by about a third last year. The credit aversion of Saudi banks is not unique in the Gulf region or globally. The European Central Bank’s January bank lending survey, along with December money supply data, suggest credit conditions remain very tight despite the ECB’s unlimited provision of liquidity to lenders. In BSF’s view, the key to unlocking even greater optimism among Saudi business leaders will be a move by banks to increase financing to the private sector. This will happen once banks are comfortable that their provisioning needs have been met — a shift in sentiment expected to take place this year.

A turn in bank profitability will also add impetus to the performance of equities. However, we are uncertain as to the degree to which the Saudi stock market is positively correlated to global equities. The bank finds little room to expect that the Saudi market will decouple in an event of a correction in global equities. Volumes in the local equity market have been low, with investors either deciding to take a cautionary approach or directing liquidity to support their businesses’ cash flow position during the risk-averse credit environment.

The private sector’s willingness to expand and grow is the other half of the growth puzzle. The government has done what is necessary and banks will also gradually begin to lend. But the global environment has demonstrated the inability for any economy to be insulated from the aftershocks of the recession. Confidence, or lack thereof, that prevails in 2010 globally will have implications on the way local business attitudes develop. We expect sentiment will be a mixed bag for much of the year.

(John Sfakianakis is group general manager and chief economist at Banque Saudi Fransi, Riyadh)