AMMAN, 9 January 2006 — The Gulf region is going through a period of prosperity unparallel in its recent history. The 40 percent rise in oil prices over the past 12 months did not as some have predicted, upset the world economy and slow world growth nor did it lead to higher inflation. Nothing on the horizon suggest that oil prices are likely to drop from their current $50-$60 level. On the contrary, there is a consensus building that oil prices have entered a permanently higher level.
We have booming economic conditions not only in the oil sectors but also in the non-oil sectors of the Gulf countries with double digit nominal GDP growth (15 percent — 40 percent) and real GDP above 7 percent across the board. This is spilling over to the non oil countries of the region, with Jordan growing at 7.2 percent, Palestine at 9 percent and Egypt at 6 percent.
Structural reforms, and more liberalization and regulation are greatly enhancing the risk/return profile of investing in the region. Investors are likely to continue to question how long the high growth period will last. The simple answer will be for as long as high oil prices prevail which is likely to extend beyond 2006.
Arab stock markets had their best performance in 2005, with the rise in the indices ranging from 17 percent in Tunisia, to 23 percent in Bahrain, 70 percent in Qatar, 78 percent in Kuwait, 92 percent in Jordan, 102 percent in UAE and Saudi Arabia and 131 percent in Egypt. This together with surging real estate prices are creating unprecedented “wealth effect”, making people feel richer and encouraging them to spend more.
The impact of this on economic growth is difficult to assess, but it would definitely boost consumption and contribute to overall economic activities.
Strong corporate earnings have so far justified higher share prices and are supporting reasonable valuations in most markets of the region. The indicators from the nine months earning figures of listed companies are quite promising. For example, most banks in the region reported a 50 percent increase in their earnings for the first three quarters of 2005. The petrochemical giant Saudi Basic Industries Corp. (SABIC) of Saudi Arabia saw its profit surge by 54 percent, while Emaar Properties of Dubai recorded a 255 percent increase. If these figures materialize for the full year and following the December correction in share prices, we are potentially seeing a reduction of P/E multiples in various markets of the region. Where valuations continue to be overstretched, especially for share prices of newly established companies, excess liquidity conditions will help support these shares.
Regional stock markets are expected to witness a flight to quality in 2006, with professionally managed portfolios rebalanced toward companies with strong earnings derived from their core business while speculative stocks and shares of newly established companies taking a back seat.
Arab stock markets delivered superior risk-adjusted returns in the last few years due to excess liquidity conditions, high earnings growth, and increasingly more money invested in the region. Multiple deregulation and liberalization themes are being introduced in the various Arab countries, and this will continue to fuel capital market development. Professionally managed money will be attracted to those markets that are well regulated, open to international investors and where there is enough liquidity allowing investors the possibility to exit in a bear market.
The key question today that investors need to address is: What level of risk are they willing to take, knowing quite well that stock markets of the region have surged, on the average, by more than 200 percent — 500 percent in the past three years and valuations for several listed companies are way above generally acceptable levels. No major stock market in the world has recorded such a stellar performance over three consecutive years. The time is ripe for corrections to bring the over valued share prices to more reasonable levels. The bouts of corrections we have seen in the last months of 2005 are likely to be repeated in 2006.
Our advice for investors at this stage of the cycle is to: Diversify away from the speculative shares and concentrate more on the leading stocks in each market. Asset allocation among markets/sectors need to be altered in response to regional and global developments. Investors should increase their reliance on fundamental analysis of listed equities, rather than the more traditional market intelligence methods. This is done by assessing management quality, future cash flows and overall performances (earnings from core business vis-à-vis profits from stock market portfolios) to come up with realistic valuation of listed stocks.
Five themes are likely to continue into 2006:
(1) Inward investment into the region in the form of infrastructure and property development especially in light of the 2006 budgets being released. Accordingly construction and building materials related sectors should be significant beneficiaries.
(2) Excess liquidity conditions prevailing and spilling over into neighboring countries, with the laggard stock markets of Morocco and Tunisia likely to benefit most from the potential influx of GCC liquidity to their economies. Jordan, Egypt, Lebanon, and Palestine will also benefit but to a lesser extent.
(3) There are areas that may witness a slowdown faster than others. Telecom companies, in particular, appear to be fully priced. Speculative shares in real estate, insurance, and the investment sectors that have outperformed in 2005, may not do as well in 2006. Investors are likely to put more emphasis on the profitability of the companies’ core businesses and less on the non-recurring profits generated from investing in the stock markets.
(4) The appetite for initial public offerings (IPOs) in the region will prevail as more enterprises decide to convert from private to public share holding companies. Most of the new issues are expected to be oversubscribed. Also existing public shareholding companies will choose to issue more equity than debt to finance their expansion plans given the relatively lower cost of capital in the region’s stock markets compared to the rising cost of borrowing. All this will reduce excess liquidity and dampen speculative pressures.
(5) The availability of capital seeking investment outlets in the Gulf region and the high valuation at which GCC stocks have been trading will encourage several leading Arab companies to list their shares on the region’s stock markets. The catalyst of this will be the newly established Dubai International Financial Exchange (DIFX). This exchange will play an instrumental role in attracting companies from the Middle East and the Indian Subcontinent to list and trade on it. The DIFX offers a well regulated global jurisdiction with listing requirements modeled after international best practices. The benefits of listing on this exchange include, 100 percent foreign ownership, IPO’s comprising at least 25 percent of the shares of the companies, trading is denominated in US dollars, no income or capital gain taxes, the possibility of dual listing through a GDR, free capital movement and state of the art trading, clearing and custody facilities.
To conclude, this has been a private sector driven boom, with governments of the region spending so far not more than an estimated 30 percent of their surplus oil revenues. With the new budgets for 2006 indicating higher government expenditures, the economic boom is likely to continue.
It is safe to argue that we are probably not going to get in 2006 the same kind of stellar performance recorded by the region’s stock markets in 2005, unless oil prices surge to the $90 a barrel. A crash is not expected either, as long as, oil prices continue to trade above the $35 a barrel level believed to be assumed in the 2006 budgets of the Gulf countries (equivalent to $40 for Brent crude). Corrections similar to what we have seen in the last few weeks of 2005 should be expected with varying length and severity. This would reduce the high stock valuations prevailing in some of the regional stock markets to more realistic levels, and encourage more capital inflows to these markets.
(Henry T. Azzam is founder & CEO of Amwal Invest.)
