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Lazard MENA Equity
Letter from the Manager
MAR
2017
MENA, Continuation of the Reform Agenda
What Happened in 2016?
The MENA region experienced a number of reality checks in 2016 as it adjusted to a new norm driven by government reforms
in response to lower oil prices. MENA stock markets started the year on a negative note, dropping more than 16% in the early
months (in US dollar terms) as investors grew increasingly fearful of major spending cuts by regional governments. These fears
eased when fiscal budgets were announced and investors realized government spending would be maintained, especially in key
sectors that would help officials achieve their long-term objectives—be it youth employment, growing local populations, or
diversifying their economies away from oil. As a result, MENA markets closed the year up 8.98%1.
Investors also quickly started to differentiate between economies that are less reliant on oil and have less need for fiscal
consolidation measures, and the ones that need to reform. From this perspective, the United Arab Emirates (UAE) (Dubai and
Abu Dhabi specifically) stood out, given they have been ahead of the curve in applying market practices and, from a fiscal position,
are the least impacted by lower oil prices and have non-existent or manageable deficits. UAE markets outperformed their regional
peers in 2016, with the Dubai and Abu Dhabi stocks markets closing the year up 12.06% and 5.55%, respectively.
Saudi Arabia: Expansionary Budget and Fiscal Reforms Leave It in a More
Comfortable Position
In December 2016, Saudi Arabia released its actual and expected budgets for 2016 and 2017. After a year of fiscal retrenchment in
2016, the government announced an expansionary budget for 2017, with expenditures likely to be up 8% year over year to 890 billion
riyals (based on actual 2016 spending) (Exhibit 1). Interestingly, about 12% of the budget is allocated to support initiatives in the
National Transformation Plan (NTP), Saudi Arabia’s roadmap to achieve its long-term objectives of mainly diversifying its economy
away from oil.
The expansion seems to be well-supported by the likely increase in non-oil revenues, which as of 2016 amounted to 199 billion riyals,
or about 37% of total revenue. This significant boost has been the result, we believe, of cuts in subsidies, increases in government
service fees, and increases in returns from the Saudi Arab Monetary Agency, which holds most of the government’s investments.
Reforms to continue at a gradual pace as
the government sees higher oil prices . . .
Exhibit 1
Saudi Arabia: Deficits Are Narrowing
While we expect the Saudi government will continue
to endorse reforms, the pace of fiscal consolidation
measures will ease in 2017, especially compared to the
last two years. The government announced the partial
removal of energy subsidies in 2015, but it recently
adopted the idea of means-directed cash allowances to
low-income families to mitigate the impact of subsidy
removals.
(Saudi Riyals; billions)
1,500
Government Revenue
Government Spending
Surplus/Deficit
1,000
The recent announcement by the Saudi Energy Minister
anticipates higher oil prices. This, combined with efforts
that led to the Vienna agreement between OPEC and
non-OPEC members to cap oil production, reinforces
the view that Saudi Arabia’s near-term policy priority
remains to rebalance the oil market. Assumptions for
higher oil prices (estimated to be $55–$60 per barrel)
have been incorporated into the Saudi government’s fiscal
budget announcement.
500
0
-500
2009
2010
2011
2012
2013
2014
2015
2016 2017E
As of 31 December 2016
Forecasted or estimated results do not represent a promise or guarantee of future
results and are subject to change.
Source: Saudi Arabia Monetary Authority, Saudi Ministry of Finance, Shuaa Capital
LR27931
All in all, total revenues are likely to amount to 692
billion riyals, implying an estimated deficit of 198 billion
riyals in 2017, 33% lower than the actual 2016 deficit
and equivalent to 8.2% of the GDP.
2
. . . Leading to a lower deficit, to be funded via the
capital markets
During 2016, Saudi Arabia’s budget deficit jumped to $107.5
billion (including the repayment of contractor arrears and projectrelated spending). Going forward, the government has announced
a controlled deficit of $52.8 billion in 2017, largely on the back of
increased oil prices and additional non-oil revenues, which will be
boosted after the announcements of various fees and levies during
the second half of 2016. Further, after the successful debt issuance
of $17.5 billion during the fourth quarter of 2016, the government
has indicated its willingness to tap the global markets for further
debt. As of 2016, total government debt stood at $84.5 billion,
implying debt-to-GDP ratio at 12.3%, well beneath the internal cap
of 30.0%.
Higher cost of funding and inflationary pressures:
where to be positioned?
As the Saudi currency is pegged to the US dollar, higher interest
rates in the United States would put upward pressure on Saudi
interest rates. In addition, the liquidity pressure due to lower oil
prices and, hence, lower government deposits within the banking
system, has driven up the Saudi interbank interest rate from as low
as 0.75% to 2.00% as of end January 2017.
Inclusion in the emerging markets index would potentially help
Saudi Arabia accomplish several objectives. One would be the
elevation of the stock market’s profile, allowing it to access a
larger pool of capital (especially considering that around 90% of
Saudi Arabia’s stock market liquidity is driven by local investors).
Tapping into international liquidity would give the country a
source of funding for the potential list of government entities up
for privatization, without impacting local liquidity. With Aramco’s
listing/ privatization in progress, and given its strategic importance
to the country’s diversification away from oil as well as its potential
size, it makes even more sense for Saudi Arabia to achieve emerging
markets index status. An upgrade might represent an upside risk to
the Saudi stock market because it could drive an equity rally based
on technical rather than fundamental factors, as has occurred in
regional peers that were upgraded to emerging markets status.
Egypt: Finally Moving Ahead with
Reforms
During November 2016, the Egyptian government implemented a
major reform: fully floating the Egyptian pound and letting banks
decide their foreign exchange rate freely. The resulting devaluation
has been viewed positively by stock market investors, lifting most
Egyptian stocks in local currency terms.
On the other side, as subsidies are gradually removed, and fees
charged by the government begin to increase as part of the fiscal
consolidation measures, inflationary pressures are expected to
grow. This will likely raise the cost of doing business for many
Saudi corporations.
In addition, the IMF’s approval of a $12 billion, 3-year loan was a
strong vote of confidence in the Egyptian economy and its potential.
This deal depended on several reforms, which the government has
started to implement by raising energy products prices to reduce
pressure on its budget.
Given these two factors, as well as slower Saudi growth and lower
corporate pricing power we reiterate our view from our 2016 Outlook
that banks and petrochemicals are in a better position to weather
these changing dynamics. The banks would directly benefit from
the higher interest rate environment, while petrochemical’s product
demand and spreads are driven by external rather than local factors.
Overall, the Egyptian government has made strong progress in
its reforms, which is estimated to have resulted in a fiscal saving
equivalent to 2.5% of GDP so far. This makes up part of the 3-year
net savings target plan of 5.5% of GDP. These savings should help the
economy reach a sustainable level over the medium and long term.
Is the recent rally in the market justified?
The Saudi market has rallied by more than 32% in US dollar
terms since its bottom in October, especially after the successful
bond issuance by the government. Oversubscribed by more than
3x, the bond issuance removed many of the concerns about the
government’s ability to pay contractors and suppliers. In addition, it
brought some liquidity relief to the banking sector and calmed some
concerns about a crowding out effect of the private sector. But the
question remains whether this liquidity-driven rally is justified from
a valuation perspective. Earnings have dropped year over year by
4%, missing earnings estimates by 20%, and there is no imminent
resumption of growth expected in 2017.
MSCI reclassification is in focus
Saudi Arabia has been taking the right steps towards its potential
reclassification in the MSCI Emerging Markets Index, whether by
opening up its market to direct foreign investments, relaxing the
rules regarding the Qualified Foreign Investors eligibility, or even
potentially changing the settlement cycle from T+0 to T+2.
As a result of the devaluation, inflation is expected to rise
significantly, mostly impacting the poor and middle income
segments of the population. Corporations are likely to adjust their
cost and pricing structures gradually. Hence, it will take some time
for spending patterns to stabilize at a new norm and for growth
to gradually pick up again, driven mainly by local and foreign
investments as fundamentals improve.
Most Egyptian stocks rallied aggressively after the November
devaluation of the pound, regardless of their near-term outlook.
The key for effective investing is to identify the companies that
are well positioned from a business perspective to benefit from
the devaluation. Investors should also consider attractively
valued companies that can maintain profitability and adjust their
pricing structure while absorbing the higher costs associated with
inflationary pressures.
3
Qatar: Infrastructure- and FIFA-Related
Spending Set to Pick Up
Kuwait: Well Positioned on Several
Fronts
In 2016, Qatar began an initiative to rationalize spending by
trimming excessive expenditures. However, fiscal spending has by
no means stopped, as evidenced by the 2017 fiscal budget. It still
forecasts a deficit, albeit a smaller one (-4.6% of GDP versus -8.2%
in 2016) given higher expected/ budgeted oil prices, and it includes
a major focus on capital spending (Exhibit 2).
Expansionary fiscal spending, at a comfortable
position
Exhibit 2
Qatar’s Budget Boosts Capital Spending in 2017
(Qatari Riyals; billions)
250
Current Spending
Capital Spending
Kuwait’s fiscal budget breakeven oil price ($48 per barrel) remains
the lowest in the Gulf Cooperation Council (GCC) because of
low spending obligations, giving it room to maintain expansionary
capital spending. Although capital spending is on the rise compared
to previous years, it is still relatively low (7.8% of GDP) compared
to other GCC countries (Exhibit 3).
Exhibit 3
Kuwait’s Capital Spending Is Relatively Small, but Growing
(Kuwaiti Dinars; billions)
25
200
Current Spending
Capital Spending
20
150
15
100
10
50
5
0
2012
2013
2014
2015
2016
2017E
As of 31 December 2016
Forecasted or estimated results do not represent a promise or guarantee of future
results and are subject to change.
Source: Saud Arabia Monetary Agency, Saudi Ministry of Finance, Shuaa Capital
0
2012
2013
2014
2015
2016
2017E
As of 31 December 2016
Source: IMF Article IV Reports
For 2017, budgeted current spending will be reduced by 6.6%
versus 2016, whereas capital spending will increase by 3.2% versus
2016 with a continued focus on major infrastructure projects,
including those related to the FIFA World Cup. Projects valued at
46 billion Qatari riyals, which represent 12% of ongoing projects,
are expected to be awarded, of which 54% are infrastructure-related
and 18% are related to FIFA.
The fiscal deficit will be filled through debt issuance rather than
foreign reserve withdrawals. Debt will likely be issued to foreign
investors, given Saudi Arabia’s recent success and the continued,
but easing, tight domestic liquidity conditions (money supply, as
measured by M2, shrunk by 5% in 2016).
Valuations have been driven up mostly by foreign investment flows
in anticipation of and following the upgrade of Qatari equities to
the FTSE Emerging Index, with the index’s P/E currently standing
at 16x. We believe these valuations are not very attractive from a
historical perspective or even compared to regional peers.
Kuwait has also been trading below its long-term historical P/E
multiple for more than two years (Exhibit 4), which makes the
valuations of many of its listed companies lower than historical
highs. This, combined with an expansionary fiscal stance by the
government, which we believe is sustainable, bodes well for Kuwaiti
corporations. In addition, some of the market transactions related to
the sale of strategic stakes of listed companies to foreign investors has
improved market liquidity, which is especially important because
some of the sellers are highly leveraged. This is expected to improve
provisioning levels within the banking sector and hence profitability,
especially given that the central bank has been conservative and has
asked banks to take provisions to historically high levels.
4
Exhibit 4
Kuwait’s Equitiesa Are Trading at Relatively Low P/E
Multiples in Historical Terms
Exhibit 5
UAE Has One of the Most Diverse Economies in the MENA
Region
(% of GDP)
(Price)
700
Mining/Quarrying
Real Estate/Business
Trade & Repairing Services
600
Construction
21x
500
Manufacturing
Transport, Storage & Comms
Financial Services
17x
400
Government Services
Electricity, Gas & Water
Actual Price
13x
300
Social and Personal Services
Restaurants & Hotels
Insurance/Reinsurance
Agriculture/Live Stock/Fishing
200
2013
2014
2015
2016
Domestic Services
0
5
10
15
As of 15 December 2016
a Kuwaiti equities = Kuwait Stock Exchange Weighted Index
As of 31 December 2015
Source: Bloomberg
Source: Federal Competitiveness and Statistics Authority, HSBC
Technical factors playing well for the stock
market
Kuwait’s weight in the MSCI Frontier Markets Index will most
likely increase after Pakistan and Argentina are upgraded to
emerging markets (they represent the second- and third-largest
markets in the MSCI Frontier Markets Index, respectively). In
addition, Boursa Kuwait took over the exchange’s operations
during the third quarter of 2016. One of its strategic objectives is
to upgrade the exchange infrastructure and business environment
to international standards, which eventually should help Kuwait
achieve emerging markets status.
Having one of the lowest levels of sell-side coverage in the MENA
region, and being relatively under-owned by regional, frontier, and
international fund managers, Kuwait remains perhaps the MENA
market with the largest number of undervalued names and where we
continue to find interesting investment opportunities.
UAE: Diversified Economy with
Less Need for Fiscal Consolidation
Measures
As mentioned in our 2016 MENA Outlook, we believe the UAE
economy is well positioned to weather the impact of lower oil
prices. With one of the most diversified economies in the MENA
region (Exhibit 5), and being ahead of the curve in adopting market
pricing mechanisms for many of its government services, the UAE
economy seems less likely to implement drastic fiscal consolidation
measures, especially given its manageable/ non-existent fiscal
deficits. In addition, prudent government planning combined
with a focus on expense rationalization, as seen recently in merger
activities, will likely put the economy on a more healthy footing.
20
25
(%)
In 2016 the strong US dollar and lower oil prices did have an impact
on tourism, real estate, and retail activities, especially for Dubai. As
the direction of these negative headwinds reverses, we expect healthy
trends within these different sectors to emerge again and contribute
to the non-oil GDP of the economy. In addition, the UAE, and
especially Dubai, has proactively positioned itself as a business,
tourist (with the opening up of theme parks and attraction and
cultural venues), investment, and transportation hub both regionally
and internationally.
Banks: further consolidations expected?
With around 50 banks operating in the UAE, the sector is quite
fragmented. We have witnessed during the course of 2016 some
consolidation/ merger activities, mainly between First Gulf Bank
and National Bank of Abu Dhabi, two Abu Dhabi–based banks. In
line with the cost-optimization implemented across different entities
and corporations, and part of the consolidation of a fragmented
sector, further mergers would not come as a surprise, especially
given the synergies and capital optimization objectives that can be
achieved from these initiatives.
Increased cost of funding, as a result of a tighter liquidity and a
currency pegged to the US dollar, has been putting some pressure
on banks’ net interest margins. However, banks in the UAE are well
positioned from a capital base perspective, as capital adequacy ratios
stand at an average of 18.5%. In addition, banks seemed to have
been proactive in cleaning their books with regards to their exposure
to the troublesome small and medium enterprises sector.
5
Oman: Further Fiscal Reforms
Essential
Impacted by lower oil prices, Oman has been cutting back on
spending, with 2016 actual spending 10% lower than in 2015.
Despite the reduction, the fiscal deficit and current account deficit
were both as high as 20% of GDP.
Oman recently announced its fiscal year 2017 budget. Spending has
been cut again compared to the previous year, by around 8%, from
$33.0 billion to $30.5 billion. The budget has an estimated deficit
of about $8 billion (about 12% of GDP) where the government is
estimating revenues of $22.6 billion (oil price assumed to be $45 per
barrel) and spending at $30.5 billion. More than 80% of the deficit
would be financed by borrowing programs. Public debt increased to
29.0% of GDP in 2016 compared to 9.3% in 2015.
Conclusion
Reform agendas have been set for MENA economies, and
implementation has started in 2016. This has affected MENA
corporations—which have sought to improve their productivity and
efficiency while optimizing and rationalizing their cost structure—and
consumers—who have reduced their spending and increased their
saving, and traded down in product category. Both have adjusted to
the reality of lower subsidies from governments. We believe that 2017
will be the year when the reforms become the basis of a new norm,
with adjustments to remove excesses in the economy as well as a
rebasing for corporate profitability and spending behaviour.
The government is looking to reduce the deficit by: increasing nonoil revenues, introducing an income tax law that is expected to be
issued this year, enhancing tax collection efficiency, and increasing
indirect taxes like fees of licenses, bringing foreign workers,
limiting tax exemptions granted for companies, standardized fees of
municipality services, and cutting subsidies gradually. These measures
are expected to have a negative impact on the operating environment
for companies and put pressure on margins and returns.
Note
1 S&P Pan Arab Large Mid Cap Net Total Return Index in US dollars
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Published on 2 March 2017.
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