Investors in the Middle East have reacted sharply on the credit events in Dubai and although we are still in the early stages of restructuring, four lessons can be learned:
- Communication is key
- Put things in context
- Long term fundamentals did not change
- Volatility will not disappear
Communication, communication,…
The Dubai announcement was clearly not expected by the market but the reality is that this action will accelerate the process of tackling the debt problem in the real estate market. Our view is that the market reaction could have been less severe had expectations been managed better. The liquidity facility by the Central Bank and the reassuring words of the UAE leaders have given investors a bit more comfort. Today, Dubai World has also made clear that the request to restructure debt has to do with the $26bn of Nakheel and Limitless World, 2 of their holdings. This was half of the levels mentioned by some analysts and should ease the market tensions. With regard to the restructuring, it seems likely that an arrangement will be found with the creditors.
Dubai is a maturing economy and it is now confirmed that there is room for success and failure. The style of communication was far from spotless but the message is clear now. By the initial reaction on markets, it seems that many foreign investors actually believed that businesses were ‘bullet proof’ in Dubai and that they could count on unconditional financial support from the local authorities. Dubai World is a state owned company but in the legal documentation it was clear that the government does not guarantee the debt. Moreover investors received a spread above governmental debt. Investors should have realized this. On the other hand corporate leaders in the Middle East should start to communicate in a more effective way with their stakeholders or revert back to 100% ownership of their equity and debt. Communication is not a “nice to have” when you have external providers of capital.
Putting things in context
It is, as always, very important to put things in the right perspective. During the past 18 months, the world has witnessed a number of restructurings, bail-outs and even bankruptcies. Only last month, we saw one of the oldest commercial lenders in the US, CIT, filing for bankruptcy as it failed to deal with USD 70 billion debt. In contrast with the current reaction by financial markets on the events in Dubai, the CIT debacle went by practically unnoticed by investors.
Most Middle Eastern economies practically have a reserve to GDP ratio in excess of 100% (UAE, Qatar, Saudi Arabia), and could afford to bail out troubled companies. In contrast to some developing countries which have stepped up state aid in the last months, the Middle Eastern governments are choosing to not to so. In essence, they are sending out a message that companies and their investors must understand they are fully accountable for their actions. This is clearly material for further thought and will obviously be subject to debate. In our opinion, if there is anything to be taken away from this experience, it is the fact that the Middle East is developing its own standards for a pragmatic economic environment which will eventually strengthen it economic texture.
Below is a chart that puts in perspective the global debt vs. reserves situation. The numbers are from 2007 so they don’t even include the various stimulus packages (more debt) that have been issued over the past two years nor does it reflect the higher reserves for the Middle East as a result of high oil revenues.
Long term fundamentals haven’t changed
Dubai’s economy represents only 8% of the GCC GDP. The remaining 92% is spread across, Abu Dhabi, Saudi Arabia, Qatar, Oman, Kuwait and Bahrain. Dubai and Bahrain are the only economies that do not have high oil-related reserves, and while the other countries do benefit from a strong national balance sheet they also share the same regional opportunities for growth. Let us not overlook the fact that more than one third of the world’s population lives within a 4 hour flight radius from this region. The GCC countries also generally benefit from low taxes which come as a result of national solvency, this provides many companies operating out of the GCC a competitive advantage in pricing power due to wider margins, which in turn puts them in a strong position to capture the regional opportunities.
To top it off, the demographics are also favorable: while the smaller countries are attracting large foreign workforces across the skill spectrum, Saudi Arabia with a population of around 30 million people boasts an average age of under 20 years old. Dubai’s population more than doubled over the past 5 years.
What one must not ignore is that until not too long ago, foreign investors didn’t even have access to most of the GCC markets, now these markets are opening up and as they continue to build credibility, foreign investors may start seeing the compelling and often dramatically undervalued opportunities for growth there. Today we have seen first buy orders back in the markets and not surprisingly the companies which performed best were the ones with the strongest competitive advantages. In the case of UAE, it was Air Arabia (most efficient low cost carrier company in the world based on load factor) and Dubai Ports (one of biggest logistics firms in the world with strategic port assets across the globe) that did well. Long term fundamentals count…even in distressed times,
Volatility will not disappear
On the short term we may still see market volatility but we think that the on the mid-term the current valuation levels may represent a unique window of opportunity for investors to build up positions in these markets. The UAE and the wider Arab markets are trading at a fraction of their 5 year highs and have far lower price earnings ratios. International investors haven’t entirely realized this and many still have to enter the market.
Below is a chart that illustrates to large extent to which Middle Eastern market valuations have lagged. Their emerging market peers and those of the ‘developed world’.
Our advise to investors is to keep their portfolios diversified across sectors and countries. An allocation to North Africa could also help investors to improve the portfolio’s risk profile though further diversification into other fast growing economies. In our Arab Falcons fund we are well positioned to benefit from the long term potential while avoiding some of the unnecessary short term volatility. We achieve this by:
- UAE allocation: Allocation is at around 15% but is very defensive. The only bank that we have in UAE (1% of portfolio) is NBAD which is the most defensive and solid name in the UAE
- Banks, Real Estate, Materials: Allocation to these 3 sectors is around 40% while market is allocation is around 60-70%.
- North Africa: Allocation to Egypt, Tunisia and Morocco is around 30% while most benchmarks have only 15%.
- Diversification: We are very diversified with around 25% in top ten while or competitors have 40-50%.
Stay tuned for more! Kind regards from the Silk Invest Team!
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