Differentiation Is Essential for Investing in Middle East Markets

by: CFA Institute Contributors

By Ed Bace

When it comes to the Middle East, it's all too easy for global investors to lump countries into the same category. Indeed, sovereign risk premia as reflected in CDS spreads have widened dramatically across the region, with spikes of as much as 88% in Bahrain and 80% in Saudi Arabia. Meanwhile, with the price of crude oil up 21% for the year, the S&P Pan Arab index has lost roughly 10%.

But yesterday, M. R. Raghu, CFA, reminded delegates at the Second Annual CFA Institute Middle East Investment Conference in Abu Dhabi that important distinctions must be made between the Gulf Cooperation Council (GCC) countries and the rest of the Middle East and North Africa (MENA) region in terms of relative wealth and unemployment. Raghu, who is president of the board of the CFA Society of Kuwait and senior vice president of research at Kuwait Financial Centre (Markaz) (the firm's blog is here) pointed out that GCC countries enjoy average GDP per capita that exceeds $20,000, on average, while the comparable figure in the rest of the Middle East is less than $5,000.

The flip side of the GCC wealth differential is the "oil curse" that has made these countries reliant on petroleum, which Raghu calls a "political commodity" (demand from the East, for example, and political pressure from the West). The GCC region accounts for 18% of global oil production, 39% of oil exports and 40% of the world's proven reserves. However, he noted that production has not topped 16 million barrels a day and is thus "lackluster."

Given the severity of the crisis in the region, government responses will be necessary — and will vary by country. GCC governments are exercising "monetary appeasement" and delivering increased spending along with reforms. Governments in the MENA region are imposing a combination of reforms and using force.

The impact of financial and political crises on regional equity markets has been widely felt. Liquidity in GCC stock markets, which are dominated by relatively few companies that are not reflective of the underlying economies, has contracted by roughly 40% over the past two years. The top 10 stocks in GCC markets represent, on average, 70% of the total market capitalization, and the names are mostly banks and other service companies — not oil and industry.

Equity market performance lately has been extremely volatile, with all GCC markets currently in negative territory year to date. Over the longer term, Raghu demonstrated that performance has mostly exhibited a high-risk, high-reward trajectory, with extreme volatility being the rule not the exception. Corporate earnings took a hit in 2008 and 2009, but recovered in 2010. Still, stocks are trading at between 20 to 30 times earnings.

For global investors, the diversification benefit of investing in the region has receded. GCC markets have historically enjoyed low correlation with developed markets. But that has changed dramatically in the wake of the financial crisis. Saudi Arabia is a case in point: its correlation with the S&P 500 was 27% between 2000 and 2008, but shot up to as much as 90%, Raghu said.

Investors looking to profit in GCC markets should focus on yield or deploy dynamic asset allocation strategies to take advantage of the region's equity market volatility, Raghu contended. Private equity also presents interesting opportunities to global investors, given that mezzanine financing can play an important role in the region's development. In addition, privatization is increasingly in the cards. And there is an emerging market in GCC countries for distressed assets, with power and infrastructure plays such as airports and roads looking the most attractive.