The Middle East and North Africa (MENA) is a diverse region, encompassing developing countries like Egypt and high income countries like Qatar. However, markets are generally immature and under-developed, potentially presenting an opportunity to invest in under-owned early stage emerging markets. Marcel Porcheron went to Dubai in the United Arab Emirates to assess the investment case for the region.
Economic Update- View from the ground
As I travelled round Dubai to meetings I was struck by the huge volume of construction, which gives the impression that Dubai has avoided the worst of the credit crunch. However, recent dramatic falls in local markets reflect concerns that the region may be running into funding difficulties that will put some building projects into the red and it will probably have to rely on Abu Dhabi to make up any shortfall. Although Dubai itself has no oil, underlying the six GCC (Gulf Co-operation Council) States, which includes the United Arab Emirates, are 61% of proven oil reserves and 41% of proven natural gas* reserves and the region’s governments are using energy revenues to support massive spending on infrastructure.
My second observation of Dubai is that the labour force is almost entirely dominated by expat workers; from South East Asian hotel workers, to British construction workers, Australian oil service engineers and my Indian driver, Emiratis are noticeable through their scarcity. The thinly-populated GCC states are striving for an economic future independent of energy prices and hoping to continue to attract migrant workers to the region. The region is betting on the development of new industries to diversify GDP away from oil, although so far success has been limited. Meanwhile, the North African countries generally don’t have oil revenues to support them. However, their larger populations provide the potential for rising manufacturing and consumption.
Falling oil prices are bad for investor sentiment in the Middle East, but the cash-rich GCC states should be able to sustain a high level of investment even if oil prices fall further. Locally-listed construction companies should benefit and while the oil price is high the region’s petrochemical, aluminum, and steel companies are globally competitive as they benefit from subsidised energy costs. North Africa has a textile industry and property markets in the Gulf have benefited from negative real interest rates. Technology is a potential industry for the future because of the cheap cost of capital in the GCC and the well-qualified expats working there.
New construction is a common sight on the Dubai skyline
What are the risks?
Without the solid manufacturing base of other emerging markets, the Middle East must rely on spending for growth and recently concerns have emerged over funding in some parts of the region and certain sectors. In some cases foreign debt levels have risen strongly and are high. According to Mina Toksoz, Head of Country Risk at Standard Bank, the UAE’s foreign debt at more than 50% of GDP is unsustainable; in Dubai it is 100% (if contingent liabilities, those debts of the semi-sovereign entities the government would guarantee, are added in) and the emirate’s bonds are trading at elevated levels to reflect this risk. At the corporate level concerns have also risen that some of the region’s companies may have difficulty refinancing debts. In the long term North African economies offer the potential for high growth and are hungry for outside capital, but these poorer countries are also exposed to higher inflation in the short term and investor sentiment has been weak here too.
Dependent on Oil
Although the GCC has large cash reserves which it can use to boost spending, it is still very exposed to an external slowdown because of the oil price. The value of total exports has risen strongly in recent years because of the oil price, but intra regional trade excluding oil is very low. Oil and gas still makes up 80% of total GCC exports and 85% budget revenues and whilst the Saudi budget still balances with oil down at around $40pb, other countries are more sensitive to the oil price. Bahrain’s budget goes into deficit at around $80pb.
The region’s industries and markets are generally fragmented and GDP is heavily dominated by oil so a fall in the oil price will have a negative impact on regional growth. At the same time the cost of financing in the region has risen, at it has been elsewhere in the World, and that could be a problem for the region’s industry which tends to be very capital intensive. It also looks as though some infrastructure and building projects may be more difficult to finance in current conditions.
Crucially, MENA markets are generally illiquid and not yet diversified enough for most investors to single them out. Global emerging market managers find it tough to produce investment ideas here and generally exposure is through a handful of holdings in Egyptian and Israeli companies (and Israel is arguably a developed market). Stock-pickers like Devan Kaloo at Aberdeen struggle with the poor quality of management, weak risk controls and generally poor corporate governance. Overall, corporate culture is in its infancy and where large numbers of new companies are appearing it is difficult for fund managers to evaluate their prospects.
Fund Manager Performance
So far the performance of most fund managers in the region has been very disappointing with most funds down between 20% and 30% over the last three months in sterling terms. Both foreign and local retail investors have taken fright in recent market conditions and local managers blame capital flight for the rapid and unexpected decline in the market. As a result they failed to reposition defensively- by using cash and derivatives and focusing on lower risk stocks- because they did not anticipate such an aggressive correction. In their view the fundamental outlook remains very strong. As at the end of October most managers are expecting broad 2008 earnings growth in the region of 15% to 25%.
Cash levels were raised significantly over September and October although generally most managers retain conviction in their holdings. The most popular stocks include construction companies in the GCC which still have very full order books, financials and property companies like Emaar which are trading well below book and fertilizer and petrochemical companies where the region’s companies benefit from a high oil price.
Source: Lipper
How can you invest?
Given the extent of capital flight and weak oil prices, we would not recommend exposure to the region for most investors. However, should you chose to invest directly in the region we recommend that you favour managers with strong track records and local experience, as local investors can have a big impact on stock market movements. Sean Taylor’s GAM Star Frontiers Opportunities Fund (offshore) has most of its holdings in the Gulf countries and the manager can use portfolio management tools to try to protect against falls. Karim Nehma, who manages EFG Hermes’ Middle East and Developing Africa fund (offshore), has a history of protecting capital. Franklin’s MENA fund is available to investors via Cofunds.
So far Bestinvest has adopted a cautious approach to this relatively immature sector so we do not currently rate these funds but have them on watch. For most investors, we recommend a diversified global emerging markets portfolio. Aberdeen’s Emerging Markets Fund (4-star rated) currently holds just 2.2% in Israel, whilst their Emerging Market Small Cap Fund has very limited exposure to Qatar. The team behind the Advance Frontier Markets Investment Trust, a fund of pre-emerging market investments, has about 25% of the fund invested in Saudi Arabia, the UAE, and Qatar.
*BP Statistical Survey