We have spoken at great length, and on several occasions, in these pages about the Gulf capital markets and equities in particular. Twice, in the last quarter of 2005, we pointed to the excesses and overly euphoric market mood, especially in Saudi Arabia, where company valuations had reached astronomic and unsustainable levels.
The mania subsided dramatically, and bubbles all over the GCC burst, leaving many small investors licking their wounds. In fact, the collapse was so rapid and devastating that one heard many anecdotes of people losing it all, betting on the stock market after borrowing money to do so. Ho hum.
The driver of the equity rises had been primarily the macroeconomic factors supported by a high and rising oil price, which had moved from near $40 a barrel, 18 months prior, to around $77 per barrel. However, and due to the un-sophistication of most small investors in the region (and similarly to the last Nasdaq bubble in the US), too many participants entered those markets inexperienced in high-octane investing. Also, given the profits they made from stock lending, the banks were willing to lend and the party lasted longer than it should have.
Now, after nearly 50% losses in most GCC share indices, and with the price of oil having receded from the high $70s to near $60 per barrel – a 22% drop – it is time to take another look at where those markets are heading in the near term, and what the key triggers are.
The sharp correction in the regional capital markets can be seen in regional corporate earnings during the first half of 2006 when many companies derived a significant part of their income from investments and activities related to the stock market. The sectors which have been hampered the most due to the declining capital markets were the investment and real estate sectors. These two sectors were the best performers during 2005 on the back of surging capital markets.
The regional corporate earnings of 410 companies listed have exhibited lackluster growth in the first half of 2006, reporting an increase of only 10.64%. However, with the exception of the industrial, investment, real estate and insurance sectors, other sectors have achieved profit growth in excess of 10% in the first half of 2006.
The banking sector achieved a profit growth of 41.80% during the first half of 2006 as regional banks’ interest income received boost on back of an increasing interest rate environment. The management fees, commission, and investment banking activities have recorded lower growth, and this was one of the primary reasons for lower profits for the regional, especially UAE banks.
Telecom sector achieved a growth of about 24.50% in 1H-2006, thanks to the increasing profits as a result of a rise in the penetration levels, especially in Saudi Arabia and Oman. This has been further complemented by the increase in average revenue per unit. In the telecom sector, Mobile Telecommunication Company (MTC) and Qatar Telecom (QTel) were the top performers with improved earnings of 54.89% and 58.12% respectively, attributed mainly to their expansion outside the region. It is likely that the telecom sector will continue to perform well with the help of expansions both in and out of the GCC region.
Hotels and tourism companies witnessed their profitability increase by 24.50%, backed by increased regional business travel and tourism and rising interest of both government and private sector in developing the nascent tourism sector.
On the other hand, the services sector recorded growth of 13.21% in profitability on the back of expansion through acquisition of related companies, which increased their revenues substantially over the last year.
The industrial sector reported a profit drop of 3.35% in the 1H-2006 as compared to the same period previous year. The industrial giant SABIC (accounting for almost 60% of the regional industrial sector profits) registered an earnings drop of 11% during the first half of 2006, which can be attributed to the price pressures in its various lines of business stemming from upward push in commodity prices with SABIC being quite sensitive to pricing in metals and the like. However, if we exclude SABIC from the industrial sector, the sector has witnessed a growth of 10.65% during the 1H-2006.
The correction witnessed in GCC capital markets has hindered the profits of the insurance sector. The insurance sector reported a decline in earnings of 49.12% in the first half of 2006, which can be attributed to the decline in investment yields as most of the insurance companies in the GCC invest about 40-50% of their total investments in equity market. On other hand, investment sector earnings are mainly triggered by the performance of regional equity markets. As a result of the declining capital markets, the investment sector reported a drop of 34.85% during the first half of 2006. Talking on the same lines, even the real estate sector reported an earnings drop of 78.32% in 1H-2006, being the biggest decliner among the sector profits.
Despite the regional markets suffering huge setbacks in the last few months, regional economic growth and improving geopolitical conditions are pointing towards the likelihood of a comeback in the final months of 2006. This is all the more reason to remain bullish towards the regional bourses, which have already started showing growth in the last month or so. We believe that this is likely to improve the profitability of sectors such as investment, insurance and real estate for the full year of 2006. But the key to this forecast is two-fold: Firstly, the lower-quality shares, which had been floated on the market in a loose environment, will probably never recover to peak levels, given that even after the big drop, their valuations and estimates are still out of sync with reality. Secondly, regional bourses will likely still suffer some short-term setbacks, because 1) the public is still too enamored with shares, and 2) stocks in the region will not only have to adjust to slower growth in oil prices, but also with lethargic and even falling global markets.
Despite the bullish outlook for corporate earnings, it is unlikely that the share market in the GCC will go back to the trance it enjoyed in 2004 and 2005. But overall for regional capital markets, the news is not all dire. As the region opens up, a transition toward global trends in the architecture of the MENA region capital markets will present spectacular opportunity.
With a fixed income market totaling only 4% of GDP in the region – versus 8% in Africa, 12% in developing Europe, and 8% in Asia – the region has ample room to grow its capital markets and deepen their structure.
This new shift will be a boon to GCC banks and financial institutions that have the strong balance sheet to support new forms of financing, helping to offset the unexciting equity outlook.