Accumulation of foreign assets will act as a cushion against global slowdown

The report painted a rosy picture of the UAE stock and financial markets.

The report, called “The bargains in the bazaar – remain bullish for 2008,” said the investment plans of the GCC economies are sustainable at an oil price of $40 per barrel to $50 per barrel, the estimated break-even oil price for budget expenditure.

“A moderation of oil prices in the near term, in our view, will dampen investor sentiment but is unlikely to disrupt real economic growth,” the report said.Merrill Lynch is particularly positive on stocks with exposure to infrastructure, real estate and capital market development across the region.

The region is not completely immune from a slowdown in the United States, particularly due to the impact of falling oil prices. Oil is still expected to constitute the bulk of fiscal revenues across the GCC in the absence of taxation. However, the real economy and region’s investment pipeline is unlikely to be disrupted as long as oil prices stay above the breakeven level of $40 per barrel to $50 per barrel.

Oil ‘windfalls’ above these levels flow to central banks and sovereign funds, with limited impact on real economic growth.Moreover, the accumulations of foreign assets during the current oil boom have provided governments with an alternative revenue source and a cushion against non-oil fiscal deficits.

Nevertheless, a softening of oil prices is likely to slowdown nominal GDP [and money supply] growth and negatively impact investor sentiment. Falling interest rates in an inflationary environment is supportive of continued inflows into capital and real estate markets.

Contrary to previous oil booms, GCC governments have been relatively prudent on spending. GCC countries have built up cumulative current account surplus of about $739bn over the past five years. The region is awash with cash – private wealth assets in the region are estimated between $1.2 trillion to $1.5trn, and the GCC’s current account surplus in 2006 alone was a quarter of the US deficit.

“We do not expect a significant reversal to oil prices in the short term and believe fiscal spending is likely to gain pace as mega investment projects are launched across the region,” it said.

Growth is also becoming less of an oil story.While the contribution of the non-hydrocarbon sector to incremental GDP growth was 49 per cent back in 2003, it increased to 85 per cent in 2006. 

Investment boom

More than $1.6trn in the region is earmarked for mega-projects and infrastructure spending and the IMF is forecasting that $800bn will be spent in the next five years, with more than 75 per cent in non-hydrocarbon sectors.

Governments across the region have cemented a political commitment towards long-term economic diversification programmes, targeting the services (trade, tourism,

transportation) as well as downstream petrochemical sectors.

Moreover, there is a need to reverse years of chronic under-investment in civil infrastructure such as water, power, utilities, education and healthcare – these translate into huge private sector opportunities.

Favourable demographics

The GCC is experiencing strong population and labour force growth and an influx of expatriate population. The World Bank is projecting population in the GCC will grow 2.4 per cent a year between 2005 and 2010 and two per cent from 2010 to 2020 (although the likes of Qatar and UAE are witnessing growth rates of six per cent and 4.5 per cent due to expatriate immigration).

The UAE, particularly Dubai, has been a trendsetter in reforms and infrastructure spending and enjoys the advantage of being the one to shape things. Other countries in the GCC have been following Dubai’s example: foreign ownership of real estate, building up of tourism and transportation infrastructure, etc.

Abu Dhabi has started to spearhead its own ‘mega-projects’, with planned non-hydrocarbon investments of about $50bn in 2007 to 2012. Moreover, with accumulated sovereign wealth assets of $500bn to $750bn, Abu Dhabi has the financial capacity to weather medium-term oil price ‘shocks’.

Qatar is the rising star of the region. With a GDP/ per capita of about $65,000, Qatar is one of the wealthiest countries in the world, expected to grow at a blistering 14.8 per cent in 2008.Qatar possesses the third largest gas reserves in the world after Russia and Iran – and is the largest exporter of LNG globally. LNG exports are expected to triple from 2007 to 2012, which in turn supports the government’s $70bn infrastructure spending pipeline from 2007 to 2012.

“We also see strong near-term momentum in Kuwait, which has recorded an average annual GDP growth of 9.3 per cent in 2003 and 2007 and has the region’s largest current account balance (33 per cent of GDP in 2008). Recent changes to the capital gains tax regime, in our view, will continue to drive a re-rating.

“Kuwait, however, remains the most oil dependent economy in the Gulf and has been relatively slow to channel petrodollars into diversification plans.”

Equity markets

Equity markets in Middle East and Africa (Mena) have had a volatile start to the year. The region’s capital markets have not been completely invulnerable to the global “margin call” and risk aversion.

 

Nevertheless, they have outperformed other emerging and developed markets – a trend that is expected to continue in 2008, the report said.

Dubai and Egypt, which are most exposed to foreign institutional investors, have been most affected by global de-leveraging.

The positive impact of Kuwait’s capital market reforms, and expected resolution of the capital gains liability constraint has prompted a broad re-rating of the market. Aside from global recessionary fears, volatility in the Gulf markets has been driven by the earnings and dividends season, which is now drawing to a close.

On the re-rating of Gulf markets, Merrill said: “GCC markets have recovered relatively quickly and broadly from the 2006 crash.Valuations have fallen from a peak 42x, trailing PE premium to approximately in line with Gulf and emerging markets.

“We expect the Gulf to trade at premium to other emerging markets given healthy macroeconomic growth; low-risk premiums; and abundant capital and solid current account positions relative to other fast-growing frontier markets. Our global EM (emerging market) strategist, Michael Hartnett has picked the Gulf markets as his top frontier recommendation, on the basis of massive oil surpluses, excess liquidity, and attractive valuations.”

The report, however, is cautious on commercial banks. “We turn more cautious on commercial banks – unless a substantial revaluation of GCC currencies takes place, margin compression is likely to create earning risks for 2008 to 2009. Although banks will continue to benefit from strong loan growth and fee generation (as well as positive trends in real estate markets), the competition for deposit funding is expected to intensify.

“Nevertheless, we think Islamic banks, such as Dubai Islamic Bank, are well positioned in this environment due to greater pricing power, lower interest rate sensitivity and secular growth arising from capital markets (Sukuks) and retail product innovation.

“Banks with greater revenue contributions from non-spread businesses are also more sheltered from the top-line impact of margin compression.”

The numbers

$739bn: The current cumulative account built up by the GCC

$1.2trn: The estimated private wealth assets in the region

85%: The contribution of non-hydrocarbon sector to GDP growth in 2006