In its investment research report Global Emerging Markets Strategy UBS, said that with massive current account and fiscal surpluses and growing currency reserves, energy- and non-energy-related activity is likely to remain robust for the foreseeable future.
However, the cloud over the horizon, it says, is rising inflation pressure, the region’s most pressing macroeconomic problem, which could reignite the debate over the peg to the US dollar.
“There is a growing discussion on whether and potentially when other countries in the region will follow Kuwait’s example,” UBS said.
“Most observers see the highest likelihood of a change in the foreign exchange (FX) regimes in the case of the UAE and Qatar.”
According to the report, the UAE and Qatar have the highest GDP growth in the GCC, but they also have the highest inflation rates, “so tighter monetary conditions are urgently needed to fight overheating pressures”.
The UBS FX strategy team considers the most likely move would be towards a basket of currencies, similar to what Kuwait did last year.
The renewed debate over the US dollar peg has been further fuelled by the US Federal Reserve’s overall rates cuts of 125bp last month.
“Given that inflation pressure in the region is likely to remain high or even rise further; the dollar might stay under significant pressure; and Fed rate cuts are likely to continue – we think the authorities will remain under pressure to consider changes to their currency regime,” UBS said.
Discussions over a change in monetary policy had been dampened in early January after the UAE’s Central Bank Governor, Nasser Al Suwaidi, said that, after a review of the current foreign exchange regime, the authorities had decided to keep the current peg against the dollar.
However, UBS’ analysts said that they were surprised by Al Suwaidi’s statement particularly his reference to “only one-third of inflation in the UAE is caused by the weak dollar, with the majority due to rising rents caused by a shortage of housing and office space… given that Mr Al Suwaidi had indicated his potential willingness to modify the FX system just a few weeks earlier”.
And UBS points to one-year FX forwards pricing the UAE dirham 2.5 per cent stronger than its current spot rates as further evidence shows the peg debate will not go away any time soon.
UAE And Egyptian Stocks Top Picks
UAE and Egyptian shares are the most attractive in the Middle East, while Morocco is the least attractive, UBS said in its view on regional equity markets.
“Valuations imply growth rates well below current GDP growth rates for almost all markets in the region, even when based on very conservative assumptions regarding the long-term return on equity,” the bank said in its report.
“We compare valuations across industry groups with other emerging markets. We find valuations in diversified financials, insurance and materials to be the most attractive. We also screen for global stocks with high earnings exposure to the region.”
However, UBS said that the greatest challenge for the regional economy is to establish the conditions for healthy growth in the long term.
To maintain the current boom careful macroeconomic management and progress in structural reform and prudent risk management is required, it said.
Global Equities Road To Middle East Economies
Investors can gain exposure to the boom in the Middle Eastern economies through global equities, UBS said.
UBS stock-picked based on which firms obtain at least 10 per cent of earnings from the Middle East or where the Middle East does not account for 10 per cent of earnings, then the region must account for a significant part of the growth in earnings, or otherwise have significant projects in the region.
“While no particular threshold was set for this latter condition, these are names that have been flagged by the analysts as significant beneficiaries [within their sectors] of growth in the Middle East,” UBS analysts said.
Growth in the construction sector is expected to remain strong, and the construction names are an obvious direct way to gain exposure.
However, construction and engineering companies tend to have relatively high operational leverage.
“In an environment where wage costs are increasing significantly, only construction and engineering companies that are able to effectively pass on higher costs will be well positioned in the region,” said UBS.
Energy companies are the most obvious direct play on the region’s comparative advantage.
However, this is also the area where political risks are higher than in other sectors, especially for companies that also operate in some of the less stable countries in the region.
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