Equity markets: Will Gulf rally stay on track?

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By:
Dominic Dudley
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Reforms to the region’s stock exchanges offer a chance for markets to bounce back. But they have a history of disappointing investors.

The first quarter of the year has been full of some unusually good news for Gulf stock markets: most of them are rising. The Dubai Financial Market (DFM) is up 24% in the first three months, the Saudi Stock Exchange (Tadawul) has risen 21%, while the Abu Dhabi Securities Exchange (ADX) is up 9%. Even the Kuwait bourse made 7.3%.

Admittedly, the Doha and Bahrain exchanges have been bumpy and the region overall has trailed behind its global peers – emerging markets globally have risen by 15.7% since January – but it was a rare piece of good news for the region nonetheless, and all the more welcome as a result.

Nadi Bargouti, head of asset management at the Dubai-based investment bank Shuaa Capital
Nadi Bargouti, head of asset management at the Dubai-based investment bank Shuaa Capital
Whether or not that early promise can be carried through into the rest of the year remains to be seen. As yet, not everyone is convinced it is the start of a sustained period of improvement. "We’ve seen the market rally, and there’s no fundamental reason for it as far as I can see," says Nadi Bargouti, head of asset management at the Dubai-based investment bank Shuaa Capital. "I don’t see a catalyst."

Overall, the regional bourses have been struggling since 2006 when the value of shares traded across the Gulf Cooperation Council (GCC) peaked at more than $1.6 trillion. Liquidity hit a low of $296 billion in 2010, but bounced back slightly to reach $335 billion last year due to higher trading volumes in Saudi Arabia and Qatar. Liquidity in all the other markets fell, declining by 46% in Kuwait and 90% in Bahrain.

There have been a number of initiatives in the Gulf this year that could help to cement the recent gains, making some market observers hopeful that things are now going in the right direction.

"The Gulf stock markets have a well-established reputation for disappointing people," says Jarmo Kotilaine, chief economist at Saudi Arabia’s National Commercial Bank, but he adds: "I’m pretty optimistic. Things are gradually beginning to look up for the regional economy. It has been a lacklustre few years, but it has also been characterized by sustained resilience."

The Tadawul, Kotilaine's local stock market, has been among those bringing in reforms this year, announcing plans to allow international firms listed on other exchanges to also list their shares there. This cross-listing could, it is hoped, be a step towards a wider opening up of the market.

There has also been an agreement between the Saudi Arabian Monetary Agency (Sama) – the country’s central bank – and the Capital Market Authority (CMA) to work more closely in supervising the financial sector. The two bodies signed a memorandum of understanding in February that will lead to more cooperation in setting corporate governance and risk-management standards, as well as coordinating their approach to initial public offerings, sukuk issuance and merger and acquisition deals.

Changes are also being made in Kuwait, where a law creating a CMA was passed by the national assembly in February 2010. This year, UK bank HSBC has been in talks with the authorities to help privatize the Kuwait Stock Exchange. This initiative could yet fall victim to the political inertia in the country that so often disrupts reform plans, but for now it seems to be on track.

Qatar is also preparing to open a junior exchange, known as the QE Venture Exchange, with less stringent entry requirements and fewer disclosure requirements. The Qatar Exchange, the country’s main bourse, was the only one that managed to rise during the course of last year, with the QE Index up 1.1%, helped by government project spending and consistent profit growth among listed companies.

The impact of these initiatives will take time to become apparent and is unlikely to provide an immediate boost for the markets or the companies listed on them, but taken together they are evidence of a more general trend that should encourage investors.

Manaf Alhajeri, chief executive of Kuwaiti investment company Markaz
Manaf Alhajeri, chief executive of Kuwaiti investment company Markaz
"Initiatives such as those on the Tadawul and the secondary market in Qatar will boost the attractiveness of those exchanges to local and foreign investors," says Manaf Alhajeri, chief executive of Kuwaiti investment company Markaz.

The greatest hopes are perhaps with the Tadawul, where it seems that, after years of speculation and caution, the authorities might finally be ready to open up the market to international investors.

"Allowing foreign issuers to list on the Tadawul in addition to talk that Saudi could be opening up to foreign institutional investors through a qualified foreign investor model are positive steps that will have an impact," says Ahmed Waly, co-head of EFG Hermes Securities Brokerage and CEO of the bank’s Kuwait operations. "It will be a longer-term rather than short-term impact, but it will put the Saudi market directly on the radar screen for foreign institutional investors."

The Saudi market is the most important in the region. With a market capitalization of close to $340 billion, it is almost as large as the rest of the GCC stock markets put together. However, it has deliberately kept out overseas investors and is dominated by local retail investors.

The other markets are, by comparison, more open to international investors, but they are still relatively weakly integrated into global financial markets. The bourses in Bahrain, Kuwait, Oman, Qatar and the UAE are all classified as frontier markets by index compiler MSCI, and foreign ownership limits are often tight.

Things could change for Qatar and the UAE if MSCI includes them in its emerging markets index when it reviews it later this year. At its last review, late last year, it decided to postpone a decision for six months, giving a chance for the authorities in the two countries to address key concerns. In the case of Qatar, it is ownership limits that mean foreign investors cannot hold more than 25% of a company’s shares. In the UAE, it is lingering concerns about the practical impact of a recently introduced delivery-versus-payment system used for share dealing.

A decision on whether or not to upgrade the two countries is due in June. Brokers and analysts suggest there is some chance the UAE might make the jump, but few expect Qatar to change its foreign-ownership limits in time.

"It’s anyone’s guess whether or not the MSCI will include them in the emerging markets index, but not much has changed since the last review," says Bargouti.

If either market does make the grade, then they can expect inflows from foreign institutional funds that are index-based. However, for the local markets to make a clean break with the past five years of disappointment, more changes will be needed in a few critical areas.

One is the need to improve the diversity of the stock markets, which in many cases are dominated by financial services and real-estate firms – two sectors that have been hit hard by the regional downturn in recent years.

Only the Tadawul is seen as well diversified. The issue could be at least partly addressed if governments privatized some of the better-performing state assets, such as Emirates, Qatar Airways or Dubai Aluminium Company. That, however, requires a more complex political calculation than simply the desire to boost local bourses.

The systems for trading and pricing of stocks also need to be brought into line with global norms. In the UAE, the Emirates Securities and Commodities Authority has drawn up some draft regulations that would allow for market making, short-selling and securities lending, but they have not been finalized.

"One of the major issues is that there is no market making," says the head of investor relations at one DFM-listed company. "You can create a liquid market only if you have incentivized market makers to bridge the gap between buyers and sellers. The spreads are huge, and nobody is doing any market making to narrow that spread. Once you get that going, that will give comfort to international investors."

Others say there is a need for a wider range of investment options. "There are not many options when it comes to investing in the GCC region," says Alhajeri. "Most funds and portfolios deal with plain-vanilla products such as mutual and sector-specific funds. Encouraging the development of a regional derivatives market would help support and raise liquidity levels by providing additional options and instruments, which in turn would allow for more diverse and sophisticated product offerings."

A third area where change needs to happen is corporate disclosure and market transparency. There are hopes that the new CMA in Kuwait will help to push this issue, and the expanded cooperation between Sama and the CMA in Saudi Arabia could have a similar impact there.

Overall, however, information on listed companies is at a premium across the region, something that is not helped by the poor level of research coverage. According to Markaz, just 17% of all listed GCC companies received research coverage last year, although that represented 77% of the total market capitalization in the region. Saudi companies gained the most attention, accounting for 33% of all research notes, followed by the UAE with 26%. In Bahrain, just 7% of companies were covered, accounting for 10% of market capitalization.

One other way stock markets could address their weak levels of liquidity would be to join forces. Each of the GCC states has at least one stock market, but Bahrain has two – the Bahrain Bourse and the Bahrain Financial Exchange – and Qatar will soon have two as well. The UAE, meanwhile, has four: the ADX; the DFM; Nasdaq Dubai; and the Dubai Gold & Commodities Exchange.

That seems too many given that, at almost $1 trillion, the GCC has an economy roughly the same size as South Korea, which manages with just the Korea Exchange, after merging the Korea Stock Exchange, Korea Futures Exchange and the Kosdaq market in 2004. Full cross-border mergers between Gulf exchanges are unlikely to happen, given the national pride at stake, but there could yet be greater harmonization of regulations between them that would make it easier to trade across different markets.

Until there is a sustained turnaround, life will remain extremely difficult for brokers and investors in the region. In the UAE, more than half of the 108 brokerage houses that existed in 2008 have gone out of business. Among the most recent to shut up shop was Al Futtaim HC Securities, a joint venture between Egypt’s HC Securities & Investment and the UAE’s Al-Futtaim Group.

As HC said in a statement announcing the closure: "The declining trading volumes over the last four years make it impossible for us to predict when the UAE financial market will recover, especially in light of the existing economic conditions in the world and the Middle East."

While the markets can do many things to try to address the shortfalls in their performance, these macroeconomic conditions are beyond their control. Another aspect they cannot change is the political climate, which was a big factor in the downturn last year and remains a source of concern.

With the continued violence in Syria and, to a lesser extent, in Bahrain and Yemen, this will continue to weigh on the minds of investors looking at the region this year, who will be troubled by the heightened rhetoric between Iran and the west over Tehran’s nuclear programme.

"There were significant declines in 2011, mainly due to political uncertainty in the region," adds Waly. "Before the Arab Spring, we were seeing interest from foreign institutional investors on GCC markets, but many foreign institutional investors chose to adopt a wait-and-see strategy after the Arab Spring.

"If the political scene stabilizes, we should see a much better 2012. During the first few weeks, we saw signs of better performance by most regional markets, as well as slightly increased daily trading values. However, the Iran issue is something to keep an eye out for."

This political uncertainty is a big cloud on the horizon, but at least the Gulf stock markets and their regulators are doing what they can to put their own houses in order. The reforms they are bringing in will not be enough on their own to ensure growth, but without them it is far more unlikely the markets could bounce back at all.