The first quarter has seen significant capital flowing into the Arab world from global markets.
Dubai and the United Arab Emirates (UAE) are attracting capital from other emerging markets (EMs) – and, indeed, from elsewhere in the region – as flight from political instability and slower growth continues.
Saudi Arabia is pouring liquidity from oil exports into local investments. And anecdotal evidence suggests many regional companies and family offices are pulling capital back home rather than running offshore risks.
Against this backdrop, there is a general view that the early-June upgrade of the UAE and Qatar to MSCI Emerging Markets status could be the catalyst for significant additional inflows. We don’t believe this is the case, though we remain positive on both markets for the long run.
In fact, we’ve recently cut our previous expectations of passive flows into Qatar and the UAE around the time of the MSCI upgrade (at the end of May 2014), even as our long-run expectations for these two markets has remained unchanged.
This brings us back to our central contention on both of these markets: they’re not your typical EMs, and a solid strategy is one that looks for non-traditional catalysts.
In the long run, a lower-than-expected bump from passive flows is nothing to be worried about. Instead, we are more cautious in the coming period in view of the potential for a correction in outperforming UAE markets and, outside the purview of today’s discussion, Saudi Arabia.
A smaller passive bid for the UAE and Qatar…
We have cut our expectations for passive flows for two reasons. The first is that the AUM of passively managed funds that track the MSCI EM benchmark has fallen sharply over the past year, according to data from EPFR: the $40 billion Vanguard EM ETF has shifted to another benchmark that already includes the UAE, while global emerging markets (GEM) ETFs tracking the MSCI EM Index have seen cumulative outflows of c. $32 billion since January 2013 on concerns over EMs growth, political instability and currency weakness.
The second is that MSCI announced on 24 April it would reduce the weight of eight securities in the provisional MSCI UAE and MSCI Qatar indices, citing “potential accessibility issues for international institutional investors to these securities due to potential reduction in their foreign room following the market reclassification”.
MSCI defines foreign room as the foreign ownership limit (FOL) minus current foreign ownership divided by FOL. Among those affected by the change are some of the biggest stocks in the UAE and Qatar: global property developer Emaar and builder Arabtec in the UAE, and Qatar National Bank and Industries Qatar.
Capping the weight of these stocks will reduce the weight of the UAE and Qatar in the MSCI EM benchmark to 0.6% and 0.5% respectively, from 0.8% and 0.6% under the old weights. Coupled with the fall in passively managed money tracking the MSCI EM benchmark, we estimate a gross passive inflow of $740 million into the UAE and Qatar together.
Net of outflows from funds that passively track the MSCI Frontier Market Index (which the UAE and Qatar are leaving), the passive bid for UAE and Qatari stocks will be around $500 million.
…And the active bid may be lower, too
Moreover, with the UAE and Qatar now likely to have a lower weight in the MSCI EM benchmark from June 2014, there may be less interest from actively managed funds that also track the MSCI EM Index, whose AUMs are many times higher than passively managed funds.
Actively managed funds are still underweight Qatar and the UAE, according to sample data from EPFR, but this underweight is far less pronounced with the adjustment factor applied.
What history teaches us – EM status comes at the top of the cycle
If history teaches us anything, it’s that we should not be surprised by a lower-than-expected bump from the upgrade to EM status. Our study of 15 markets that have ascended to MSCI EM in the past two decades found weaker performance in 12 of them in the year following their upgrades.
Simply put, countries tend to be boosted to EM status during cyclical upswings in those countries: reforms are implemented, and liquidity and market cap rise with the cycle. They tick all the boxes and are upgraded – and then correct with the cycle.
UAE equities are running hard
We are keeping a particularly close eye on UAE markets for a potential correction in the run-up to or immediately after reclassification. MENA markets as a whole continue to trade at a significant premium to EM due primarily to the UAE and Saudi Arabia – Dubai equities trade at 19x 2014 P/E.
We have recently downgraded UAE equities to neutral from overweight, despite our continued belief that the market is in the midst of a strong cyclical upswing. Current valuations price in much of the UAE’s potential, and we see a gradual slowdown in global liquidity growth as threatening recent asset-price expansion in both MENA and developing markets.
Margin trading has helped to drive both the UAE and the Kingdom of Saudi Arabia higher this year, driven by a surge in cross-border capital flows in the case of the UAE.
There’s no doubting the long-term beneficial impact of an MSCI upgrade – there’s simply a larger market for capital raising, and capital inflows can contribute to a virtuous circle of reform and growth. But the short-run impact of this summer’s upgrade may not be big as large as expected and, indeed, may be negative.
Lower flows this summer may not ultimately matter
Lower-than-expected inflows and even a short-term correction are not reasons for doom and gloom. In fact, the data from EPFR show that the contribution of ETFs to total outflows from EM-dedicated funds over the past year is entirely out of proportion to their AUM. One of the primary advantages of ETFs – frequent liquidity – leads to much higher volatility in terms of inflows and outflows compared with active funds.
So while the initial upgrade bid from the UAE and Qatar may be smaller than expected – and a UAE correction may be overdue – long-term drivers for active funds are potentially far more important, and in this respect, our fundamental view remains unchanged.
Both markets are attractive, but there’s more room for market cap-to-GDP expansion in the UAE, which comes from a lower base and is fundamentally a more diverse economy with stronger non-oil growth drivers. (Qatar, by contrast, is a better market for accurately anticipating passive flows, being as it is less liquid and less volatile than the UAE.)
Ultimately, passive buying is of much less relevance over the medium and long term and should not be the primary focus of investors looking at UAE and Qatar. The longer-term benefits of MSCI inclusion – including more IPOs and rising FOLs – are more important, as are the prospects for non-oil growth and earnings growth.
In addition, it is worth noting that actively managed funds are substantially bigger in size than passively managed ones, and as such the UAE and Qatar could still see strong foreign bids as a result of the upgrade, should GEM investors invest at equal-weight or overweight the UAE and Qatar.
Today, active GEM managers remain underweight UAE and Qatar, even accounting for the MSCI adjustment factor.
Meanwhile, Egypt faces much lower risk of a downgrade from MSCI EM status
As we head into summer following a raucous first quarter, we’ve also seen new flows into Egypt, where the Central Bank of Egypt’s recent clearance of a c. $700-800 million repatriation backlog has both reduced MSCI downgrade risk and sparked early signs of buying from foreign investors.
MSCI signalled last June it was closely following the situation, in which foreign portfolio investors faced significant delays in repatriating their funds because of a shortage of foreign exchange. The message was that Egypt risked a downgrade from MSCI EM status if there was no remedy in the offing to the backlog.
While MSCI has not yet said the moment of maximum danger has passed, the fact that offshore investors can now get into and out of the market more easily is unquestionably positive. The hope of the Egyptian authorities is obviously that the environment should remain favorable and that both portfolio and direct investment should swell; any measures the state can take to ensure the free movement of capital will help in this respect.
Indeed, we have seen foreign investors as net buyers since the backlog has been cleared, as some have used the recent sell-off in Egypt as a good entry opportunity. The market still trades at a discount to MENA on a P/E basis, and the medium-term outlook for earnings growth is better than the rest of the region and many emerging market economies.
We maintain our overweight in Egypt, admittedly with a preference for stocks that offer some hedge against weakness of the Egyptian pound and / or inflation.
Long-term prospects for Egypt remain, of course, contingent on both presidential and parliamentary elections – and, of course, progress on poor balance-of-payments (BoP) fundamentals. A structural shift in the country’s energy balance, sharp decline in tourism revenue and poor capital flows remain the dominant themes of the BoP, a situation we expect to last for the coming 12-18 months.
This and the ongoing impact of labour market reforms in Saudi Arabia are every bit as much in our minds heading into June as are the MSCI updates for Qatar and the UAE.