Equity markets: Will Gulf rally stay on track?

Reforms to the Gulf stock exchanges offer a chance for markets to bounce back after a long slump. Published in Euromoney, April 2012

Note: the version here is the original unedited version, not the published one.

In the early weeks of 2012, there was some unusually good news for Gulf stock markets: most of them started to rise again. The Dubai Financial Market (DFM) was up by 6.1 per cent in January, the Saudi Stock Exchange (Tadawul), rose by 3.3 per cent and the Abu Dhabi Securities Exchange (ADX) was up 2.2 per cent. Even the Kuwait bourse made a modest gain of 0.9 per cent.

Admittedly, the Doha and Bahrain exchanges both fell and the region trailed behind its global peers during the month – emerging markets globally rose by 11.8 per cent in January – but it was a rare piece of good news for the region nonetheless, and all the more welcome as a result.

Whether that early promise can be carried through into the rest of the year remains to be seen. As yet, not everyone is convinced that it is the start of a sustained period of improvement. “We’ve seen the market rally in the last couple of weeks 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 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 in 2011 due to higher trading volumes in Saudi Arabia and Qatar. Liquidity in all the other markets fell, declining by 46 per cent in Kuwait and 90 per cent in Bahrain.

There have been a number of initiatives around the Gulf this year which could help to cement the recent gains and some market observers at least are 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 characterised by sustained resilience.”

Kotilaine’s local stock market, the Tadawul, 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 country’s central bank, the Saudi Arabian Monetary Agency (SAMA), and the Capital Market Authority to work more closely in supervising the financial sector. The two bodies signed a memorandum of understanding in early 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 Capital Markets Authority was passed by the National Assembly (parliament) in February 2010. This year, UK bank HSBC has been in talks with the authorities to help privatise the Kuwait Stock Exchange. This initiative could yet fall victim to the political inertia in Kuwait which so often disrupts reform plans, but for now it seems to be on track.

To the south, Qatar is also preparing to open a junior exchange, known as the QE Venture Exchange, with less stringent entry requirements and fewer ongoing disclosure requirements. The country’s main bourse, the Qatar Exchange, was the only one that managed to rise over the course of 2011, with the QE Index up 1.1 per cent, helped by massive government project spending and consistent profit growth among listed companies.

The impact of all these initiatives will take some time to become apparent and they are 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 for reform which should encourage investors.

“Initiatives such as those on the Tadawul and the secondary market in Qatar will certainly boost the attractiveness of those exchanges, both to local and foreign investors,” says Manaf Alhajeri, chief executive officer 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 definitely put the Saudi market directly on the radar screen for foreign institutional investors.”

The Saudi market is easily the most important in the region. With a market capitalisation 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 in the past and is dominated by local retail investors.

The other markets are, by comparison, more open to international investors, but all of them 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 decides to include them in its Emerging Markets Index when it reviews it later this year. At the time of its last review, in late 2011, it decided to postpone a decision for six months, giving a chance for the authorities in the two countries to address some key concerns. In the case of Qatar it is the ownership limits which mean that foreign investors cannot hold more than 25 per cent 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 to upgrade the two countries is due in June. Brokers and analysts suggest there is some chance that the UAE might make the jump, but few expect Qatar to change its foreign ownership limits in time. “It’s anyone’s guess whether 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 an inflow of funds from foreign institutional funds that are indexed based. For the local markets to really make a clean break with the past five years of disappointment, however, 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 which have been hit hard by the regional downturn in recent years.

At the moment, only the Tadawul is seen as well diversified. The issue could be at least partly addressed if governments decided to privatise some of the better performing state assets, such as Emirates, Qatar Airways or Dubai Aluminium Company (Dubal). 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 needs to be brought into line with global norms. In the UAE, the Emirates Securities & Commodities Authority has drawn up some draft regulations that would allow for market making, short selling and securities lending, but they have not yet been finalised.

“One of the major issues is that there is no market making,” says the head of investor relations at one company listed on the DFM. “You can only create a liquid market if you have incentivised 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 like 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 in terms of corporate disclosure and market transparency. There are hopes that the new Capital Markets Authority in Kuwait will help to push this issue and the expanded cooperation between SAMA and the Capital Market Authority 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 per cent of all listed GCC companies received research coverage last year, although that represented 77 per cent of the total market capitalisation in the region. Saudi companies gained the most attention, accounting for 33 per cent of all research notes, followed by the UAE with 26 per cent. In Bahrain, just 7 per cent of companies were covered, accounting for 10 per cent of market capitalisation.

One other way that 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 harmonisation of regulations between them which 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 which closed its doors on 23 January.

As HC Securities said in a statement announcing the closure, “the declining trading volumes over the last four years makes it impossible for us to predict when the UAE financial market will recover, specially in light of the existing economic conditions in the world and the Middle East.”

While the markets can do many things to try and address the shortfalls in their performance, these macro economic conditions are clearly beyond their control. Another factor which they can do nothing to change is the political climate, which was a strong 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. In addition, the heightened rhetoric between Iran and the West over Tehran’s alleged pursuit of nuclear weapons could easily escalate into outright conflict.

“There were significant declines in 2011 mainly due to political uncertainty in the region,” adds Waly. “Before the Arab Spring started, we were seeing interest from foreign institutional investors on GCC markets, but many foreign institutional investors chose to adopt a wait and see strategy following the Arab Spring. If the political scene stabilises, we should see a much better 2012. During the first few weeks of 2012  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 that the markets could bounce back at all.