Market analysis: Challenge is to rebalance government spending in low oil price environment

Last month, Mena markets started on a positive note as concerns about slower global growth seemed overblown.

The data from US domestic activity proved to be reassuringly resilient. Most notably, the labour market has continued to improve this year, pushing the economy closer to full employment. Emerging markets (EM) moved up as concerns over a US interest rate increase subsided, while the European crude benchmark Brent moved above US$50 per barrel. However, markets gave up most of the gains and the US dollar strengthened as the European Central Bank indicated further extension of its quantitative easing policy.

In its latest world economic outlook last month, the IMF cut the global growth projection to 3.1 per cent this year, down from its previous forecast of 3.3 per cent in July. The revision was largely because of weakening commodity prices and rising concerns about China’s economic growth.

The challenges China faces today are raising questions about the general growth of emerging markets. The slowdown in global growth affects the US economic outlook, and as divergence in the global growth increases, demand for US assets is expected to further strengthen the dollar.

On the Mena front, S&P last month downgraded Saudi Arabia’s credit rating by one notch to A+ with a negative credit outlook, based on the kingdom’s deteriorating budget deficit because of lower oil prices.

Comments from Ali Al Naimi, the Saudi oil minister, suggest that policymakers are considering following their counterparts in the UAE by cutting energy subsidies. The government is said to be looking at a number of privatisations and other avenues to cover the deficit. These have also been causing volatility in the Saudi market, as the policies are expected to affect certain industries and consumers.

The current low oil price environment has clearly posed strategic challenges, but provided opportunities as well.

The key challenge lies in rebalancing government spending to a lower oil price environment. In the near term, regional governments need to spend on development projects and infrastructure. But over the medium term, the reality of lower oil revenue needs to be aligned with lower government spending and an increase in non-oil GDP growth, leading to slower but still solid economic growth.

In its latest policy review the IMF revised the GDP growth of Saudi Arabia upwards by 60 basis points to 3.4 per cent in 2015 on the back of the increased production of crude oil. Regional economies such as the UAE and Qatar are expected to have continuous growth in the medium term supported by key events including the Expo 2020 in Dubai and the 2022 Fifa World Cup in Qatar.

A combination of MSCI inclusion and the continuing relaxation of the qualified foreign investor rules can potentially bring a passive allocation of about $36 billion in Saudi Arabia, further strengthening the regional markets.

Over the past year, earning expectations of Mena companies were revised downwards by 18 per cent. Overall, third-quarter results were broadly in line with market expectations and a stable outlook is forecast for next year.

We expect earnings to be supportive for the regional markets. Most of the Saudi companies have reported their third- quarter numbers and the petrochemicals sector performed better than analyst expectations. Banking sector numbers were also broadly in line with expectations.

There were some question marks raised regarding the quality of earnings. For example, in the petrochemicals sector better than expected profitability was driven by lower feedstock costs and higher operating rates. As for the banks, better than expected earnings were because of lower than expected provisioning. However, sustainability of this trend remains arguable.

Going forward, we anticipate that some of these earning drivers may not be present. Nonetheless at current levels, valuations are attractive and earning expectations of the markets are clearly factoring in the current reality. We like the consumer, utility, telecoms and banking sectors as well as selective companies in the petchem and real estate sectors which have resilient earning power and capacity to generate free cash flow on a sustainable basis.

Saleem Khokhar is the head of fund management at National Bank of Abu Dhabi.

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