Although GCC fixed-income markets are commonly assumed to be correlated to the price of oil, the fact remains that the correlations of indexes such as the GCC component of the Citi Mena Broad Bond Index to oil are insignificant.
A relative underperformance such as last month’s is more easily explained, in our view, by lower volatility compared to emerging markets and a somewhat weaker outlook for bond spreads (including in developed markets).
We remain cautious about the outlook for the global economy ahead of a US Federal Reserve rate hike, although we believe that such a hike – when and if it comes – will provide a measure of clarity for global markets about the state of the US economy. At the same time, we are hopeful that the extra liquidity being provided by central banks in Europe, China and Japan can further boost investor sentiment.
Looking into the medium term, we are trying to form a clearer idea of how some GCC governments intend to adapt their budgets to depressed hydrocarbon prices.
In October, the IMF lowered its growth forecasts for GCC countries this year and next, driven mainly by lower capital expenditure.
Also, Standard and Poor’s last month lowered its sovereign rating on Saudi Arabia to A+/A-1 from AA-/A-1+, while the outlook remained negative. S&P cited a rise in the general government fiscal deficit as a result of the sharp drop in oil prices as the main factor for its ratings decision, while the negative outlook reflected “the challenge of reversing the marked deterioration in Saudi Arabia’s fiscal balance”, S&P said.
We are especially interested in understanding how the Saudi government intends to deal with its rising fiscal deficit in the upcoming state budget.
It seems obvious that governments in the GCC and Mena region will turn increasingly to conventional and Sharia-compliant financial instruments to fund spending at a time when low oil prices are slashing export revenues and hurting finances.
Governments have already boosted domestic sales of conventional bonds this year to cover a big budget deficit, and we expect this trend to continue. But even though in many cases the trajectory of state finances might look alarming as governments pump up public spending, Arabian Gulf countries still have huge financial resources, and public debt remains paltry. We are encouraged by efforts to diversify economies in the region, as well as by the reforms to ultimately unsustainable tax and subsidy mechanisms that the drop in oil prices has triggered.
The economic trends are likely to result in more diversified economies and financially resilient governments, with sukuk and debt markets that are deeper and better developed. However, the short-term outlook is slightly more uncertain as the market oscillates between expectations of what the Fed might do next month.
As a consequence, we believe the most prudent position in this environment is to maintain liquidity to take advantage of dislocations in credit markets on which we maintain constructive views.
Mohieddine Kronfol is the chief investment officer for fixed income and global sukuk in the Middle East at Franklin Templeton Investments.
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