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The Arabian Markets 15062009

The Arabian Markets 15062009

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June 15th, 2009

T h e A r a b i a n M a r ke t s
Memo

Highlights:
• The recovery in stock prices has raised hopes of an end to the credit crisis. • It is possible that the local markets have reached their post-bubble lows. • The environment remains challenging and any further upside should be capped by a muted recovery in profits. • The ingredients for a sustainable rally in regional equities are missing. • Markets will likely oscillate between hope and despair in a process that will run into next year and play out within the parameters of a wide trading range. • A revolution in corporate practices is required to break out of this cycle.

Soft Revolution

Content:
Blips and Dips Alphabet Economics Regional Comment Stock Talk Quality Counts Half Integrated The Bottom Line 2 3 5 6 7 8 10

Tarek Fadlallah, CFA Executive Director Nomura Investment Banking P.O. Box 26893 Manama, Bahrain Tel: +973 17530 531 Fax: +973 17530 365
June 15th, 2009

Nomura Investment Banking (Middle East) BSC (c)

Page 2

Blips & Dips As expected, the regional equity markets have experienced a schizophrenic shift in sentiment and bounced back strongly from a floor that may prove to be historically significant. While the correlation among the international markets remains high there are signs that investors are favouring the emerging markets over the debt-laden developed markets, with the S&P500 index up only slightly for the year while Brazil (71%), Russia (78%), India (61%), China (51%) have risen sharply. The economic environment continues to be challenging but investors have been encouraged by the sequential improvement in the economic data—the apocalyptic end to capitalism it seems has been postponed with consensus forecasts shifting towards a resumption in global growth later this year. The chart shows that monthly US auto sales have fallen by 40% from an average annualized rate of 15.4 million vehicles in recent years to a low of 9.1 million in February. Economic activity has slumped so sharply that the S&P index has understandably begun to rally in anticipation of a rebound from these severely depressed levels.
(mn)

1600 1500

21

19 1400 1300 1200 1100 1000 900
Target?

17

15

13

11

S&P500
800

US Auto Sales (rh scale)
9

700 600 Jun-04 7 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09
Source: Bloomberg

The scenarios going forward range from a continued recovery to the possibility of secondary credit effects that prompt a further leg down in the world economy and financial markets. Debt levels remain high and though bank balance sheets look a little healthier, this is partly due to the transfer of obligations to the taxpayer. Indeed systemic leverage has actually increased since total borrowing – led by governments – has risen in the context of falling asset values and shrinking GDP. Whether throwing everything but the kitchen sink will help put the global economy back onto a sustainable growth path before it reaches fiscal Armageddon is a debate best left to the pundits. The working assumption is that a systemic meltdown has been averted but that any rebound will be tempered by a prolonged period of subnormal economic growth. Governments have bought a quick fix but at a cost that will become evident only from next year when the stimulus wears off. In the meantime markets will oscillate between hope and despair in a process that will run into next year and play out within the parameters of a wide trading range that is finding its upper boundaries.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 3

Alphabet Economics There have been countless debates over what letter of the alphabet best represents the shape of current and expected economic activity. In truth there are still too many uncertainties to make bold predictions and the range of opinions among the brightest minds is an indication of the confusing nature of this unprecedented downturn. But despite the more cheerful data it seems unlikely that we will be lucky enough to experience a ‘V’ shaped recovery particularly in the indebted Anglo-Saxon economies. The Fed’s hope that it can inflate away huge debts by printing money without consequences appears to rely on the unproven premise that you can fool all of the people, all of the time! Interest rates need to be kept low but there is a perverse logic in the idea that we can escape a credit bubble by encouraging another—whether by creating debt at the government or consumer levels. It may be politically expedient to help engineer a short term pick up in activity but it fails to address the root cause of the crisis, which is easy money, excess borrowing and inflated asset prices. Notwithstanding some important caveats Japan again provides an interesting template for economies suffering from the hangover of a balance sheet recession.
6
%

The chart shows the trajectory of nationwide sales in Japan during the ‘lost decade’ and sketches out the shape that may best depict this cycle. This scenario will likely play out much faster and with less severity since the global economy is unencumbered with the structural obstacles that hindered Japan’s fight with deflation.

Japan Nationwide Department Store Sales (YoY) 4

2

0

-2

-4
World Economy Q3/09?

6m Moving Average -6
Bloomberg

12m Moving Average

-8 Dec-91

Dec-93

Dec-95

Dec-97

Dec-99

Dec-01

An up-trending ‘W’ with a higher second trough seems plausible in the highly levered economies while elsewhere, including the GCC, a more conventional, if slower, recovery is more likely. The focus may shift back onto the sustainability of this recovery, perhaps in the autumn, but for now the positive momentum will continue to boost sentiment and induce further market gains. Meanwhile, any attempts to compare the GCC credit crunch with the Asian financial crisis a decade ago are wide of the mark given the region’s strong overall fiscal position and fair currency valuations.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 4

Market Signals A feature of this economic downturn is that financial turmoil has been the cause rather than a consequence of the recession and this has placed the credit markets at the heart of any recovery. Sovereign Credit Default Swap (CDS) spreads have peaked and the bond market has re-opened for the better regional credits. Overall risk premiums continue to be elevated compared to a year ago however, and the market is closed to most corporate borrowers. The crisis has evidently eased but normality is not yet restored.
1000 900 800 700 600 500 400 300 200 100 0 Aug-08
Source: Bloomberg

Sovereign CDS Levels

Sep-08

Oct-08

Nov-08

Dec-08
Bahrain

Jan-09

Feb-09
Qatar

Mar-09

Apr-09
Abu Dhabi

May-09

Jun-09
Dubai

Saudi Arabia

Other indicators of risk appetite such as oil and the Baltic dry index have moved sharply higher in the past few weeks while safe haven assets such as US treasury bonds and the dollar have declined.
Demand Indicator Oil (WTI $/barrel) Baltic Dry Index China Steel (Y/Tonne) Signs of Fear 10 Yr Treasury Yield % US$ Index Gold $/OZ 30-Jun-08 86.4 9,589 7,253 30-Jun-08 3.97 72.36 923.6 31-Dec-08 50.6 774 4,531 31-Dec-08 2.21 81.31 875.3 %∆ -41% -92% -38% %∆ -44% 12% -5% 14-Jun-09 67.5 3,809 4,542 14-Jun-09 3.79 80.14 939.3 %∆ 33% 392% 0% %∆ 72% -1% 7%

Source: Bloomberg

The dollar’s renewed weakness has again raised the issue of the currency peg and whether it places undue constraints on the ability of the regional authorities to manage local economic activity. It is now generally acknowledged, for example, that Alan Greenspan’s decision to keep interest rates low for an extended period had repercussions for asset prices well beyond US borders. An easy monetary stance is clearly required at the moment but it is not difficult to envisage a situation next year when the US interest rate regime may no longer be relevant to many parts of the region. An inability to independently manage regional monetary policy could induce unexpected inflation further down the road and might even lead to the formation of new asset bubbles. As the Noble Prize-winning economist Paul Krugman has noted the dollar-peg is exposing the region to “gratuitous fluctuations” and that “a basket that reflects trade weights” might be an alternative.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 5

Regional Comment The GCC’s economic performance was never as good as previously advertised and nor is it as catastrophic as currently reported – it’s just a shame they didn’t legislate against the media hype! Notwithstanding the damage done, it is important to recognize that a great deal has been spent on building valuable assets – homes, roads and ports that are critical to regional economic development. The inflated cost of these major projects is making the digestive process painful and is one reason why the local stock markets have lagged their Asian peers through the latest rally. But the economy will eventually grow into this new infrastructure that has helped make the region more globally competitive and appealing to investors.
80 77.4 70 60 50 40 30 22.0 20 10 0 S&P 500 MSCI Asia DJ Euro Stoxx 50 GCC 200 MSCI GCC 14.6 4.8 37.7 From Low YTD
Source: Bloomberg

51.3 41.9 42.1 41.3

2.5

The lesson here is not that liberalization is wrong but that moderation is sensible, transparency vital and that business models should be built on solid foundations and stress-tested. Meanwhile credit creation remains difficult with the banks taking a cautious stance on new lending while they evaluate exposures under opaque valuation methods and questionable accounting practices. There is still plenty of time for more bad and restructured loans to hit the books given that the real estate and regional credit markets hit a wall less than one year ago.
180% Year-on-Year Changes 140% Tadawul 100% 20% 60% 15% 20% 10% -20% 5%
Source: Bloomberg

30%

25% M2 (rh scale)

Whether they choose to actually recognize nonperforming loans or prefer to conceal them, banks will be hindered in their ability to generate profits and reward shareholders. One positive development is that the monetary aggregates are beginning to offer support to the asset markets with Saudi Arabian money supply (M2) growing at 18.3%yoy in April.

-60%

-100% Nov-00

0% Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08

However a recovery that does not address the prevailing structural impediments is likely to be short lived and eventually lead to disappointment, again and again.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 6

Stock Talk With the MSCI-GCC index having risen an impressive 51% from its lows and now sitting 23% above its 200-day moving average there is a growing sense that stocks have run up too far and quickly. Technical analysis is hardly an exact science but the charts offer no hint of an imminent reversal and suggest that the rally is still on track. Predicting inflection points is tricky so the trend is a friend—for now! Two other interesting observations captured in the technical analysis are worth noting.
800 MSCI GCC Index

700 200 Day MA 600 50 Day MA

500

400

300
Source: Bloomberg

200 15-Jun 15-Jul 15-Aug 15-Sep 15-Oct 15-Nov 15-Dec 15-Jan 15-Feb 15-Mar 15-Apr 15-May 15-Jun

First, the flight to quality that is implied by the relative outperformance of SABIC (43% year-to-date) and other stocks such as Emaar (84%) or Zain (33%) against their respective local benchmarks.
Saudi Market Performance (YTD)

27%

Investors are favoring blue chip stocks at levels that ought to represent good long term value. Second, is the underperformance of the banking sector presumably on concerns over asset quality.
43%

Banks

TASI

21%

SABIC

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Source: Bloomberg

These trends and the overall market direction will ultimately rest on the outlook for profits.
40%

And while earnings across the region fell by a quarter last year there is no suggestion that much of this can be recovered quickly. In Saudi Arabia, where profits fell modestly, there will be virtually no rebound effect. Support for a continued rally will have to come from elsewhere.

Million

GCC Earnings Growth

$60,000
2007 2008 YoY%

31% 20%

$50,000 -1% -8% $40,000 -16% -20% $30,000 -25% 0%

-40%

$20,000 -64% $10,000 -96% $Saudi Arabia
Source: Markaz Research

-60%

-80%

-100% Kuwait UAE Qatar Bahrain Oman GCC Total
Note: data for Saudi Arabia and GCC exclude Kingdom Holdings

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 7

Quality Counts The GCC boom was driven by oil revenues but it was formed primarily by a combination of relaxed monetary conditions, rampant asset inflation and the willingness to take risk through leverage. It is no surprise then that the quality of earnings has been poor and that the three largest credit related sectors – banks, real estate and investment companies – accounted for over 70% of aggregated earnings in Kuwait and the United Arab Emirates in recent years.
45 45 Price Earnings Ratio (PER) 40 40 35 GCC 30 25 MSCI World 30

The slump in corporate earnings has exposed their poor quality and raised the aggregate PE ratio even as stock prices have declined. Although it is normal to experience PE multiple expansion during an earnings trough, the strength of any rebound may be compromised by an inability to repeat profits that were built on levered returns.

35

25 20 20 15 15 10 5
Source: Bloomberg, GIC

10

5 06-01-01

06-01-02

06-01-03

06-01-04

06-01-05

06-01-06

06-01-07

06-01-08

0 06-01-09

Moreover, according to Bloomberg data the aggregated price to earnings ratio for the GCC is now at its highest level in over three years and trading 45% above the current ratio for the S&P500 index.
Historice (LTM) S&P 500 Index DJ Euro Stoxx 50 GCC Bloomberg 200 Saudi TASI Brazil Bovespa Russia RTS$ India Sensex Shanghai Composite
Source: Bloomberg

Relative to S&P 500 Index PER 100% 131% 145% 127% 144% 46% 110% 186% PBR 100% 62% 89% 101% 85% 49% 162% 145% DivYield 100% 168% 128% 114% 116% 64% 39% 58%

PER 14.9 19.5 21.5 18.9 21.4 6.8 16.3 27.7

PBR 2.1 1.3 1.8 2.1 1.8 1.0 3.3 3.0

DivYield 2.9 4.9 3.7 3.3 3.4 1.9 1.1 1.7

Dividend yields seem attractive but while the price to book ratios appear comparatively cheap, the discount may be justified by a lack of transparency in the Gulf. China’s hyped-up recovery comes at a steep price according to the data and the upside in both India and Brazil may be capped in the short term by extended valuations. Time to take money off the table? Making quantitative comparisons across these valuation matrices can be useful but quality also counts, and various studies have shown that investors are willing to pay valuation premiums of up to 30% for qualitatively superior earnings that are stable, predictable and transparent.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 8

Half Integrated Not every industry reaps huge gains from economies of scale and a few, including bio-pharmaceuticals and technology, tend to thrive in smaller configurations. Much of the commercial activity within the GCC, however, is in relatively low-value added industries that benefit from a volume effect – petrochemicals, banking, telecoms, cement, materials and retail. To this extent the diminishing prospect of an early and all-inclusive currency union is an unfortunate blow to hopes for an integrated regional economic bloc on the global stage. Monetary union is not essential for cross-border mergers and acquisitions but a common market under and a single currency together with unified regulations, common accounting practices and shared corporate governance standards tend to be supportive of transnational business combinations. Managing a regional bank under a single jurisdiction or simplified reporting requirements, for example, would certainly support the consolidation process in the financial sector. There are currently about 111 licensed banks, dozens of insurance firms and hundreds of investment companies serving a total population of around 35 million across the Gulf. Too many.
Top GCC Banks Total Assets (Mn) Market Cap. (Mn) $76,906.91 $6,236 $66,846.95 NA $47,702.41 $12,180 $44,838.72 $6,602 $43,979.52 $28,299 Top International Banks $3,949,156 $37,054 $3,375,818 $40,292 $3,086,971 $41,117 $2,909,144 $73,023 $2,317,194 $34,169

Name EMIRATES NBD PJSC NATIONAL COMMERCIAL BANK SAMBA FINANCIAL GROUP NATIONAL BANK OF ABU DHABI AL RAJHI BANK ROYAL BANK OF SCOTLAND BARCLAYS PLC DEUTSCHE BANK BNP PARIBAS CREDIT AGRICOLE SA

GDP (Mn) $180,180 $381,938 $381,938 $180,180 $381,938 $2,674,090 $2,674,090 $3,667,510 $2,865,740 $2,865,740

Assets/GDP 43% 18% 12% 25% 12% 148% 126% 84% 102% 81%

Source: Bloomberg, Bankers Almanac (May 2009), IMF

Total assets by themselves are not an indicator of efficiency but the regional banks are small by international standards and will face considerable challenges in maintaining their profitability over time. Fragmentation is not limited to the financial sector and will continue to be a major obstacle to regional development and global competitiveness. The importance of scale has been understood by some companies and there are now several firms that can claim to be regional champions and even global players in their respective industries. Unfortunately the benefits of consolidation have been mostly subordinated to factors that are unrelated to economics and derived from historic divisions, emotional attachments and outsized egos.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 9

The Power of Ownership The reluctance of many companies to embrace fundamental change provides uncomfortable parallels with Japan that is still mired in corporate malaise twenty years after its financial markets peaked. One reason that Japanese companies were able to resist change for so long was due to the keiretsu system of interlocking corporate cross-shareholdings which prevented independent shareholders from exerting any influence over management. Foreign ownership was insignificant in the early nineties, domestic institutions were docile and retail investors too divided to challenge incumbent management, even when they performed poorly.
Japan Shareownership
Source: TSE

This changed gradually after the market crashed and accelerated as companies became desperate to raise capital. Amid the diminished incentives, cross-shareholdings by Japanese firms have fallen steadily to 21% of total market capitalization as foreign ownership has risen from just 4% in 1990 to 28% last year.

0% 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Govt. & Local Govt.

Financial Institutions

Companies

Securities Cos.

Retail

Foreigners

The shareholder structure in the Gulf is dominated by governments that tend to be fairly passive and family operators that are reluctant to cede management control. The lack of independent activist shareholders has often led to the appointment of compliant directors and resulted in a tolerance for mediocre performance by managers in lifetime jobs. However the collapse in profits and a spate of corporate scandals has exposed companies to criticism about transparency, risk management and the failure to implement good corporate governance. The increase in outside shareholders, including domestic and international institutional investors, along with wider public ownership of equities has increased the need to have robust checks and balances that safeguard the interests of all stakeholders. A sustainable recovery and a structural improvement in profitability will be difficult without reforming a process that is dominated by insiders and strong vested interests. The need for wholesale changes in business culture and corporate policy is clear—whether this can happen quickly and voluntarily remains to be seen.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

Page 10

The Bottom Line Despite the improved sentiment and the encouraging price trends it is unlikely that the financial crisis is completely over or that we are in the early stages of a new regional bull market. Weaker pricing power, greater competition and tighter credit conditions are likely to persist for longer than anticipated and keep profits subdued. However, this relatively stable period provides a useful window for companies to re-evaluate their business strategies and adjust their financial obligations. Companies have prospered largely on the excesses of asset inflation, either directly or indirectly, but investors have become more discriminating and demand a higher quality of earnings. Quality can be improved through economic efficiency offered by scale but perhaps more effectively by making managers more accountable to every shareholders—both large and small. The region has had its fair share of booms and busts and it is in the general interest to encourage changes that will reduce the risks of excessive economic volatility and the continuous reliance on petrodollar subsidies. What is required is nothing less than a soft revolution in which change in the corporate landscape is not gradual and begrudging but bold and sweeping. Change, we can believe? Or business as usual?

WARNING & DISCLAIMER: PLEASE NOTE THAT THE PERSONAL OPINIONS EXPRESSED IN THIS NOTE ARE SOLELY THOSE OF THE AUTHOR AND DO NOT REFLECT ANY RECOMMENDATIONS OR ATTEMPT TO SOLICIT BUSINESS. THIS PUBLICATION HAS BEEN ISSUED BY NOMURA INVESTMENT BANKING (MIDDLE EAST) B.S.C. (c) AND IS PROVIDED WITHOUT COMPENSATION. THIS DOCUMENT IS NOT INTENDED FOR RETAIL CLIENTS WITHIN THE RULES OF THE UK FINANCIAL SERVICES AUTHORITY (FSA) OR THE CENTRAL BANK OF BAHRAIN (CBB) AND IS NOT TO BE DISTRIBUTED WITHOUT PRIOR AUTHORISATION AND IS NOT INTENDED FOR PRIVATE INDIVIDUALS AND SHOULD NOT BE DISTRIBUTED AS SUCH NOR SHOULD IT BE COPIED TO ANY OTHER PERSON WITHOUT OUR EXPRESS CONSENT. THIS DOCUMENT SHOULD NOT BE CONSIDERED AN OFFER TO BUY OR SELL INVESTMENTS. WE ARE NOT YOUR INVESTMENT ADVISER AND THIS INFORMATION IS PROVIDED ON THE BASIS THAT YOU HAVE SUCH KNOWLEDGE AND EXPERIENCE TO EVALUATE ITS MERITS AND RISKS AND ARE CAPABLE OF UNDERTAKING YOUR OWN OBJECTIVE ANALYSIS OF THE INVESTMENT AND ITS SUITABILITY TO MEET YOUR REQUIREMENTS. THE INFORMATION IS BASED ON SOURCES WE BELIEVE TO BE RELIABLE BUT WE DO NOT REPRESENT THAT IT IS ACCURATE OR COMPLETE. ANY VALUATIONS CONTAINED HEREIN ARE SUBJECT TO CHANGE WITHOUT NOTICE. NOMURA INVESTMENT BANKING (MIDDLE EAST) B.S.C. (c) AND/OR CONNECTED PERSONS DO NOT ACCEPT ANY LIABILITY WHATSOEVER FOR ANY DIRECT, INDIRECT, INCORRECT OR INCONSEQUENTIAL LOSS ARISING FROM ANY USE OF THE INFORMATION OR ITS CONTENT. NOMURA INVESTMENT BANKING (MIDDLE EAST) B.S.C. (c) IS AUTHORISED AND REGULATED BY THE CBB.

Nomura Investment Banking (Middle East) BSC (c)

June 15th, 2009

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