When America sneezes, the world usually catches a cold, or at least most of it does. The relative insulation of the hydrocarbons-rich Middle East from the current global economic crisis is challenging this conventional wisdom.
For the Middle East and North Africa (Mena), which is part of the ‘frontier market’ that is galvanising interest among global investors, the phenomenon promises to yield a further wave of investment to add to the rampant economic growth and multi-billion-dollar fiscal and current account surpluses.
The Middle East’s mix of cheap corporate valuations, abundant liquidity and vibrant economic growth are attractive to investors. With more than 300 million people and two-thirds of the world’s oil reserves, but only 3 per cent of global stock market value, the region offers substantial potential.
All this means that Mena firms are now a key target for fund managers, who are switching their attention away from emerging markets - headed by Brazil, Russia, India and China, collectively known as the Bric economies - towards the less correlated corners of the global economy, known as ‘frontier markets’.
A clutch of funds are looking to tap into this appetite. Large international banks have led the way. In March, Barclays announced the launch of its Barclays Global Investors Frontier Markets fund, providing exposure to pre-emerging market economies - one-third of them in the Middle East. In early July, Halbis, HSBC’s asset management arm, opened its New Frontiers fund to institutional and high net worth investors. The fund, which was launched in February, aims to raise $500m and invest 45 per cent of its assets in Mena firms.
Smaller institutions are also getting involved. In May, Swiss bank Pictet launched its Targeted Mena fund, which will try to take advantage of the lack of correlation between the regional and global economies. The portfolio will include companies from the GCC and countries such as Jordan, Egypt, Morocco and Tunisia.
In June, Dublin-domiciled investment management firm GAM launched its GAM Star Frontier Opportunities fund, which is heavily biased towards the Gulf and Middle East. In the same month, Charlemagne Capital, a specialist emerging markets group, launched its first Mena fund, aiming to exploit market inefficiencies.
The HSBC fund’s heavy tilting to the Gulf - Dubai-based property developer Emaar Properties alone accounts for 5 per cent of the fund - reflects the growing appetite among institutional investors for Gulf risk, says Andrea Nannini, senior portfolio manager at Halbis.
“When we designed the fund at the end of the last year, the intention was to have a 30 per cent allocation, but by the time we launched, it was obvious we had to have a much higher allocation,” says Nannini. “You have got a very resilient and decoupled macro environment and we have therefore seen a lot of demand.”
Halbis now wants to diversity its offering and is considering private equity and Mena-specific funds.
Although frontier markets are spread thinly across the globe, Mena economies are the star performers of this asset class. About 50 per cent of Merrill Lynch’s new Frontier Index, which tracks the 50 largest companies in 17 frontier markets, is in the Mena region.
This is significant considering the scale of investment that is flowing into frontier markets. In the first half of 2008, $5.3bn was withdrawn from emerging market equity funds, according to EPFR Global, a US-based firm that tracks funds and asset allocations. However, frontier market funds grew by $2.5bn over the same six months.
The trend has inspired regional investment banks to launch their own funds. Egypt’s EFG-Hermes has partnered with South Korea’s KB Asset Management to launch the KB Mena Equity fund, which will devote 70 per cent of its funds to Mena equities. It aims to attract $200m in its first year.
Most recently, Kuwait’s Global Investment House has announced plans to raise $1bn from international investors wanting to target Middle East stock markets.
Others are offering single-country exposure to international investors. The Epicure Qatar Equity Opportunities (EQEO) fund, which was launched in July 2007, offers foreign investors exposure to the booming Qatari economy. The Doha Securities Market is one of the region’s star performers and the fund has invested more than 90 per cent of its assets in shares listed on the exchange.
Qatar-listed companies produced an average 60 per cent increase in profitability in the first quarter of 2008 and investors are taking note.
“Most of the companies that are accessible to investors are doing well and seeing multi-year growth coming through,” says Sandeep Nanda, investment adviser to the EQEO fund. “That is what is driving the valuations in the region.”
The trend is supported by the growing links between global and regional stock exchanges, with local markets tying up with international giants including the London Stock Exchange (LSE) with Qatar, and NYSE Euronext with Abu Dhabi. These are creating a more acceptable platform for investors, say fund managers.
The entry of new institutions also widens an investor pool that is dominated by regional investors. Until now, most pension fund money coming into the Gulf has been linked to private rather than listed companies. The new focus promises much higher volumes of institutional money heading towards the Mena markets.
These changes are important, but it is the underlying fundamentals that are attracting the most investor attention. Most Middle East economies are highly liquid and unleveraged - the opposite of the North American and European markets. Demographics are also important. Rising populations and the growing number of young households have underpinned the region’s construction and real estate sectors. This is driving interest in the hottest stocks such as Emaar, Aldar Properties and Dubai-based construction firm Arabtec.
“What we like in Mena is everything to do with infrastructure, whether real estate, cement producers or construction companies - these are all firms that are feeding into the infrastructure build-out theme,” says Nannini. “That is what is really driving economic growth.”
These factors could help the region even if oil prices fall sharply. But market reforms need to be accelerated if Mena economies are to remain attractive to foreign investors.
Most funds’ heavy weighting towards financial services - which account for nearly 40 per cent of the Epicure fund and nearly two-thirds of the HSBC fund - reflect the sector’s improved transparency levels and regulatory conditions. But some of the most attractive stocks in the region remain off limits to foreign investors. “Investors have to accept that two of the major asset classes - family business and the oil sector - are the dominant players in this region and they are not represented on the bourses,” says Faisal Hasan, head of research at Global Investment House.
Even those that are open to investors quickly reach a ceiling on the amount foreign investors can hold. HSBC says its fund’s Gulf exposure might have been even higher had access not been limited.
“In Qatar and Dubai, there are three or four companies that have closed out now to foreign investors,” says Nanda. “This happens because they are the prime target for international money and they get closed out quickly. However, these are not permanent ceilings that can never be changed. As the markets mature, the ceilings will become more accessible to international investors.”
Companies are circumventing foreign investor restrictions and more Middle East firms are listing on exchanges outside the region, which allows international investors to take stakes. Commercial Bank of Qatar, for example, listed a global depository receipt on the LSE on 2 July. Large players such as Deutsche Bank, Credit Suisse and UBS are also looking at pricing derivative products in the region.
The difficulty for Middle East capital markets is that the more sophisticated they become, and the more open they are to institutional capital flows, the more correlated they will be to international markets. If that happens, they could find their appeal to foreign funds waning.
This concern may be one to consider at a later date. Much more could still be done to encourage institutional funds to target the Mena region’s stock markets and indices, say fund managers. “These have to become investable indices,” says Nanda. “Once you get the benchmarks right and there is more liquidity in the markets, you will see a lot more institutional interest coming into the region. The markets needs more standardisation, and that is not quite there yet.”
There is another factor that will hamper closer correlation. No matter how much capital is ploughed into the region’s stock markets, they will still be dominated by regional investors, in contrast to emerging markets such as Turkey and Russia, where foreign investors drive the market. Arab investors tend to ignore what is happening in the US housing market, and that, say fund managers, is not going to change, no matter how hard the US sneezes and how bad the global economy’s viral infection proves to be.
Credit ratings agency Standard & Poor’s, which runs a frontier market index of 22 countries, defines these markets as ‘pre-emerging’.
Typically, liquidity is relatively low, information is scarce and formal market systems are still being put into place. They also tend to be experiencing high growth rates and represent significant opportunities for investors with the appropriate risk appetite. Company valuations reflect this risk by being lower than in more established markets.
In many cases, the investment opportunities are more closely related to private equity than normal portfolio investment. It is difficult to assess the earnings outlook and capital structure of companies because of the lack of institutional research.
As such, frontier markets require more basic assessment by potential investors. And this is where several investors are carving out a niche.
According to Halbis, 18 of the 20 fastest-growing economies over the past five years are frontier markets. And of the 19 indices tracked by the Morgan Stanley Capital International (MSCI) Frontier Market index, seven are Mena economies: the UAE, Bahrain, Oman, Qatar, Kuwait, Lebanon and Tunisia.