Market analysis: Risk appetite emerges into the light

Low inflation and expected moderate growth lead to a recovery in equities following a tough start to 2014.

Confidence that European and US interest rates could remain low, alongside prospects for low inflation and moderate growth, meant that equities in developed and emerging markets recovered in February after a turbulent January.

In the bond market, US Treasury yields flattened as disappointing data helped US government bonds maintain their gains from January. US GDP growth in the final quarter of 2013 was revised downward from an annualised rate of 3.2 to 2.4 per cent, and job creation for January was weaker than expected. In Europe, data continued to point to recovery for some of the most crisis-ridden economies, although low inflation figures triggered fears of deflation.

Emerging market bonds benefited from the risk appetite recovery. Credit default swaps declined by 34 basis points (bps) in February, as measured by the CDX Emerging Markets Index, while the JPMorgan Emerging Market Bond Index Global Diversified Index rose 3.03 per cent in US dollars. Although volatility persisted in a number of local markets, investors remained attracted to the prices and higher yields offered by a range of emerging market bonds. February was also positive for Mena bonds, which returned 1.69 per cent (as per Citi Mena Broad Index), with spread compression evident in many markets thanks to upbeat news flow and a strong appetite from local accounts. However, Mena and GCC bond indexes underperformed the emerging market bonds rally after having outperformed during January’s volatility.

In the UAE, Dubai continued to experience positive momentum. Forward indicators such as the purchasing managers’ index pointed to further expansion in Saudi Arabia and the UAE, while inflation remained in check in both places. Qatar decided to engage in some cost-cutting to protect the country’s AA sovereign rating, although Qatar’s finances continued to look robust.

Moody’s and Standard & Poor’s upgraded their long-term corporate credit ratings of Dubai’s Emaar Properties (from Ba3 to Ba1 and from BB+ to BBB- respectively) and affirmed a stable outlook on the ratings. S&P highlighted Emaar’s “high-quality, Dubai-based leasing and hospitality assets” and justified its ratings upgrade by noting a rise in recurring income, increasing presales of residential developments in Dubai as well as a substantial reduction in financial leverage.

As for negative ratings, S&P downgraded the Qatar-based telecoms operator Ooredoo from A to A-, citing concerns about negative free cash flows given the “expectation of higher-than-expected volatility in economic conditions in emerging markets”. Moody’s withdrew all ratings of Dubai Holdings Commercial Operations Group, including its medium-term note (MTN) and its B1 rating on the £500 million bond due February 1, 2017 issued under the MTN programme, citing inadequate information to monitor the credit. Finally, Fitch revised its outlook on Batelco’s BBB- rating from stable to negative on regulatory uncertainty and a challenging domestic operating environment for the Bahraini company.

In Dubai’s first sukuk issuance this year, Dubai Investments Park issued a US$300 million five-year sukuk at a rate of 4.3 per cent and issued at 265 bps over mid-swaps, an aggressive 35 bps inside guidance; orders came to about US$4 billion. Abu Dhabi Commercial Bank sold a $750m, five-year conventional bond at 140 bps over mid-swaps, some 10 bps below initial guidance, as international investors showed significant interest. The Saudi Arabia-based Islamic Development Bank priced a $1.5bn five-year sukuk at 23 bps over mid-swaps. Pricing for this issue, the largest-ever Islamic bond from this supranational lender, was also inside guidance.

Favourable performance characteristics of GCC assets in recent months have continued to enhance the region’s attractiveness. Tensions between Russia and Ukraine have boosted the price of hydrocarbons, with a positive effect on GCC countries. The status of some GCC members, particularly Dubai, as a safe haven has benefited financial assets, while the pegging of local currencies to the US dollar gives investors an extra degree of comfort. Dubai’s credit fundamentals have sharply improved since the crisis of 2009, and the emirate has been taking advantage of the strong economic rebound to relieve some debt burden.

GCC members should continue to benefit from their attractive fundamentals and to offer investment grade opportunities without the debt and unemployment challenges of developed market economies. They offer development and growth opportunities comparable to some of the better emerging markets without external or fiscal imbalances and currency fluctuations.

In a world where economic growth is improving, and where financial markets have begun to undertake a material rerating of risk assets, the value of diversification looks set to increase. An allocation to Mena/GCC bonds appears increasingly rational to equity investors in the region as well as to international bond investors.

Mohieddine Kronfol is chief investment officer, fixed income and global sukuk, at Franklin Templeton Investments (ME)

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