Last year was a record one in terms of GCC bond sales, with debt issuance reaching $85 billion as governments explored new ways of raising funds amid dwindling oil prices and revenues. Sovereigns made up more than half of GCC bond sales in 2017, up from 12 per cent in 2015. And if we look at how 2018 is trending, the first two quarters have blown out previous records. It is becoming increasingly clear that GCC economies are on a more sustainable footing, providing support for local debt markets.
There are several positive indicators that the region is over the worst and entering a new phase of its credit cycle. These include taking a closer look at government spending and deficits, corporate balance sheets and economic and social reform efforts across the GCC.
Although government spending across the GCC decreased by 20 per cent between 2014 and 2017, we are finally starting to see an uptick in investment again. Deficits also troughed in 2016, and despite projections for further shortfalls, the region is clearly on a much more solid ground. Deficits for example in 2017 were on average 43 per cent narrower than 2016. And with deficits that still need to be funded, reserve drawdowns have been significant and debt issuance has increased sharply – yet reserves remain supportive at over 200 per cent of GDP. And debt, while more than doubling to 26 per cent of GDP, remains comfortable and significantly below emerging market and developed market averages.
Corporate balance sheets also give us a fair indication of the region’s economic health. They have remained relatively strong in the three years following the oil price collapse, which gives us further confidence in the region’s potential for more growth.
Another indicator, and one that is most indicative of the region’s future development in my view, is the wave of reform across the GCC. This is ongoing and we are finally starting to prioritise growth again. Saudi Arabia in particular has made substantial changes to its market infrastructure and implemented a slew of economic and social reform initiatives in the past few years.
So what do these positive developments mean from a fixed income point of view? GCC bonds generally can be safe and stable. Even in periods of volatility, they have remained resilient and offered strong, risk-adjusted returns, especially since they are not correlated to oil price performance and are denominated in US dollar. And as we enter a new phase of the credit cycle, they are becoming an even more attractive asset class, particularly when compared with similarly rated emerging market peers whose performance has traditionally suffered during bouts of volatility or US dollar strength.
In fact, the silver lining to all of these positive indicators is that the GCC bond universe is developing rapidly. The region’s debt issuance has now become a significant part of the global fixed income landscape. It may go unnoticed, but the GCC region is a significant issuer of emerging market sovereign debt and becoming an increasingly relevant participant in global bond markets. We saw close to $90 billion of debt issued in 2017, and our expectations are for a further $80bn this year. The majority of emerging market sovereign issuance now comes from the Middle East and Africa region. And for a $350bn GCC bond market, corporate issuance is healthy at above $200bn – across many sectors – allowing for diversified portfolios. Almost all of these issuances are denominated in US dollar – and the 13 per cent that isn’t, is pegged to the dollar – making GCC bond markets one of the more attractive investment grade dollar blocks available.
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The investment opportunity in GCC bonds is clear. But despite many of these attractive characteristics, investors remain chronically underweight on GCC bonds. Representation in indices is still very low, and allocations in large cross border funds are also minimal, even though adding GCC debt to portfolios may improve returns, is not correlated to oil prices, and reduces portfolio risk. For a region that accounts for 15 per cent of dollar denominated emerging market debt, allocation in indices and large cross border funds remain below 2-3 per cent.
Looking ahead, we believe we are at an inflection point. GCC governments have wisely recognised the unsustainable nature of their economies in the long term, and this recognition is causing an increase in investment spending related to transitioning away from oil and toward service sectors that are fast-growing and better positioned for long-term growth such as technology, health care and tourism. So GCC countries are now operating with growing deficits, and these deficits, which we believe are likely to remain for the medium term, will be financed by a combination of liquidating the large asset reserves built up over recent decades, and by debt issuance, making the GCC an increasingly important part of the global fixed income landscape.
So with all of this in mind, for us the future trajectory of local debt markets looks promising. With credit rating downgrades largely behind us, outlooks stable, massive fiscal consolidation achieved, and attention finally returning to growth and profits, it is clear that the region is on a more stable footing and we have entered a new phase of the credit cycle. We look forward to what the remainder of 2018 brings.
Mohieddine Kronfol is the Chief Investment Officer of Global Sukuk and MENA Fixed Income at Franklin Templeton Investments
