Keeping an eye on debt woes

Quarterly review Debt was one of the main reasons behind wild swings in the market during the last three months of 2009 and caution will likely prevail in the Middle East for the rest of the year.

Any hopes that 2010 would spare Middle East investors from the violent ups and downs that were common during the previous two years of market action have been dashed quickly and cruelly. The momentum of a late fourth-quarter rally gave stocks a lift as January began, but prices soon turned lower, falling about 15 per cent in less than three weeks. The trading pattern so far this year - large swings with a generally downward bias - looks depressingly familiar, but while the story has remained the same throughout the bear market, some of the characters driving the action have changed.

The major plot development in the fourth quarter was the renewal of anxiety about Dubai's financial stability. The announcement in late November that government affiliates, most notably the Dubai World holding company, planned to postpone payments on billions of dollars of debt stimulated fears of a sovereign default. That prospect brought a months-long recovery in bourses there and in Abu Dhabi to an abrupt end. The fears dissipated significantly in December, however, when assistance from Abu Dhabi allowed Dubai World to meet its approaching obligations, and stock markets in both emirates finished the year strong.

The latest decline is also partly the result of fears over a sovereign debt default. There are two key differences, however: The defaulter-in-waiting is Greece, and so far no one has come to its rescue. Other sources of consternation include the possibility that economic recovery in the United States is not proceeding as smartly as anticipated - or much at all - and the more vigorous steps that China is taking to rein in economic growth. Then there is the concern that Greece may be just the first in a closet full of shoes to drop within Europe; financial conditions remain unsettled in Italy, Spain, Portugal and Ireland, among other places.

This extensive and diverse catalogue of troubles, potential and extant, has unsettled bourses all over the world, including in the UAE. The DFM index of Dubai shares fell 17.7 per cent in the fourth quarter and was down 12.3 per cent this year through Feb. 26. The ADX General Index in Abu Dhabi has been far more resilient, recording a 12.2 per cent loss in the fourth quarter and a 1.5 per cent loss so far in 2010.

Benchmarks such as the Standard & Poor's 500-stock index in the United States, the FTSE 100 in Britain and the MSCI Emerging Markets index rose between 5 per cent and 8 per cent in the fourth quarter and were showing losses this year ranging between 1 per cent and 6 per cent. Giles Conway-Gordon, co-chief investment officer of Cogo Wolf Asset Management, remarked that the renewed wariness being displayed by investors reflects different concerns from a year ago, but that it's wariness all the same.

"Last year was the financial markets' response to alarm" over the threat to the credit system, he said. "Now investors, including in the Middle East, want to know where growth is going to come from." Mr Conway-Gordon said that while conditions may make the world a less scary place for investors today, the recovery in stock markets through much of 2009 reflects that, and possibly then some. "After the bungee jump rise last year of emerging markets, things are looking fairly heavily valued, or were until the recent correction," he said.

The UAE has been more or less an innocent bystander for a change through that correction, so investors here may feel hard done by when they see their stocks being swept along in the same tide carrying global share prices downstream. But analysts and portfolio managers point out that sufficient lingering uncertainty exists about credit conditions in Dubai for investors to continue standing by too; they want to avoid the prospect of being let down again.

"We began to see reasons for a [macroeconomic] recovery in the region to be in place" last autumn, said Simon Williams, chief economist for the Middle East and North Africa at HSBC. He cited a rebound in energy prices and an easing of the logjam in bank lending. "We thought that created a positive environment for equity and credit markets." The inelegant handling of the Dubai debt difficulties caused him to second-guess that assessment. "We had been looking for stabilisation for 2010, but we're not expecting that anymore," Mr Williams said. "We think 2010 is going to be a very difficult year for Dubai because of the way the debt situation has evolved. Access to funding will be difficult, and confidence locally and internationally has taken a severe hit."

True enough, but as Oliver Bell, a manager of emerging market equity portfolios for Pictet Asset Management, points out, Dubai is only a small part of the Middle East and a part unlike most of the rest of the region, which is less showy and more financially sound. "Everyone focuses on what Dubai has done, but it's just one million people out of 300 million," Mr Bell said. "It's very misleading and misses the fact that the rest of the region has ongoing surpluses and deep pockets. The systemic risk hasn't been as bad."

Farid Samji, lead manager of a Credit Suisse fund focusing on Middle East and North African shares, echoed those sentiments. "Dubai is not a proxy for the MENA region," he said. "When investors heard the bad news about Dubai [in November], it left a bad taste in their mouths, but Dubai is a mere 6 per cent of the region's [economic output]. We have decent countries around here." Ones that he expects to provide decent opportunities for investors in the next year include Abu Dhabi, Saudi Arabia and Qatar, which he described as "strategic overweights."

Mr Bell likewise contends that Gulf stock markets do not reflect the generally benign backdrop. "We're fairly comfortable that business prospects are really good for companies in the Gulf, but price-earnings multiples have been down at 4 to 5 when they had been 10 to 12," he said. "Valuations are some way off what they should be based on future growth levels." Other investors may be coming around to his and Mr Samji's way of thinking. Share indices elsewhere in the Gulf have bucked the downward trend in force in much of the rest of the world lately. The Tadawul All-Share recently sported a 5.7 per cent gain for 2010, and the Kuwait Stock Exchange Price Index was up 5.3 per cent.

Mr Bell finds some encouraging signs within Dubai, too, including efforts to diversify the emirate's economy away from property and affiliated industries like construction and banking. He highlighted Dubai's efforts to "sell itself as an east-west hub," with the port operator DP World and Aramex, a transportation and logistics company that Mr Bell likened to a "DHL Lite," assuming leading roles. The Dubai debt situation, meanwhile, has shown signs of improvement since the most acute phase of the crisis passed. The Dubai government was reported last month to have chosen not to assume preferred creditor status in the restructuring of Dubai World. That is expected to assuage the concern and anger of bank creditors and smooth the path to a successful workout.

That is important because, while Dubai may be a small part of the region, it's the part that tends to capture the attention of foreign investors. The lingering, albeit possibly diminishing, tribulations there have meant that the region is not capturing much investment to go with that attention. The Institute of International Finance, a trade group for global banks, estimates that net private capital flows to the Middle East and Africa plunged 59 per cent in 2009, to $43 billion, with the UAE and Egypt accounting for much of the drop. Net portfolio investment was essentially flat.

That jibes with observations in a recent study of the Middle East fund industry by Standard & Poor's. The chronically weak performance of stock markets has been a double whammy for funds in the region, causing asset bases to shrink from falling share prices and from withdrawals by clients, notably foreigners, who have had enough and don't want to play anymore. The atrophying investor bases result in higher expenses as fixed costs are spread over fewer dollars under management. That reduces the popularity of some funds further and could make them not worth the trouble to keep open.

"The majority of teams in this region manage far less than $1 billion," the S&P study says. "While fees are higher in this part of the world than in Europe or the US, reaching critical mass is increasingly becoming a problem. Most single-country funds in this review have less than $10 million under management and might at some point become unviable to manage." This long-term erosion of confidence and the more recent discrepant performances across Middle East stock markets make it more likely that investors who stick around in the region will become more circumspect and selective. Some investment advisors caution that they and their peers will take particular care about which companies and markets they buy, if they buy anything at all.

"I don't think buy and hold is going to work for our markets," said Mr Samji, the Credit Suisse portfolio manager. "There won't be the major trends that we saw in the last few years. There's a lot of volatility and a lot of distinction between companies within each sector. It's going to be a stock-picking market." He expects the stocks that get picked to be the ones of more financially sound companies.

"People want solid, robust balance sheets," he said. "They want to see where you stand on the debt side; they want to see bottom-line earnings." That caution probably will persist for several months until it becomes clear that economies and financial systems are on a firmer footing. "There's still a bit of bad news to come, so fund managers are playing it safe," Mr Samji said. "In these times you would rather not be an aggressive player in the market."