We are pleased to present to you our first investment 2017 newsletter. We see a number of opportunities to achieve strong risk-adjusted returns across a broad array of investment strategies this year. However, investors need to tread carefully as there are a number of potential risks that should be considered when making investment decisions. The 2017 investment outlook attempts to outline both the potential opportunities as well as the risks across Equity, Fixed Income and Alternative strategies.
Equities: Challenges ahead, but opportunities still exist
Historically, decision makers in the GCC have pushed for economic and social reforms during tough economic conditions, especially in a low oil price environment; and therefore, the recent structural changes come as no surprise. There is no doubt that the recently announced reforms across the GCC will result in fiscally sounder economies in the long run, where governments enjoy a relatively more diverse revenue base, a lower burden of subsidies and moderate levels of leverage, thus allowing spending on strategic projects to continue and increasing private sector participation along the way. However, the ride from status quo to the ultimate goal is far from being smooth and in our view it is divided into two phases:
2017 is expected to be a challenging year since it is part of the Adjustment Phase. From a top-down view point, our asset allocation today calls for an overweight position in Kuwait, Qatar and the UAE at the expense of Saudi Arabia and Bahrain. While Oman looks unfavourable from a top-down view point, the bottom-up approach drives us to an overweight position due to a huge valuation gap found in certain stocks that we know well and have researched for years.
We continue to favour the retail story in Kuwait, where purchasing power and disposable income remain relatively high. Furthermore, government spending and project awards should provide a much needed boost to the overall economy at this point in time and banks, in our opinion would be the best way to capture improving economic activity while keeping risk to a minimum. Sudden regulatory changes and clashes between the cabinet and parliament may amplify the execution risk.
In Qatar, the investment thesis continues to revolve around infrastructure spending and gearing of the country to host FIFA world cup in 2022. Qatar has reiterated its commitment to spend over USD 100 billion* over the coming few years. Our overweight allocation to Qatar is dampened due to the risk that Qatar may lose its right to host the event in 2022. We prefer banks and retail/consumer based companies, a theme that remains intact in Qatar.
As for the UAE, we are overweight on Dubai in a big way with limited exposure to Abu Dhabi at this point. We believe that the real estate sector will outperform as the city gears itself to host Expo 2020. Advertising and marketing to mark the completion of every milestone in the project will create the required buzz and help turn sentiment around. In addition, growth in Dubai’s tourism sector remains on track, although there are risks associated with a stronger US Dollar and major negative developments in the three largest countries (India, Saudi Arabia and Britain) in terms of international tourist arrivals to Dubai. We take a cautious stance on UAE banks, where we feel provisions will remain high, thus pressuring the bottom line for at least the next couple of quarters.
Our underweight position in Saudi Arabia is due to a number of challenges and ambitious plans set by the government. However, we feel that Saudi Arabia is in a far better position compared to Oman and Bahrain given Saudi Arabia’s wealth and a reform plan that has been well communicated to the public and the outside world. Keeping in mind that plans are subject to change and execution remains a major risk.
The lack of vision and the absence of a clear game plan in Oman casts huge doubts over the future of the economy. The government took some measures to boost revenue, but has failed to show any serious cuts in expenditure. The devaluation of the Omani riyal remains a major risk considering limited financial resources of the country. Although our allocation to Oman in the portfolio is the lowest compared to other countries, it is still an overweight relative to the country’s small neutral weight ~2.5%**. Our allocation to Oman is based on a bottom-up approach, where we feel the steep discount in valuation is unwarranted.
From a sector point of view, we like companies operating in the healthcare and education sectors, not only because they remain underserved, but also the quality and standard of services in some GCC countries have continuously deteriorated over time. For healthcare, ramping up capacities, an increased emphasis by GCC government on health insurance coverage and favourable demographic trends are among the positives for the sector. Furthermore, we believe that future healthcare reforms will see the governments removed from managing the operations on a daily basis and instead outsourcing it to the private sector, which will present numerous opportunities to all private healthcare providers. Therefore, we believe the risk is to the upside for all healthcare stocks we currently own in the portfolio.
We remain cautious on UAE and Saudi banks where we see further NPL formation resulting in higher provisions thus keeping earnings under pressure throughout 1H2017, unless management teams decide to kitchen-sink in 4Q2016, which is more likely to be the case for UAE banks than Saudi banks. Total GCC banking sector leverage (Assets/Equity) stood at ~7.4x**, which clearly indicates that GCC banks remain cautious and are unable to identify lucrative lending opportunities. We believe that total leverage could easily grow by 20% resulting in robust future earnings growth, which suggests that the banking stocks have a massive upside potential whenever the macro situation improves.
The removal of subsidies and slashing of public sector wages have taken a toll on the Saudi consumer stocks and the outlook remains challenging for the sector. However, we believe certain consumer companies that are run by sound management teams with strong track records could benefit as people become more cost conscious and new spending patterns emerge.
Companies with high government ownership offering an attractive dividend yield backed by a healthy stream of cash flow should be a good place to allocate capital. Improving liquidity seems to be a high priority for all GCC governments. Therefore, the probability of a dividend cut for such companies is quite low. In fact, we feel the risk is to the upside as governments may force a higher dividend from cash rich companies.
*Sources: Qatar Ministry of Finance, December 2016.
**Rasmala Internal Analysis
Fixed Income: Embrace the volatility
2016 witnessed a number of events which resulted in a sharp spike in market volatility. Brent oil prices slid to a low of USD 27 per barrel in January, pressurizing the finances of many petro dollar economies with the Gulf oil producers being no exception. Simultaneously, concerns surrounding the perceived weakness of the Chinese economy dominated market sentiment resulting in acute pressure on commodity currencies as commodity prices and export volumes plunged. We also witnessed what some may view as “black swan” events in 2016. The first being the Brexit vote in the UK and the second, Donald Trump’s unexpected victory in the US elections towards the end of the year. Ten year US Treasury yields gyrated from a low of 1.36% (post Brexit) to a high of 2.65% (post Trump’s election victory), the magnitude of which reflects the dramatic swings in market sentiment and underlying volatility encountered in 2016.
2017 is expected to provide more of the same for fixed income investors with all eyes on Donald Trump and the execution of the Republican Party’s economic and fiscal policies, which are yet to be fully disclosed. These policies include the lowering of corporate and personal taxes, an increase in infrastructure spending and generally turbocharging the US economy whilst embracing trade protectionism. These policies, if executed successfully, raise the prospect of higher US economic growth at a time when the US economy is on an upward trajectory. This could translate into inflationary pressures which the Fed may be forced to respond to more forcefully than the two 25bps interest rate increases currently priced in by the futures market for 2017* (The Fed has indicated three 25bps rate rises in 2017).
Although the oil price has started the year at a higher level than 2016, it remains well below the fiscal break-even price for most regional governments and is expected to trade between USD 45 – USD 65* per barrel in 2017. Therefore, fiscal austerity and a further tightening in regional liquidity looks set to continue with regional governments expected to tap the debt capital markets regularly in 2017 to fund a portion of their budget deficits.
Whilst governments are expected to dominate debt issuance, banks will also be active in the primary market as they start to ready their balance sheets, both from a liquidity and regulatory capital perspective, for the implementation of Basel III.
Despite the pricing advantages of sukuk at the shorter end of the curve, conventional bonds are likely to once again dominate GCC issuance as governments endeavour to attract deep pools of external liquidity into the region rather than merely recycle local liquidity, which would likely be the case with sukuk issuance.
The expected lack of sukuk issuance in 2017 and the inclusion of certain sukuk in JPMorgan’s suite of emerging market indices will underpin the existing strong technical backdrop to regional sukuk prices whilst the abundance of conventional issuance will be one of the factors that limit material credit spread compression in conventional bonds. Another key driver of regional credit spreads includes the level of the oil price which has a direct impact on the balance sheet strength of regional governments. We expect oil to have limited upside potential in 2017 due to the extraordinary efficiency gains by US shale producers thus the steady deterioration in regional credit quality is likely to continue.
We believe that on a macro level, heightened political risk could be one of the key drivers of volatility in 2017. Political risks could emanate from a number of sources including, but by no means limited, to Trump’s unpredictable political agenda, a material deterioration in the US / Chinese relationship, unexpected French or German election results, “hard” Brexit negotiations (which appears likely), or the implosion of Egypt’s or Turkey’s political structure as dissatisfied and/or disenfranchised citizens attempt to be heard.
Against this challenging backdrop, we believe that it would be prudent to adopt a cautious approach to both credit and duration risk so as to be well positioned to exploit expected periods of market weakness that will inevitably present attractive alpha generating investment opportunities over the course of the year.
The outlook for many alternative investment strategies in 2017 remains bright. At Rasmala, we are focused on alternative investments which are supporting the real economy, such as Trade Finance, Equipment Leasing and Real Estate.
Trade Financing Opportunities and Equipment Leasing: Alternatives will thrive
We think that trade financing opportunities will continue to grow as banks reduce their exposure to this segment of the lending market; and entrepreneurs seek out alternative financing solutions. We have now crossed the two-year track record and our registered encouraging performance. We have a large, and growing number of counterparties which are utilizing our financing to grow their businesses in such sectors such as agriculture, petro chemicals and fast moving consumer goods. We have built up our experience, and as our presence in the market grows, we are being presented with a growing number of credible opportunities to deploy the Fund’s capital at rates of return which are very attractive compared to their inherent risks. With trade and economic development expanding in the GCC and in the neighboring regions of African and Asia, we think the Rasmala Trade Finance Fund is well positioned to meeting our investor’s requirements with regards to regular income, capital preservation and liquidity.
At Rasmala, we have developed a strong track record in equipment leasing with a dedicated focus on financing the leasing of long-life, low obsolesce, equipment to high quality corporate credits in the USA. We have expanded our capabilities together with our partners in the US, Atel Capital Group, who have a 30-year track record in this segment of the leasing market. In 2017, we are planning to close our second equipment leasing fund and launch our third fund in this segment. We expect equipment leasing opportunities to be plentiful as the US economy continues to expand and business opportunities grow. The strong US economy will underpin the residual value of the equipment leading to strong investment returns. Higher interest and financing rates due to the rise in the Federal Reserve’s Fed Funds Rate will provide further support. As interest and financing rates rise, we will be able to secure higher returns as we release the equipment during the term of the lease, as well as being able to secure higher returns on the initial term for new leases. With economic growth looking solid in the US, we are confident that our leasing program will continue to perform well.
Real Estate: Brexit or no Brexit, investment volumes will rise
Since the June 2016 referendum in which the UK voted to leave the EU, the UK economy has entered a period of uncertainty. Until Article 50 is invoked and the UK’s exit process formally commences, economic uncertainty will remain. Despite this, property prices in the UK have managed to hold firm to date, and indeed we have seen strong demand for some assets recently, for which final prices have been above initial offer prices. Good quality assets with strong covenants and with stabilised long term income continue to attract international and domestic capital.
Although there were concerns that Brexit would lead to stress in UK property markets, corrections in share prices of housebuilders and in NAVs of retail real estate investment trusts in the immediate aftermath of the June referendum did subsequently stabilize towards the end of 2016. Owners of medium to large commercial properties have refrained from putting their assets on the market unless their price expectations were matched. Rents remained stable, thus keeping total returns for commercial property – particularly warehouses – in positive territory for the year.
Our expectation is that investment volumes in 2017 will be above those seen in 2016. Despite a likely increase in inflation and bond yields to tempt investors away from the real estate asset class over the coming year, we anticipate that the continuing excess of international and local demand for UK property will support the market. Whilst the traditional high street and retail sector has experienced a difficult period over the last 5-7 years, as consumer habits and shopping experience expectations have shifted, online retail businesses continue to drive the need for strategically positioned logistics sites, and long leases backed by multinational tenants with strong credit standings continue to be the area of focus for income-seeking investors. These types of quality asset underpinned by ‘sticky’ tenants in strategic locations are also in high demand in continental Europe, particularly Germany.
Towards the end of 2016 we observed fierce competition amongst both domestic and international capital, particularly from Asian and the Middle Eastern investors seeking to diversify across currencies and geographies. The more aggressive of these buyers took advantage of a brief moment of opportunity immediately post the June referendum by buying at slight discounts from fund managers seeking to redeem retail fund units. The key to closing deals in such circumstances was the access to liquidity at very short notice, and strong due diligence and structuring capabilities.
We recommend in these uncertain times that investors continue to deploy robust investment processes and consider geographical and currency diversification as a potential strategy. A comprehensive asset origination and due diligence process that sweeps the market for opportunities in multiple geographies will reveal that there are few assets of the appropriate quality for long term income generation and capital preservation, and when these arise investors should act quickly.
Rasmala continues to evaluate and originate a healthy pipeline of opportunities in the UK, US, Germany and the UAE. The supply of quality stock in these locations remains tight and when the best assets come to market, these have been well contested. As is always key to real estate, location and asset dynamics are of primary importance when assessing any acquisition. We continue to put emphasis on these key factors, and allied to our comprehensive structuring process, look forward to sharing these opportunities with you.