GCC (excluding Saudi Arabia) equity markets stumble on policy changes - expect higher volatility ahead

(MENAFNEditorial) The Saudi Arabian index has moved steadily upwards (+9%) over the last month. Saudi M&A activity is increasing with Savola officially announcing its interest in Kuwait Foods (Americana). The Saudi food and retail sectors have been outperformers this year (+ 55% YTD) with consensus earnings growth forecast at 25% and 17% for 2014 and 2015, respectively. We like the defensive nature of the sector, with an average beta of 0.9 and would stay invested in Savola, the GCC's largest and most diversified food company.

The Qatar market briefly rallied last week in expectation of increased weightage in the MSCI Emerging Market Index (quarterly August review) but is currently pulling back. It was announced that Qatar National Bank and Industries Qatar, already up +18% and +10% respectively (from their lows in mid-2014) will have increased weightage in the MSCI indices, as their Foreign Ownership Limits have increased. However, the surprise Monday removal of a small-cap stock, Mesaieed from the MSCI EM Index stunned analysts and looks likely to raise volatility in the near term.

Regional credit flows well balanced

Flight to safety supported the bid for US treasuries with 10 year UST at 2.34% after touching 2.30% on Friday, 14th August. Over the week, 10 year UK gilts and the German bunds followed suit strengthening 16 bps and 10 bps, respectively. GCC bond and credit spreads were a tad wider given the sharp move in USD benchmark rates.

One of the most popular Sukuks – Sovereign notes backed by the Ras Al Khaimah government matured (USD 400 mn, 8 % coupon due 22 July 2014). The month of September also awaits benchmark bond maturities from National Bank of Abu Dhabi, TAQA, ISDB (Islamic Development Bank) and Ras Laffan totaling USD 4 bn. We expect these proceeds to be reinvested, potentially tightening existing credits in the GCC space. Dubai 5 year CDS has already tightened to 160 bps.

Damac 5 year Sukuk saw renewed interest over the week, after the company reported positive earnings. TAQA bonds across the curve were well supported after headline news on asset sales as well as news on their not returning to debt capital markets at least till 2017. Regional laggards such as the Investment Corporation of Dubai (Sukuk), and the Emaar Malls group saw demand as investors picked up relative value in the 7 to 10 year space. The Tier 1 and Tier 2 UAE based credits were also in popular demand.

Rising geopolitical tension and slowing global growth should not be ignored

Geopolitical events continue to dominate and volatility increased with the CBOE Volatility Index spiking. There is not much change in the Gaza standoff, the Ukraine Russia conflict and warfare continues in Iraq and Syria. Equity markets, which had begun selling off last week, took a breather with President Putin striking a conciliatory tone. Russian companies have begun feeling the impact of sanctions, with Rosneft Oil being the first to request bailout funds.

As expected, Japan's economy shrank 6.8 % in the second quarter on the back of lower consumption, affected by a 3% increase in sales tax on 1st April. The German economy has contracted 0.2% while France remains in stagnation. China's bank lending has slowed and additionally Chinese banks are being forced to fortify their balance sheets against an expected rise in bad loans. Investors flew to the safety of the Yen and the Swiss Franc leading to a strengthening of both the currencies.

We remain overweight on Japan as we see an increased allocation by Japan's pension fund with equities generating higher returns than the lower yielding Japanese Government bonds. We are neutral on Europe until we see trade return to normal with Russia. However, we remain cautious on markets in the short term and until we see clarity on ECB and Fed policy and an abatement of the current military conflicts.

We favor high dividend yielding equities versus high-yielding bonds

The current year was supposed to mark – according to consensus research – the first one since the Great Recession in 2008 when the US economy would reach 'escape velocity', that is a self-sustained growth path whereby the economy would not need stimulus anymore.
Actually the analysis of asset performance across the globe and latest economic data – waning investors' confidence in Germany and weak retail sales in the US –may instill doubts about the strength of global growth, although the 'escape
velocity' is there.

The top performing sectors in the MSCI World – the world equity benchmark – are (year-to-date) information technology and pharma. Both sectors rely heavily on research breakthroughs and thus can easily expand for extended periods of time above GDP growth rates. They tend to outperform the rest of the market when it is difficult to find widespread growth in those pockets more directly related to the business cycle.

Economic data, although good on the surface, do not speak in favor of high-flying expansion rates yet. In all major developed economies, the US, Europe, the UK and Japan, wage growth is sluggish, so much so that inflationary pressures – another indicator of rampant growth – are non-existent.

Long term bond yields – directly linked to long-term economic growth – are quite subdued as well. US 10-year yields are stubbornly below 3% and in Europe Germany 10-year yields are dangerously close to 1%, bringing to mind recollections of what happened in Japan in the so-called 'lost decade'.

In a lower economic growth environment we think it is best to circumvent the world of low returns by investing in high dividend-yielding stocks, which tend to outperform by compensating investors with larger dividends, and by focusing on stock and equity fund selection.

On the other hand we advise clients against a plain overweight strategy in high-yielding bonds, although until recently a favorite asset class supported by the hunt for yield. The forthcoming end of Quantitative Easing (QE) by the Fed in October, combined with overly tight spreads of junk bonds and the recent outflows recorded in this market segment, do not speak of continued outperformance versus equities.

Commodity prices remain elevated primarily on the Russia Ukraine conflict.

Palladium seems to have broken out from an important level of USD 890 per ounce and if it manages to sustain these levels we could see new highs.