Lazard Insights MENA Equities: An Overlooked Dimension within Emerging Markets Walid Mourad, Portfolio Manager/Analyst, Middle East North African Equity team Summary MENA governments are committing a large amount of capital to drive growth, while the emergence of an increasingly educated population should boost long-term economic prospects. Many investors have historically associated the MENA region with oil. However, over the last seven years, their equity markets were less correlated to oil prices than emerging and developed markets. In response to lower oil prices, MENA governments have accelerated economic reforms to reduce fiscal deficits. MENA s representation in the MSCI Emerging Markets could increase to 6% once Saudi Arabia is added, which we believe is too significant to be ignored. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights. Some investors favor more established emerging markets over the Middle East North Africa (MENA) region, dismissing it as closed, reliant on oil, and politically unstable. However, MENA is an under-researched region currently undergoing a number of structural changes, which we believe have lowered the region s correlation to the price of oil. In this paper, we review the region s opportunities, structural advantages and differentiators, economic reforms, and its larger representation in emerging markets indices. Structural Advantages Like many emerging markets, MENA countries have sectors that have significant growth potential. In Saudi Arabia, for example, mortgage penetration rates are as low as %, compared to the 6% 7% average in developed markets. 1 In Egypt, organized retail represents less than 15% of the total retail market and more than 55% of the population still consumes milk in loose form (i.e., in plastic bags). While many industries are still in early stages, we believe that the MENA region has unique, structural characteristics that represent growth potential. The region has one of the fastestgrowing populations higher than that of the five major emerging economies of Brazil, Russia, India, China, and South Africa
Exhibit 1 A Growing Population and Better Education Should Boost Long-Term Economic Prospects A Growing Population Literacy Rates Are Improving (%) 3 Y/Y Population Growth MENA (%) 1 1985 15 75 5 1 Y/Y Population Growth BRICS 5 4 6 8 1 1 14 16 Oman Kuwait Saudi Arabia UAE Morocco Tunisia Egypt World MENA Average As of 31 December 16 Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: IMF As of 31 December 15 Source: Human Development Reports United Nations Development Programme (BRICS) (Exhibit 1, left). More importantly, MENA s population is becoming more educated. The region s literacy rates have improved from 5% thirty years ago to 8% today (Exhibit 1, right). MENA is also home to one of the world s youngest populations, with more than 5% of its population below the age of 5. The workforce in the MENA region has increased on a yearly basis and, perhaps more importantly, growth rates for women in the workforce have boomed over the past decade. However, this growth is from a very low base (Exhibit ). In Saudi Arabia, the female workforce participation rate is about 8% compared to the world average of about 4%. In the past, women in Saudi Arabia could only work in specific sectors and jobs, but there are fewer restrictions today, and women are gaining access to different areas of the workforce. MENA governments also have significant financial reserves and low leverage. Most have accumulated substantial amounts of wealth and assets during the periods of high oil prices, which can be used to finance deficits in the future. Kuwait and Qatar could support their fiscal deficits for 1 and years, respectively, using their financial reserves. In addition, since leverage is low, MENA governments can easily raise debt when needed to continue their spending programs. Despite lower oil prices, MENA governments have continued to invest, especially in strategic sectors that could help them achieve their long-term goals, such as diversification away from oil or employment of their young and growing populations. For example, Saudi Arabia has maintained its spending on infrastructure, health care, and education (Exhibit 3). Exhibit Although Still Low, Female Participation in the Workforce Is Increasing (Thousands) (%) 1,5 1, 75 5 5 6 Female Labor Force [LHS] 7 8 9 1 11 1 As of 31 December 15 Source: HSBC Research, Saudi Arabian Monetary Authority 13 Exhibit 3 Despite Low Oil Prices, Saudi Arabia Has Continued Its Investment in Key Sectors 14 15 Budget Support Provision 14 15 Human Resource Development 16 Economic Resource Development Health & Social Development Transport & Communications Infrastructure Development Municipal Services Defense & Security Public Administration & Other 18 36 54 7 9 ($B) As at 15 November 16 Source: IMF, Regional Statistics offices & Regional Ministries of Finance
3 The Impact of Lower Oil Prices Many investors have historically associated the MENA region with oil. However, petrochemicals, oil and oil-related companies represent a very small percentage, about 16%, of the region s total market cap. In addition, the correlation of MENA markets with oil was below.4 from May 1 May 17, which was lower than both the MSCI Emerging Markets and MSCI World indices correlation. 3 We believe this is the result of investors realizing, with time, that the sustainability of government spending drives MENA markets rather than just oil prices. Moreover, MENA equities can be a good diversifier to both emerging and developed markets equities since the correlation of the MENA region with emerging and developed markets is also low (Exhibit 4). Economic Reforms Lower oil prices have clearly decreased GDP in many MENA countries. However, instead of cutting back on infrastructure spending, MENA governments have accelerated economic reforms to reduce fiscal deficits. Subsidies, mainly on water and electricity, have been removed. The United Arab Emirates and Dubai specifically have been ahead of the curve in applying market practices when it comes to pricing government services. These countries have also been the least impacted by lower oil prices given their non-existent or manageable fiscal deficit. In 15, Saudi Arabia announced the National Transformation Plan (NTP) an ambitious plan for economic development that aims to diversify the country s economy away from oil by 3. The four main pillars of the plan include privatization, diversification of revenues away from oil, pro-growth structural reforms, and fiscal consolidation measures. Privatization focuses on the energy sector, mainly Aramco, which is expected to initiate one of the largest IPOs in history. Aramco is the sole producer of oil in Saudi Arabia and has estimated reserves of around 5 billion barrels. The second pillar of the NTP is diversification away from oil. The proceeds of the privatization efforts will be used to create what the Saudi Arabian government believes will be the largest sovereign wealth fund in the world. This fund will be responsible for investments internationally. The third pillar is to implement structural reforms that will focus on growing strategic sectors such as mining and real estate. The private sector will play a bigger role through the development of the Private Public Partnership model. The fourth pillar of this plan is the implementation of fiscal consolidation measures, mainly through the removal of subsidies, to manage any fiscal deficits. In the 198s and 199s, Norway, whose economy was mainly driven by the oil Exhibit 4 MENA Markets Correlation with Oil is Low and Less Than that of Emerging and Developed Markets 1 May 1 1 May 17 MENA sector, underwent similar reforms. The Norwegian experience of diversification away from oil was successful and Saudi Arabia is taking a similar implementation route (Exhibit 5). Representation in the MSCI Emerging Markets Oil MSCI Emerging Markets MSCI World MENA a 1.399.48.478 Oil.399 1.43.46 MSCI Emerging.48.43 1.786 Markets MSCI World.478.46.786 1 As of 1 May 17 a MENA is represented by the S&P Pan Arab Some countries within MENA have successfully diversified their economies away from oil. For instance, a significant portion of the United Arab Emirates GDP is generated by sectors such as real estate, retail trade, transportation, and financial services. Source: Lazard, Bloomberg We believe Saudi Arabia has taken the right steps towards becoming a constituent of the MSCI Emerging Markets. The country has opened its market to direct foreign investments, relaxed the Qualified Foreign Investors eligibility requirements, and has changed its trade settlement process. With Aramco s public listing and privatization on the table, and given its strategic importance as part of the diversification away from oil efforts and its potential size, it makes even more sense for Saudi Arabia to achieve emerging markets status. This upgrade will give Saudi Arabia access to a larger pool of international capital instead of having to tap into local liquidity. Currently, the United Arab Emirates, Qatar, and Egypt are part of the MSCI Emerging Markets with a combined weight of about 1.3%. If Saudi Arabia is included in the index and if Aramco is listed with a 5% free float on the Saudi stock exchange, MENA s representation in the index could increase to 6%, which we believe is too significant to be ignored (Exhibit 6). From a valuation perspective, MENA markets are trading in line with emerging markets with slightly higher ROEs. 4
4 Exhibit 5 To Diversify Away from Oil, Saudi Arabia is Embarking on a Similar Path as Norway Growth in Norway has Outpaced the European Union by more than 5% since 1991 Importance of Human Capital Prudent Conduct of Fiscal Policy Surplus Revenues from Hydrocarbon Invested Globally Privatization of Oil The Norway Lessons Priority for building human capital, investing in education, increasing labor force participation, and supporting productivity growth Emphasis on stabilizing the economy and facilitating a gradual phase-out of oil revenues (priority to achieving productivity gains in non-oil sectors) The Norwegian Government Pension Fund mainly invests globally, thereby diversifying the government s revenue stream away from oil Privatization of state oil champion (Statoil) has paved the way for more foreign company involvement in the Norwegian economy, allowing capital to be redeployed in other countries and sectors The Saudi Implementation Priority given to spending on education and human resource development within the Saudi budget NTP focus on diversifying revenues away from oil through higher productivity. Government has also focused on raising international funding not to crowd out the private sector Reshaping of the Public Investment Fund into a Sovereign Wealth Fund, to be responsible for investments internationally Aramco sale/ipo is being considered seriously Source: Lazard Conclusion MENA countries are undertaking exciting structural changes that will help diversify and grow their economies. Governments are committing a large amount of capital to drive growth, while the emergence of an increasingly educated population should boost long-term economic prospects. For emerging markets investors, MENA is becoming a more significant part of the opportunity set. We believe the evolution of MENA is one of the most compelling investment stories and is an opportunity in a sometimes misunderstood, but increasingly prosperous, market. Exhibit 6 MENA Could Represent 6% of the MSCI Emerging Markets MENA Countries Current and Potential Representation in the MSCI Emerging Markets (%) (%) 8 8 6.5 6. 6.5 6 4 1.3 3.9.3 4.4.5.8.8.8.6.8.7.7 May 14 UAE Kuwait Qatar Egypt Arabia (without Aramco) Expected Arabia (with Aramco) Expected Saudi (without Aramco) Saudi (with Aramco) 4.4 Arabia (with Aramco) and Kuwait Expected MENA (GCC+Egypt) [RHS] 4 As of 31 December 16 Source: Lazard, Arqaam Capital Research, Bloomberg, MSCI
5 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 Source: Marrmore MENA Intelligence, Saudi Arabian Monetary Authority Source: McKinsey, CI Capital 3 Source: Bloomberg, Lazard 4 Source: Bloomberg Important Information Published on 7 March 18. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 19 May 17. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. RD199