GCC states put fixes in place to weather oil storm

Market review

The continuing weakness in hydrocarbon prices has created several challenges for the GCC states.

In recent months the countries have responded to those economic challenges.

Much attention focused on the budgets of the various GCC members, and whether they would effectively take into account the impact of oil prices and other uncertainties and initiate needed reforms.

Saudi Arabia announced its 2016 budget in December, indicating lower expenditures than last year and a projected deficit that was below market expectations. General global reaction to the budget was positive, with observers citing realistically financeable spending, a conservative assumption for oil prices and meaningful reforms that the government said it would prioritise. Such reforms included a gradual reduction of energy subsidies, an optimisation of capital and operational spending and increasing revenues through a variety of sources, such as new and existing fees and the implementation of a value-added tax.

The kingdom’s purchasing managers’ index (PMI) reported for November was 56.3, an increase from the previous month, but down from the levels reported for August and September (58.0 and 56.5, respectively). However, the latest PMI is still well above the 50.0 level that separates economic expansion from contraction. Among other GCC members, the UAE’s November PMI of 54.5 represented a slight recovery from its October level of 54.0, a two-and-a-half year low, but was still below its August and September levels of 57.1 and 56.0, respectively. During the calendar quarter, the UAE unveiled an US$82 billion plan to develop a knowledge-based economy.

As 2015 drew to a close, Dubai announced its budget, in which a deficit is not expected. Qatar also approved its 2016 budget, which included a 7 per cent cut in total spending compared with its last budget.

Overall, the fourth quarter saw a general strengthening of ties among members of the GCC. The Gulf states agreed on key issues for implementing a value-added tax in the region, moving the six-nation bloc closer to introducing direct taxation for the first time.

Market outlook

Our view is that the US is now at the late stage of its economic recovery cycle. Consequently, we are more selective in our credit-risk positioning than we have been at any other point during this long period for the world’s largest economy. We are seeing some evidence of weakness among some lead indicators and a widening of credit spreads, both of which we view as cautionary signs. With the US beginning its long-awaited rate-increase cycle in December, we expect the US dollar to have reached its peak levels, or at least be very close to its peak. Such a development would be consistent with previous rate-increase cycles.

A dominant economic theme in GCC countries this year has been continued weakness in hydrocarbon prices. The natural assumption is that low oil prices would have a negative effect on fixed-income markets in the region. However, our analysis indicates that the medium-term correlation between oil prices and GCC fixed income is minimal. There appears to be a higher correlation between GCC bonds and the emerging-market and global bond asset classes, suggesting movements in global investment-grade spreads could be a more consistent driver of GCC fixed income performance. It is important to note that GCC fixed income exhibits lower levels of volatility than emerging-market bonds.

We believe GCC fixed-income markets are fairly unique, in that they have investment-grade characteristics but are generally considered outside the scope of developed-market asset classes. The latter factor has led to a lack of depth of investors, and few dedicated investors outside of regional banks and their treasury desks. According to our analysis, these conditions have created a fertile environment for identifying potentially undervalued investment opportunities, including those in corporate and longer-dated sovereign and quasi-sovereign issues. We view this fixed-income space as being in the early stages of an exciting period of development and innovation, with particularly promising potential to be found in the sukuk market.

Our outlook for the GCC’s fixed-income asset class remains constructive, due to its combination of valuations, lower-than-expected correlation to oil prices and lower volatility relative to emerging-markets debt.

Mohieddine Kronfol is the chief investment officer for fixed income and global sukuk at Franklin Templeton Investments ME.


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