Market analysis: Policy response to oil will set the tone

April was a positive month for most global risk assets, with many fixed income and equity indexes generating robust returns.

A significant driver of these gains was a strong rally in oil prices – the price of West Texas Intermediate gained about 20 per cent for the month. Continued movements towards a more normalised supply and demand environment for oil helped to support the price gains, with contributing factors including a decrease in production in the United States and a slowing growth rate in inventory levels.

Price gains were not deterred significantly by a summit of 16 oil ministers that did not produce the concrete actions previously expected. At the summit, Saudi Arabia stated that any agreements on price freezes would only be possible if every member of Opec signed on, which most notably would include Iran.

Besides the rebound in oil prices, another important positive factor underpinning the risk asset rally was a moderation of concerns about China’s economic growth. The monetary policies of Europe and Japan continued to reflect a stimulative stance, although central banks in both regions did not make any new moves or signals towards further easing financial conditions.

Both these economic regions could still go further with their stimulative policies if needed, although the IMF stated that developed economies might be running out of capacity to use monetary policy to improve economic outcomes. The euro and yen strength that resulted helped to feed into the weakening of the US dollar, a development that supported emerging markets and commodity prices.

The IMF revised its growth projections for this year slightly downwards, to a modest 3.2 per cent expansion in GDP, compared with the 3.4 per cent reported in January. The adjusted number is roughly in line with last year. The IMF has characterised the nature of global growth for the remainder of the calendar year as positive, with possible strengthening in 2017, but has also emphasised there remains some fragility in the world economy.

In fixed-income markets, the JP Morgan Emerging Market Bond Index Global-Diversified returned 1.77 per cent, with emerging markets benefiting from strengthening commodity markets and improving fundamentals in select countries. Argentina’s return to international bond markets was considered a success, with its US$15 billion issue attracting considerable interest and making quick gains. Spreads for emerging-market bonds over US treasuries, as measured by the CDX Emerging Markets Index, contracted slightly.

In the GCC region, economic reforms intended to improve economic fundamentals and diversification continued, with further developments outlined in public statements by the deputy crown prince Mohammed bin Salman of Saudi Arabia.

The prince’s now widely publicised Vision 2030 policy directions concerning the kingdom’s economic future include an IPO of 5 per cent of Saudi Aramco, Saudi Arabia’s national oil company, a sale that is expected to raise close to $100bn.

The IPO and related actions surrounding the kingdom’s remaining stake in the company are expected to make Saudi Arabia’s sovereign wealth fund the largest in the world, amounting to about $2 trillion in assets. The fund is expected to be used to help diversify the nation into non-petroleum concerns.

Other initiatives outlined by Prince Mohammed included additional privatisation plans, raising of more debt, reductions in budgetary deficits, peace efforts in Yemen and continuing to look at non-oil sources of public revenue, such as taxation measures.

Reaction to the prince’s statements has been generally positive, including gains in the domestic stock market. The Tadawul rose about 2.5 per cent after the announcements. A $10bn bank loan request from the kingdom also drew significant investor interest.

As hydrocarbon prices continue to be a focal point for investors and analysts globally, the gain in oil prices after the sharp declines early this year have given GCC economies and markets some benefits.

For fixed-income markets specifically, however, the gains have been lower than in other emerging markets, partly because of factors we have highlighted in the past – low correlation to oil prices and lower beta to risk assets.

Nonetheless, the decline in US oil production is among the factors which, if sustained, can support oil prices and benefit GCC fixed-income and sukuk markets as well – particularly as spreads for these regions are still wider for the year, despite recent gains. The risk of higher oil prices in the short term may include an unfortunate slowdown in the pace of reform.

The policy response to lower prices is arguably much more important to market performance in the short and medium term, and we are paying close attention to these potential developments. Saudi Arabia’s Vision 2030 plans sets a high benchmark for reform and, despite the significant challenges in implementation, will support future engagement with local and international capital markets and balance the need for growth with sustainable finances, in our view.

The GCC looks set to undergo a prolonged period of economic and financial market reform, similar to that of many emerging markets over recent years, with significant prospects for investment returns.

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

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