In a marked departure from the trend at the start of the year when movement in oil prices was synonymous with how regional markets behaved, in the past two months there has been a breakdown of that correlation.
The deviation away from oil prices is visible across all asset classes in the region, albeit to varying degrees.
In the three quarters ending in March this year, a 36 per cent decline in oil prices translated into a 32 per cent decline in the Tadawul All Share Index and a 43 per cent increase in credit spreads on average GCC bonds.
However, recently, while oil prices have fallen 15 per cent since the Brexit vote, the Bloomberg GCC 200 equity index has risen by 1.5 per cent.
Tadawul, the index most correlated to oil prices in the region, fell only 4 per cent, and Dubai’s DFM, in fact, advanced 4.5 per cent. The weekly correlation between the GCC200 index and Brent prices in the first quarter of this year was 0.87, which has dropped to 0.55 since start of June. The divergence is even wider in fixed-income markets. The weekly correlation between Bloomberg’s index of UAE’s most liquid bonds and Brent prices has dropped to minus 0.87 since June from positive 0.77 in the first quarter.
Besides moderating impact on financial securities, the influence of oil prices has also diminished on the sentiment of the private sector. For example, the Emirates NBD UAE Purchasing Managers’ Index rose to 55.3 in July from 53.4 in June despite oil prices falling in the preceding three months. The story was similar in Saudi Arabia, where the PMI last month (56) was at the highest level since September last year.
The reasons for the market’s phenomenal resilience are multifold.
The foremost underlying driver has been the capital flow dynamics. Liquidity injection from various central banks’ expanded QE programmes in Japan, the euro zone and the United Kingdom, among others, has driven one-fourth of the developed-world sovereign bond market into negative yield territory and is forcing investors to hunt for yield elsewhere.
The copious liquidity has ultimately found its way into emerging market securities that offer relatively higher returns. GCC bonds trade on an average yield of about 4 per cent, and dividend yield on GCC stocks is about 4.3 per cent (as per Bloomberg’s GCC 200 index) compared with average yield of negative 0.11 per cent on 10-year Japanese government bonds. Foreign investors have bought stocks worth US$1.7 billion in Mena markets since the beginning of this year, with nearly 20 per cent of that coming last month alone. The trend is similar in the fixed-income space, with majority of the $32bn of GCC bonds issued so far this year being placed in foreign investors’ hands. This hunt for yield is likely to get further intensified as central banks remain in accommodative gear.
Another key factor is the flatter US interest rate curve. It does appear that the US Federal Reserve’s decision to stay on hold so far this year and moderating the probability of a future rate hike has negated any risk of capital outflow arising from increasing cost of borrowing. Lower-for-longer rates have created an abundance of cheap liquidity and also provided an indirect support through dollar weakness.
The recent increase in pace of reforms in the GCC has given a boost to investor sentiment even though government budget deficits remain high because of weak oil prices. Sovereigns in the region have reduced expenditure by cutting energy subsidies. Plans for the introduction of VAT in 2018 are well under way and corporate taxes are being initiated or increased. These are far more sustainable revenue measures than simply relying on oil revenue.
The absence of exogenous negative shocks such as concerns surrounding the health of the Chinese economy has assisted market mettle. Geopolitical tension in the GCC also seems to have taken a back seat amid bigger issues elsewhere.
Looking ahead, we think the dominance of carry trades and flow dynamics will continue in the foreseeable future, provided oil prices do not stage a catastrophic decline. Thus, despite rich valuation, fixed-income and equity markets in the region should remain buoyed.
Even with the Tadawul’s recent underperformance compared with its GCC peers, the Saudi Arabian market is likely to gain support from fast-tracking of capital market reforms that will allow more foreign capital to flow in the country.