Mena equity investors have had a stormy year so far. We have seen decent swings in both directions, but despite the volatility, Mena equities are now where they started the year, although some countries and sectors have fared better than others. While liquidity is down, foreign inflows are strong and we consider that it may be worth looking at sectors where the underlying fundamentals represent a solid investment case.
UAE banks may just be one of those sectors.
At the country level, in a region routinely beset by political uncertainty and widely seen as demanding a high(er) risk premium, the UAE’s unique political and federal governance structure is a strong and sustainable differentiator, as decentralised governance fosters not only competition, but also cooperation, and has translated into a high degree of efficiency in the provision of services and infrastructure.
The UAE’s rankings in the World Bank Ease of Doing Business Survey – No 1 in Mena and No 26 worldwide, ahead of many developed economies – attest to this. We also note that unlike many countries classified as emerging according to the MSCI indexes, the UAE has a strong capacity for reform.
For example, energy subsidy reforms have already been carried out and the country is in the midst of important fiscal consolidation programmes, while the introduction of VAT is planned in the near term.
UAE banks last year recorded combined profits of about US$10 billion, broadly on par with Saudi banks, but well ahead of Turkish banks and several times more than South African or Polish banks.
Our analysis of banking sector return on assets suggest that this is not a function of unsustainable returns, rather a high banking sector penetration underpinning the profitability of the industry. Some of the reasons behind this relatively high penetration over the years include political stability, the peg to the US dollar, the lack of taxes and efficient cost structures. Much of this seems sustainable over the medium term, in our opinion.
Economic headwinds brought about by lower oil prices and fiscal tightening are likely to put pressure on earnings in the short and near term. We think net income for many lenders could be flat or drop slightly year on year in 2016, as asset quality weakens marginally.
Unlike in other regional banking markets, we point out that liquidity pressures are not critical and that deposits are still growing. Further fixed asset expenditure related to Expo 2020 and Abu Dhabi Vision 2030 should underpin steady medium-term growth, and we see no major liquidity constraints for UAE banks to fund this expected growth.
UAE banks also enjoy high levels of capital, which we believe will enable them to maintain relatively steady dividend payout ratios even if profits decrease. Critically, the implementation of Basel 3 regulation, expected by 2019, should also prove easier for UAE banks than for some other economies given the high capital levels.
Similarly, a new regulation related to asset quality provisioning, known as IFRS 9 and expected by 2018, could prove less of a headwind for UAE banks than for some other regional and emerging banking markets given the high level of general provisions.
Following the announcement of a merger between FGB and NBAD, we think that the structural arguments for further consolidation are now weaker. Our studies indicate that in a sample of a dozen emerging and developed economies, the top four UAE banks had an average market share of loans of 53 per cent last year. Post merger, these banks will have a combined 56 per cent market share domestically. One area, however, where the structural rational for more consolidation remains sound is Islamic banking.
There is much to consider in the coming months. US elections are imminent, the oil price continues to fluctuate along with the direction of other major commodities. Monetary policies worldwide are also at risk of diverging further, impacting global currencies and the emerging markets dynamic. Safety in a sound sector, like UAE banks, may just warrant consideration in this uncertain world.