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Jadwa Investment - Monthly Bulletin
October 2009
Paul Gamble
Debt deal boosts banks
An improving global economy, rising oil prices and stimulatory government policy provide a healthy backdrop for the Saudi economy, but the private sector has not fully benefitted from this owing to weak bank lending and a broader lack of confidence. Short-term economic prospects appear brighter as a deal between a troubled local company and its local commercial bank creditors appears to have provided a much needed boost to confidence. The TASI has responded favorably and rising share prices will have a positive effect on consumer and business sentiment. Furthermore, the agreement has removed a source of uncertainty from local banks and could encourage a revival in lending. However, the apparent exclusion of foreign creditors from the deal is a setback to restoring the willingness of foreign financial institutions to lend to the Saudi private sector.
Leading economies across the world have started growing in response to unprecedented government stimulus and growth in emerging markets is also picking up. This healthier economic outlook has helped to lift oil prices to over $80 per barrel. Within the Kingdom, government spending appears to have been very strong and interest rates remain extremely low. Despite these highly supportive conditions economic performance has been subdued this year, in part due to a lack of bank lending. Commercial bank credit to the private sector went up in only two of the eight months to August. While declines in lending for up to three consecutive months have been recorded before, the length of this weakness is exceptional.
It is clear that lending has been effected by two distinct factors. For the months following the intensification of the financial crisis in September 2008, banks were more concerned with shoring up their balance sheets and were far less inclined to lend, not only to private sector companies but also to other banks. This was reflected by the large spread between the interbank rate (the rate that banks lend to one another) and the reverse repo rate (the rate that SAMA pays commercial banks for deposits). This spread stabilized in February and all things being equal we would have expected lending to recover in the second quarter. However, it was then that problems at two local companies became public, which caused banks to adopt a very cautious attitude to lending to the private sector (see the July Monthly Bulletin).
Latest data show that bank lending to the private sector jumped in August. The 1.9 percent increase was the highest since September 2008. However, the bulk of this new lending was for an individual project (the Rabigh independent power project) so we do not think the gain suggests a more generalized improvement in lending.
While total outstanding lending to the private sector is up by only SR8 billion over the first eight months of this year, deposits have grown by SR53 billion (new government deposits account for SR43 billion of this total). As a result, the loan-to-deposit ratio has been around 80 in the past few months, compared with over 90 in September 2008. Banks currently have SR67 billion in non-statutory deposits at SAMA earning just 0.25 percent and have built up their net foreign assets by SR48 billion so far this year. With this liquidity available, the lack of recent lending reflects banks being unwilling rather than unable to lend.
We think that the recent debt deal is likely to make banks more inclined to lend. No details of the deal have been released publically. All that is known for certain is that around the same time as reports of the agreement emerged, stock exchange data reveal that the owner of the troubled company cut his stake in local bank Samba from 7.8 percent to below 5 percent (the level at which individual holding have to be disclosed). The same day, the Public Pension Agency raised its stake in Samba by 2.6 percentage points.
The deal had a positive impact on stock market perceptions of the health of the banking sector. Banking shares jumped by 7.9 percent the first day the market was open after rumors of the deal emerged (September 26) and the banking sector has outperformed the market by 3 percentage points from that date. The TASI as a whole has outperformed both global emerging and developed markets over the same period, after many months of underperformance (the TASI’s 9.5 percent gain compares to a rise of 3.4 percent for the US S&P 500 and 6.6 percent for the MSCI emerging markets index).
This positive sentiment has been reinforced by the generally encouraging results reported by the banks for the third quarter. Profits rose in comparison with the third quarter of last year for six of the nine banks that have reported despite a rise in provisions. Only Saudi Hollandi Bank and Sabb recorded double-digit declines in profits. With many consumers and private sector business heavily invested in the stock market and retail investors dominating activity, rising share prices should lift confidence and encourage greater spending and investment.
While we think that a modest turnaround in domestic bank lending may now occur, lending from foreign banks is likely to remain constrained. Foreign banks became more risk averse after the financial crisis and have generally cut back their positions throughout the region. Many were unsettled by the high-profile troubles at two local businesses and were apparently excluded from the debt deal. Foreign bank credit is essential as local banks do not have large enough balance sheets to finance the vast amount of projects planned and underway in the Kingdom. There is a clear differentiation in credit markets now, with some top tier names still having fairly easy access to lending. For example, Aramco and French oil company Total recently had more than 30 expressions of interest from banks for the financing of a $12.8 billion refinery.
In brief: Economy
Food prices jumped in August in line with their usual trend in the first month of Ramadan. Food prices were up by 1 percent in August compared with an annual average monthly fall of 0.4 percent in the previous seven months of the year. Over the past eight years food prices have risen more than five times faster in the first month of Ramadan than the average rise for the other months of the year. In year-on-year terms food price inflation remaind relatively subdued, also at 1 percent. Overall inflation hit a two-year low of 4.1 percent in August before picking up to 4.4 percent in September, the month that the bulk of Ramadan occurred during.
Point of sales transactions (the closest approximation to retail sales available and an important guide to the health of consumers) showed encouraging growth in August. After two successive months of decline in year-on-year terms, point of sales transaction rose by 2.2 percent in August compared to August 2008. While this is very low when compared with the first three quarters of 2008 (when year-on-year growth averaged 34 percent), we think future months will see further gains in line with rising share prices and a gradual improvement in confidence.
Import volumes through the Kingdom’s ports were down by 14.8 percent over the first eight months of the year compared with the same period of last year. Import volumes are an important indicator of economic activity in the Kingdom, as raw materials, machinery, technology and consumer goods are all mostly imported. Part of the drop in import volumes is because stocks built up during the second half of last year are being drawn down (for example, imports of construction materials are 28 percent lower). Nonetheless, the decline reaffirms our view that economic growth will be much lower than last year.
The volume of non-oil exports through the Kingdom’s ports was 2.6 percent lower over the first eight months of the year than in the first eight months of 2008. Lower exports of refined products and “other products” account for the decline. In riyal terms, non-oil exports were down by 22 percent over the first seven months of the year compared to the January to July 2008 total. The difference between the two measures is the result of lower commodity prices.
Oil market watch: Oil prices hit new high for the year
Oil prices have hit new highs for the year owing to improvements in the global economy and a weakening dollar. WTI touched $81 per barrel on October 21, its highest level for almost exactly a year and 13 percent up on the end-September figure. Oil prices are now over 75 percent above their level at the start of the year. If they remain unchanged for the reminder of the year it would be their second largest annual gain since the 1970s (only 1999 was higher).
In part, the strengthening of the oil price reflects an upturn in the global economy. Growth has resumed and emerging markets that account for the main source of oil demand growth (notably China) are performing particularly well. The International Energy Agency has raised its projection for global oil demand for 2009 over the past few months, from a low of 83.3 million barrels per day in May to 84.6 million barrels per day in October.
Opec producers were clear that the health of the global economy would determine their near-term policy direction in the communiqué that accompanied their decision to hold production quotas unchanged at their mid-September summit in Vienna. Opec is happy with oil prices at their current level though it acknowledged that setbacks to the economic recovery could lead to a sharp fall given the role that financial investors (who can quickly withdraw their money) play in determining prices.
It is notable that Opec did not call for greater discipline from its members in adhering to existing production quotas, as it has done after all of its other meetings this year. Production had been edging up across Opec without seeming to affect prices, but it fell in September for the first time in four months according to independent estimates, due to lower output from Iran. Oil production has been rising modestly in Saudi Arabia. It was unofficially estimated at 8.2 million barrels per day last month, up from 8 million barrels per day in April.
While global economic conditions have improved, there are still large inventories and the rise in prices does not appear to reflect the fundamentals. Rather, investment demand seems to be playing an important role in pushing up oil prices. Oil prices (and those of several other commodities) are benefitting from a renewed weakening of the dollar. A strong inverse relationship has developed in recent years between oil prices and the dollar, with investors buying oil (a dollar-denominated asset) to offset weakness in the value of the dollar. Although this relationship broke down during the extreme turbulence of late last year and early this year, it has reasserted itself in the last few quarters.
Movements in oil prices are also currently relatively strongly correlated with stock markets, other commodities and indicators of financial conditions, even though historically there has been no relationship. These relationships reflect continued uncertainty among investors in an environment of high liquidity and very low interest rates and some analysts have raised concerns about the potential for new asset price bubbles. WTI is on target to average near $60 per barrel this year, the annual average was last at this level in 2005, when the global economy grew by 4.5 percent.
In brief: Oil market
Crude oil stocks have declined in recent months, but remain at high levels. Data from the US put oil stocks in mid-October at 10 percent below the 19-year high they reached in May. The decline is in line with the historical pattern and reflects greater consumption during the US driving season. Nonetheless, stocks are 8.5 percent higher than their five year average for mid-October. Stocks for the whole of the OECD fell to 60.7 days of future demand at the end of August from 61.4 days one month earlier and their recent peak of 61.8 days earlier this year. They are 3.7 days (6.4 percent) higher than in August 2008.
Unlike crude, stocks of oil distillate, which is used in heating and for machinery, have continued to rise in the US. Distillate stocks are up by 25 percent so far this year and are 40 percent higher than they were in mid-October of last year owing to the weakness of industrial production in the US. There has been a modest increase in distillate demand in the past few months in line with a rebound in industrial output, but the high inventories for both distillate and crude illustrate the fragility of oil market fundamentals.
Price differentials between heavy and light crudes produced by Saudi Arabia remain around their long-term lows. This is because Saudi Arabia and other Opec producers have concentrated their production cutbacks on heavy crude, which is generally less sought after than light crude as it is more expensive to refine. However, more refineries have been configured to handle heavy crude in recent years, so lower supply has caused prices to hold up relative to other blends of crude. The chart to left shows the difference between the discount or premium over WTI that Saudi Aramco charges to clients in North America for Arab Light and Arab Heavy; the lower the value on the graph, the smaller the differential.
New data published by the US Commodity Futures Trading Commission (CFTC) gives a more detailed picture of who holds oil derivatives, which could eventually determine the influence that investors have on oil prices. Rather than a simple breakdown of commercial and non-commercial holders of futures and options contracts, the new disaggregation features swap dealers and money managers (the latter category includes hedge funds). Data for October 13 shows that producers and users were net short on oil meaning that they were anticipating price falls, while all other holders were net long. It also shows that producers and users hold 37 percent of total contracts. CFTC plans to release back data at a similar level of detail, which should give a clearer indication of positions during the exceptionally sharp rise and then fall of oil prices in recent years.
Stock market watch: TASI rally could have further to go
Improving confidence and healthy company results have lifted the TASI. The market is up by 15.1 percent since the end of August after four months of moving sideways. Over this period it missed out on a sustained rally in global emerging and developed markets and it now looks reasonably attractively valued on a global basis. We therefore think that the TASI has the potential to narrow the performance gap with other markets over the remainder of the year, though we are cautious on the scale of the possible rise given that many emerging markets appear overvalued.
The revival in the TASI began in the final few weeks of Ramadan as investors responded to rapidly rising stock markets elsewhere in the world, amid signs that the global economic outlook was improving, and higher oil prices. As we note elsewhere in this report, the debt deal between a troubled local company and its local bank creditors helped bolster the market immediately after Eid. Now, generally positive third quarter results for listed companies (profits at Sabic came in well ahead of consensus estimates and profitability improved at most of the banks) are lifting the TASI.
Despite the recent rise, the TASI has underperformed other stock markets by a significant margin. Since the middle of May, when the high-profile news of troubles at two local businesses began to emerge, the TASI has climbed by only 11 percent, compared to a gain of 22.3 percent for the US S&P500 and 36.7 percent for the MSCI emerging markets index. This divergence is particularly notable given the close correlation in moves between these markets over the previous nine months.
On a valuation basis the TASI now looks relatively attractive against these markets. It is currently trading on a price-to-earnings ratio of 17.5, on a par with the S&P 500. Given the strong potential earnings prospects for Saudi companies, we think that a better comparison is with fast growing Asian economies. China, India, Indonesia Malaysia all currently trade on higher P/Es than the TASI, which is broadly in line with the emerging market average. It is still the most expensive market in the GCC, followed by Kuwait (with a P/E of 16.2) and Dubai (14.3), but this is in line with long-term trends given the home bias of the large local investor base. Furthermore some regional markets have also been held back by uncertainties in the financial sector owing to exposures to troubled businesses.
The recent gains have taken the TASI above our end-year fair value projection of 6,200. The TASI tends to overshoot fair value and we are not concerned about the sustainability of the recent rise. Indeed, the ongoing improvement in sentiment can lift the market further over the remainder of the year. The greatest risk to the rally appears to come from a correction in global stock markets. Emerging markets have experienced large investment inflows owing to the ability of many to better withstand the recession than developed countries. The MSCI emerging markets index is more than double its low of March this year. However, the forward P/E for emerging markets is well above its five year average, a crude indication that they may be overvalued, especially as the earnings environment is still not that attractive.
Source: Jadwa Investment
For comments and queries please contact the author:
Paul Gamble
Head of Research
pgamble@jadwa.com
or:
Brad Bourland
Chief Economist
jadwaresearch@jadwa.com
Head office:
Phone +966 1 279-1111
Fax +966 1 279-1571
P.O. Box 60677, Riyadh 11555
Kingdom of Saudi Arabia
http://www.jadwa.com
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