Saudi Arabia - An important milestone

MSCI confirmed that it will be including Saudi Arabia in the MSCI Emerging Markets index. The index provider said that the decision follows the implementation of a number of regulatory and operational enhancements which effectively increased the access to international institutional investors.

The fine print

Saudi Arabian equities, on a pro forma basis, will have an approximate weight of 2.6% in the MSCI EM index with 32 securities. It will be a two-step inclusion process with the first one coinciding with the May 2019 semi-annual index review and the second one as part of the August 2019 quarterly index review.

The stocks and details of companies which will be included in the index are attached at the end of this document.

Importance

Size

Saudi Arabia, with a market capitalization of USD 524bn, is by far the largest equity market in the GCC. In fact, the market capitalization is bigger than the combined market cap of all other GCC equity markets.

Market Capitalization (USD bn)

Source: Bloomberg, Emirates NBD Research

However, when compared to other large emerging markets i.e., India and China, the market capitalization is relatively small. For reference, the market cap of Indian and Chinese equity markets stands at USD 2,185bn and USD 6,741bn respectively.

Ownership

The Tadawul is dominated by retail investors. Institutional investors own more than 87% of the total market but account for only c.30% of total trading volumes. The foreign ownership is low at 5% and when adjusted for strategic ownership, the ratio falls further to mere 2%. This is lower than foreign ownership in other GCC equity markets which are part of MSCI EM index i.e., UAE and Qatar. According to market estimates, the foreign ownership could increase to c. 8% over the medium term.

Flows

In anticipation of this decision, the stock market has seen sustained inflows from foreign investors in 2018. The total year to date inflows from foreign institutional investors stands at USD 3.4bn. This translates into roughly 8% of total inflows seen into broad emerging market equity funds so far into 2018.

Tadawul - Foreign investors inflow, net (SAR mn)

Source: Tadawul, Emirates NBD Research

The inclusion of Saudi equities into the MSCI EM index could trigger passive inflows of c. USD 10bn. To put that into context, the average daily value traded on the Tadawul in 2018 in first five months of 2018 is USD 1.1bn. It is also worth highlighting that as of June 2017, nearly USD 1.7 trillion of assets / funds tracked the MSCI EM index. This included USD 1.3 trillion of active funds and USD 0.4 trillion of passive funds

Performance & Valuations

The Tadawul is the best performing market within the GCC universe with ytd returns of +13.0%. This is relative to +8.0% ytd gain in the S&P Pan Arab Composite index and -5.6% ytd decline in the MSCI EM index.

The market is currently trading at 15x 2018E earnings and 13.5x 2019E earnings. This implies a 12% (2018) discount to 5 year average PE multiple of 17x. However, it is trading at a premium to the broader MSCI EM index which is trading at a 2018E PE multiple of 11.8x and 2019E PE multiple of 10.8x. The trailing dividend yield for the Tadawul is 3.7% compared to 2.9% for the MSCI EM index.

From a historical perspective, the UAE and Qatar were trading at 14.2x and 11.4x PE multiples when they were included in the MSCI EM index. The broader EM index at the time was trading at 10.3x PE multiple. It is also worth highlighting that UAE and Qatar equity markets rallied +68% and +48% in the interim period of decision and implementation.

The macro picture

The inclusion of Saudi Arabia in the MSCI EM index marks the culmination of a series of measures over the last few years to open up financial markets for foreign investors.  The desire to attract inward investment intensified after the sharp decline in oil prices from 2014 – 2017, which focused greater attention on the need to diversify the Kingdom’s economy away from oil, and boost non-oil sector growth.  Opening up financial markets for foreign portfolio investment is part of a broader plan to attract funding for economic diversification efforts.  Other steps include the creation of the Public Investment Fund and a program to privatise some state-owned enterprises across several sectors of the economy. 

We expect Saudi Arabia’s economy to return to growth, albeit modest, this year following a recession in 2017.  The -0.7% decline in GDP last year was entirely due to the cuts in oil production following the November 2016 OPEC agreement; Saudi Arabia had reduced output by more than required under the agreement which weighed on headline growth.  The non-oil sector expanded by 1.0% last year, according to preliminary estimates.  We expect both oil and non-oil sector growth to rebound this year, by 0.5% and 2.3% respectively.  While households have been faced with higher taxes and cuts to energy and utilities subsidies, the government has provided a cash stipend to the lowest income households, as well as reinstated public sector bonuses to help mitigate some of the impact of the higher living costs on consumers.  Overall, central government spending is expected to rise by around 13% this year.

The big picture

The benefits of increased inflows from foreign institutional investors is obvious. However, the intangible benefits of attracting newer set of sophisticated investors should result in improved standards of financial disclosures and corporate governance. It is also possible that there will be a positive impact of Saudi Arabia’s inclusion on the broader region given the increased weightage of the overall region in the broader EM index. 

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