A MENA View on the Coronavirus
Concerns over the coronavirus impact on the global economy and corporate earnings have taken financial markets by storm. Middle East North Africa (MENA) markets have also been caught up in the coronavirus crosswinds, following the lead of global markets lower. Further declines were exacerbated by a large drop in oil prices after Saudi Arabia pulled out from OPEC+ discussions and significantly increased oil production.1 We expect the virus outbreak to have a temporary, yet sharp impact to consumption and business activity over the next few months. Sectors that are most likely to be affected include retail, tourism and hospitality, which have already seen a fall in demand.
Many countries in the region have introduced strong measures similar to other countries, in order to contain the viral outbreak. These include school closures, travel bans, border closures, restrictions on religious practice, mall and restaurant closures and the cancellation of cultural events. Governments are also preparing stimulus and aid packages to support the economy. Gulf Cooperation Council (GCC) governments’ response to the COVID-19 pandemic has been swift and comprehensive. All have decisively enacted a range of measures to suppress the spread of the virus.
While the situation remains fluid as we continue to closely monitor developments, we’ve engaged with company management teams and industry channel checks, which has allowed us to draw a clearer picture of the impact of the coronavirus. We believe that most company earnings will be impacted in the first quarter and potentially the second quarter, with a likely normalization in the year’s second half and beyond. In our view, the longer-term growth potential remains strong.
Reasons to Stay Invested
In our experience, times of exceptional stress have historically provided opportunities to reallocate capital and to potentially rebalance and establish new entry points into quality names and strategies that could benefit from the eventual normalization in our markets.
We believe the current market should provide long-term opportunity for investors who stay the course or take opportunities as they arise. Consumption will come back. All countries have implemented massive fiscal stimuli directed at first containing COVID-19, but also at driving demand and consumption. Over the next few months, effective government policy will have to be directed at reducing the fear factor and providing enough economic security so that once COVID-19 is contained, people will go out and start rebuilding and consuming again. We have already seen meaningful steps being taken by MENA governments, and we expect policymakers to stay the course for the rest of the year.
This too shall pass. We believe that longer-term investors should try to look past the current crisis and not base their investment decisions solely on current events.
Our on-the-ground presence in the MENA region allows us to see the full effects of meaningful social and economic reforms that governments have implemented over the past couple of years. We’ve observed some encouraging signs these reforms have had a material impact on the overall sentiment toward regional economies. We believe we have only scratched the surface on what could be a secular shift in competitiveness and productivity.
MENA equities are also becoming increasingly prominent within the emerging market universe. With Saudi Arabia’s recent inclusion in the MSCI Emerging Markets Index and Kuwait’s inclusion slated for June 2020, in addition to several other smaller, liquidity catalysts lined up over the course of the next two years, the MENA region’s overall weight in the index could potentially increase to almost 7%.2 This would put it on par with the likes of South Africa, emerging Europe and Brazil, and should provide a continuous flow of investment from emerging market investors.
Our View on Oil Prices
As it stands, it appears that Saudi Arabia’s decision to lower selling prices after the breakdown in OPEC+ talks in Vienna has overwhelmed an already weak market that has been reeling from lower demand following the outbreak. Both sides seem to have ample financial capacity to sustain a price war for some time. Although Russia is better positioned, we believe Saudi Arabia could be using this gambit in an attempt to bring Russia back to the negotiating table.
We believe current oil prices are unsustainable for almost all market participants. While higher-cost producers like US shale clearly cannot generate profits at these levels, cheaper producers like Russia are likely to see challenges in this price environment, in our view. Saudi Arabia, while having very low production costs, also has domestic spending needs that likely require oil prices to be higher in the long term as well. Despite this, we believe there is continued room for prices to remain lower in the short term.
Our analysis suggests that the current strategy could, more likely, result in two outcomes: bring back all major participants—OPEC, Russia and the United States—to the negotiating table and agree on shared supply cuts or maintain the current price war, which would lead to further supply reductions as more producers shut down existing wells. In both cases, we do see oil prices settling back at normalized levels as we go into the latter part of the year.
Given this new competitive paradigm, we currently expect oil prices to hover around US$30 per barrel in the second and third quarter of 2020—with the caveat that if the rhetoric from OPEC becomes more aggressive, prices could test US$20 per barrel, as they did as of March 2020—before subsequently moving up toward US$50 per barrel by the end of the year, and normalizing in the US$50–US$60 per barrel price band. Here is what is driving our expectations:
- The majority of US shale producers are loss-making at US$30 per barrel, but a high percentage of these producers are hedged and will continue to produce until the hedges run out in an estimated six to nine months.
- Saudi Arabia can wage a price war for several months up to a year given its ample reserves and moderate debt-to-gross domestic product (GDP) ratio. Despite this, Saudi Arabia is limited given its high fiscal reliance on oil revenues, with its fiscal breakeven price around US$80 per barrel. Additionally, this price war comes at a time in which the government is due to launch several large-scale domestic projects, as well as having a key impetus of safeguarding its citizens from fiscal austerity.
- Longer term, we will likely see a supply response, with the higher-cost US shale producers having to shut down production. In addition, all oil wells, conventional and shale, have natural declines in production and require ongoing maintenance capital expenditures (capex) to stem such declines. When oil prices are low, the motivation to spend such capex drops. Thus, natural production decline at the wells would be expected to accelerate, similar to what we observed back in 2016, following a year of relatively low oil prices.
Beyond Saudi Arabia, the oil-exporting GCC governments will take a meaningful hit to fiscal revenues if crude prices fail to recover from these levels quickly. According to the International Monetary Fund, the fiscal breakeven oil price for the GCC countries ranges between US$45 to over US$100 per barrel.3 The large variances reflect the different risk profiles across the region: Oman and Bahrain continue to be highly vulnerable in this environment, while countries such as UAE, Qatar and Kuwait appear better equipped to absorb medium-term losses given their lower debt profiles and ample reserves.
It is worth noting that GCC economies have come around since the last oil price shock in 2014. Governments have had time to address and adjust their fiscal imbalances and ballooning spending. Noticeable reforms such as the removal of subsidies, introduction of taxation and rationalization of spending have been implemented. GCC debt levels are relatively low, and government reserves continue to be meaningful and well above global norms. We expect Saudi Arabia, supported by other GCC countries, to continue with the market’s share strategy as long as it finds it manageable to do so.
Naturally, lower oil prices and COVID-19 fears will continue to weigh on investor sentiment. While the price action is undoubtedly negative in the near term, our base case does suggest a potential silver lining in the form of higher crude production as OPEC members gain market share and oil prices normalize. As such, if lower oil prices are short lived, we expect regional balance sheets and foreign exchange positions to be meaningfully restored once prices recover.
Snapshot of Our Sector Views: Consumer and Health Care
- COVID-19 is expected to solidify market leaders’ positions given the acute challenges faced by smaller competitors.
- Social distancing and other quarantine measures have been helping accelerate digital conversion, which would benefit certain companies we favor.
- Fiscal stimulus and expansive monetary policies are expected to support demand long after the risks of COVID-19 subside.
- The region has a young and growing population of nearly 200 million people,4 with improving living standards and evolving consumption requirements.
- Attractive demographic trends are creating strong demand for private sector education and higher consumer product penetration across the region.
- Government policies are supportive of protecting discretionary middle and lower incomes for citizens in Saudi Arabia, while Egypt is witnessing a growing middle class and rising real GDP per capita.
- The rise in costs and structural change in consumer behavior (online retailing) is shifting the market toward organized players.
- There has been increasing participation of women in employment thanks to social reforms.
- We have focused on high-quality, industry leaders in the consumer space that have dominant positions and established competitive advantages.
- The GCC countries and Egypt have an undersupply of beds, so there is room for additional capacity.
- There is a high incidence of lifestyle diseases in the MENA region.
- We see potential for high margin and high return on equity versus other emerging markets, in our analysis.
- There are a number of bottom-up stories offering inorganic and organic growth potential, as well as consolidation in the industry.
- We are targeting leading players that appear well-positioned to benefit from the governments’ focus on turning around decrepit public health care services and those with a demonstrable track record of cross-cycle resilience.
We believe that global governments and central banks will not hold back with any further measures to improve liquidity and support consumption in the wake of the coronavirus. Additional fiscal stimulus is to be expected and should help counter the severe adverse effects of a prolonged pandemic. As investors, to bring more confidence we would need to see more action for companies—particularly smaller businesses—and for workers that may not get paid for many months.
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1. OPEC+ is an alliance of oil producers, including members and non-members of the Organization of the Petroleum Exporting Countries.
2. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
3. The Gulf Cooperation Council is an alliance between six Middle Eastern countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates (UAE).
4. Source: International Monetary Fund, World Economic Outlook Database, October 2019.