Before we look toward the new year and what it may bring, perhaps it is worth taking some time to look back on 2021 and the things that were top of mind for us then. As American poet and activist Maya Angelou once said, “you can’t really know where you are going until you can see where you have been.”
Coming into 2021, we were worried that interest rates were too low, and perhaps markets were underestimating growth expectations. We were confident growth and oil prices would be supportive for Gulf Cooperation Council (GCC)1 credit spreads, and we were outright bullish on structural reform. We were concerned with valuations—already rich in some sectors—and did see this as possibly leading to heightened volatility. Lastly, and obviously, we cited the virus as an ongoing risk, though we viewed its impact as diminishing.
So where did we land? As we look at the state of the world today, growth delivered in spades, but it was more uneven than predicted. Some emerging markets underperformed, perhaps the result of policy missteps (such as China or Turkey), or a delay in vaccination rollout. Risk assets performed well, and while valuations are still full, we see dispersion across and within markets, potentially creating some opportunity. Interest rates ended marginally higher, which is surprising given the growth in the United States, higher inflation prints and the Federal Reserve’s (Fed’s) pivot on monetary policy.
Structural reform in the GCC continues to surprise to the upside, with the most recent announcements around the UAE’s 50th anniversary particularly encouraging. The rebound in oil prices certainly helped a lot, with meaningful improvements to budgets, current accounts and sovereign bond issuance.
The key global risks we think investment managers must contend with are:
- Omicron, and potential for serious slowdown
- Fed policy, and potential for error
- Supply-chain issues and inflation expectations
- Valuations
The key transmission channels to our markets are through interest rates, oil prices and tourism receipts.
Our views and positioning are conservative, but not necessarily consensus.
On COVID-19, we continue to think—despite the latest Omicron surge—economies will continue to open and acclimate to evolving health protocols. Vaccinations and boosters should help keep hospitalization and deaths low. In addition, this latest strain, while apparently much more contagious, is also reportedly less virulent. In this way, it may provide added immunity against future strains while also limiting economic impact. We think demand for oil will remain, as will demand for products and services.
Still, the risk of a more threatening new mutation cannot be excluded, so we believe any strategy must accommodate potential increases in volatility and the need for liquidity (such as maintaining higher cash balances).
Interest rates and inflation are also less certain and carry much more risk for fixed income investors. While a gradual, tempered adjustment in interest rates that accommodates current valuations and softly moderates growth and inflation is possible, it is a big ask.
We see real rates in the United States today at -1.1% and close to a five-year low, inconsistent with the strength of growth and inflation. Even with Omicron clouding short-term forecasts, an adjustment in real rates seems probable.
Mathematically, the adjustment may come from higher nominal rates, or lower inflation expectations, or both. Time of course will tell, but in the short term, nominal rates look vulnerable, while over the next few quarters, new inflation data could change expectations significantly. Improvements in supply chains, a pickup in capital expenditures and easing of commodity price pressure should be supportive.
Given the significant risks volatility and interest rates present, in our view, a thoughtful hedging strategy, focused on real rates and duration exposure, is warranted.
With respect to valuations, we are fairly constructive, and on a relative basis, bullish. Spreads for GCC credit, on average, are at the low end of historical norms and warrant caution, but these averages, like stock valuations, are skewed by very high-quality issuers and mask quite a bit of dispersion between rating categories, sectors and countries. As such, we see opportunities for investment.
With oil prices comfortably above US$70 per barrel, oil producers see immediate benefits to their budget and export revenues. For many countries, this also often translates to increased government investments and improved growth outlooks.
We believe the GCC region is particularly well placed because it is still a high-quality emerging market, its bonds are denominated in US dollars, and strength in oil prices may serve to insulate it from inflationary risks. In our view, the GCC is among the best emerging markets to shield portfolios from currency volatility or the threat of rising inflation. When combining these structural characteristics with an impressive reform agenda that is tackling economic, social and environmental challenges at a rapid pace, we believe the relative performance of GCC assets should be material.
The GCC market has grown considerably over the past few years, and our outlook is for this growth to continue. US$120 billion in issuance and 20%-30% of emerging market sovereign dollar issuance is certainly possible. There will likely be some decline in sovereign issuance with improved budgets, but healthier growth and massive renewable energy targets should fuel additional corporate and energy issuance.
While we are cautious near term in 2022, we are constructive on our outlook as the year progresses, and outright bullish for GCC bonds long term—particularly relative to other fixed income sectors and asset classes. Setting aside the potential risks associated with interest rate volatility and inflation, assuming it is possible to hedge against the worst outcomes, regional economic forecasts are strong in absolute and relative terms, and policy and structural reforms are very supportive of these markets.
Geopolitics is the significant risk to this forecast. Despite meaningful de-escalation in tensions over the past 18 months, from normalizing ties with Israel, ending the Qatari embargo, and restarting negotiations with Iran, the risk of a setback remains. Theatres in Yemen or Lebanon, or shipping route disruptions, could pull regional and global superpowers back into the region, even if reluctantly. However, we are cautiously optimistic the region will continue to trend toward constancy.
What Are the Risks?
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1. The Gulf Cooperation Council is a regional, intergovernmental political and economic union with member countries Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates.
