Saudi Arabia: Emerging market tag on the horizon

Saudi Arabia will have to wait a little longer to earn its first emerging market tag after FTSE Russell refrained from classifying the country as such in its annual review last week, according to Bassel Khatoun, chief investment officer of Middle East North Africa equities at Franklin Templeton Investments in Dubai, who was speaking to Bloomberg.

Signalling the kingdom will meet requirements for inclusion from early 2018, when enhancements to its Independent Custody Model are expected to be introduced, the index provider congratulated the country on “the pace of recent market reforms” in a statement on Friday. Neighbour Kuwait was awarded the status of secondary emerging market, classification likely to generate as much as $600 million of inflows to the smaller Gulf state, said Khatoun.

The money manager expects Saudi Arabia to earn the classification by FTSE and MSCI Inc. next year. Below is an outline of his position, shared in answers to five questions on the topic:

1. How do you view FTSE’s decision?

By March this year, Kuwait had already substantially met all nine criteria required by FTSE for inclusion into the secondary emerging markets index. Saudi’s case is more complex and, whilst we had expected inclusion during this assessment, we were aware of the possibility of a FTSE delay in order to allow time to introduce further enhancements to the Independent Custody Model.

The market’s expectation going into this assessment was mixed and, year to date, the Saudi market had only gained 1 percent prior to FTSE’s decision. Any weakness in the market will likely be short-lived given the clear anticipation of inclusion in early next year. Overall, this is another important milestone and a positive step towards the region’s transition into mainstream emerging market investment.

Despite not being included this time, FTSE will, in fact, proceed with the launch of stand-alone Saudi Arabia country indices and global and regional Saudi Arabia inclusion indices to assist domestic and international investors who wish to seek early index-based exposure to the market. In many ways, this reads like a deferred offer for inclusion, assuming Saudi delivers on the promised enhancements to its custody model.

2. How much capital is at stake?

An estimated total assets under management of $115 billion, largely passive, are benchmarked against FTSE EM indices, and Kuwait’s share of the index is likely to be close to 0.5 percent, resulting in flows of $600 million. If eventually included, Saudi Arabia could constitute about 2.5 percent of FTSE’s secondary emerging index, resulting in passive fund flow of about $3 billion. However, with the privatization of Saudi Arabian Oil Co., Saudi Arabia’s weight in the index may increase to about 5 percent over time.

3. What are your preferred sectors in each market?

We are targeting companies operating in sectors with high structural growth as well as supportive government policy — insurance, healthcare, education and logistics all fall into this category as do certain consumer staples. We have a clear preference for domestically driven stories that will be transformed positively by government policy to unlock their potential. We are less optimistic on export-led companies or those companies whose profits have relied heavily on government subsidies in the past.

Both countries are also home to a young and growing population whose living standards and consumption needs are evolving. Very low product penetration in areas like insurance, healthcare and education result in higher margins compared with other emerging markets. These sectors have demonstrated a degree of demand resilience across cycles and we feel that current market valuations discount long-term growth potential.

In Saudi Arabia in particular, we are also optimistic about growth prospects for the banking sector, where margin compression has subsided, with significant upside potential from a rising interest rate environment as a result of a large share of non-interest bearing deposits.

4. Is MSCI inclusion still on the way for Saudi Arabia?

Even though Saudi Arabia was not included in the FTSE for this round, this has no impact on its potential to be included in the MSCI as the MSCI inclusion process is entirely independent of the FTSE decision. Nomination onto the watch list (in June) is no guarantee for an MSCI EM inclusion. However, a June 2018 MSCI inclusion announcement remains our base case scenario, and we think there is a strong chance Saudi Arabia will also meet the requirements for FTSE secondary emerging market inclusion in early 2018. Saudi’s upgrade will be determined by how well the QFI framework and operating models are functioning. Investor feedback, so far, has been positive.

5. What does that mean for markets in the region?

Overall, if Saudi is included in both the FTSE and MSCI EM indices by the end of 2018 this would be a key milestone for the region’s capital markets. Inclusion in the MSCI EM, for example, would be a transformative catalyst, not just for Saudi Arabia’s stock market, but for exchanges throughout the entire region helping eliminate what we have always viewed as a material disconnect between the GDP contribution of this region and its representation in MSCI EM. We believe that the transition of the region from the peripheries into the mainstream of emerging market investment provides investors with an additional incentive to be invested in MENA. The regional opportunity remains in its infancy and we remain very excited by upcoming capital market developments.

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