Jun 17 2013
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A whole new world: UAE and Qatar upgraded to EM status
In the short term, we see upside capped by valuations. We remain neutral on the UAE and would use strength to lock in profits, particularly in small and mid cap names. We remain overweight in Qatar as its growth justifies a higher valuation premium, in our view.
MSCI makes numerous changes to its indices
MSCI surprised markets by announcing that the UAE and Qatar would be upgraded to emerging market (EM) status, effective May 2014. More widely expected was Morocco's downgrade to frontier market status (see Research Monthly Middle East, June 2013) effective November 2013.
We remain neutral on the UAE and would use strength to take profits
We recently downgraded UAE to neutral from overweight, in part due to the 45% rally year-to-date, which left it trading at a rich premium to the MSCI EM - the current euphoria has pushed this premium to 36% (see Figure 1). We maintain our neutral stance in light of the UAE's upgrade for two reasons:
First, EM investors are already heavily invested in the UAE market, particularly Dubai. As a result, we believe Western institutions are likely to use prevailing strength as an opportunity to take profits. Second, the holy month of Ramadan is approaching, which has traditionally led to a lull in trading activity and pre-emptive profit-taking. We believe a similar trend is likely to emerge this year.
On a bottom-up basis, we see greater downside risk for small and mid cap names than large caps in the face of a market consolidation. This segment has seen the sharpest increase in speculative activity over the past 2-3 months and most of the stocks in it are ineligible for entry into the MSCI index. We also note that Abu Dhabi is trading at cheaper levels than Dubai and has materially lower foreign investor interest. As a result, it should see less of a consolidation relative to Dubai.
Qatar's performance has lagged behind that of the UAE (+12% YTD) and it has less foreign investor penetration than Dubai. Qatar is currently trading at a 10% premium to EM, but we believe its strong earnings growth and high dividend yield (4.8%) justify a premium of as much as 20%-25%. We therefore expect to see performance catch up in the short term.
UAE and Qatar's allocations could be sizeable over 12-24 months
MSCI estimates that Qatar would account for 0.45% and the UAE 0.40% of the EM index. In our view, however, both markets are likely to see a significant improvement in trading volumes and stand to outperform the benchmark EM index. In May 2014, therefore, we believe nearly all the stocks in the index stand a good chance of being upgraded to EM status.
Should that happen, we estimate that both markets would have a combined weight of 1.3% in MSCI EM (UAE 0.6%, Qatar 0.7%); and a combined weight of 6.8% in the emerging EMEA index (UAE 3.3%, Qatar 3.6%).
According to EPFR data, global emerging market funds have assets under management (AUMs) of USD 450 bn (28% of which are passive ETFs) and emerging EMEA funds have AUMs of USD 45 bn (37% of which are passive ETFs).
On the face of it, this would suggest a re-allocation of a sizeable USD 4.6 bn into Qatar and USD 4.0 bn into the UAE as a result of the upgrade, in a best case scenario. The actual amount would differ though, since active funds could choose to go over- or underweight, and passive funds could choose to omit exposure to both markets as their weights are below the permissible tracking error for most ETFs. In addition, the EPFR's data is a sample representation and does not include, for example, event-driven funds and hedge funds that could seek arbitrage opportunities.
Since the upgrade is not effective for another 12 months, we would expect western institutions to seek better entry opportunities in the UAE (which we believe will occur over the coming summer), but to build up exposure in Qatar given relatively attractive valuations.
Paradigm shift on a long-term view
On a five-year horizon, we would expect the impact of this upgrade to be exponential in scale. It is instructive to compare Egypt's experience of being upgraded to EM status back in May 2001 and important to keep in mind that Egypt's experience was amplified by its almost complete lack of foreign investor interest at the time of its upgrade and poor local economic conditions, with the central bank defending an overvalued currency.
The immediate impact was negligible, but, over the 2002-2007 period, the MSCI Egypt index rallied by over 2000% (see Figure 2). Value traded increased from USD 1.5 m monthly to USD 2,500 m over the same period. While Egypt at its peak accounted for less than 1% of the MSCI EM index, GEM funds were in aggregate allocating over 2% of their portfolios to the market.
Over time, we would expect a comparable transformation for the UAE and Qatar. Increased fund inflows from new international investors should act as a strong pull factor, encouraging increased participation from local investors. As valuation multiples increase and liquidity is sustained at elevated levels, companies will be encouraged to conduct IPOs. Both the UAE and Qatar have indicated their intentions to list large cap government-related enterprises, which we believe is now very likely in the coming few years. In turn, new listings attract more trading activity, and so on.
The main long-term downside risk to inclusion is the likelihood of increased correlation with the EM index. Up until now, one of the key characteristics that the UAE and Qatar (along with the rest of MENA) have offered has been a substantial diversification benefit. Over time, we would expect this benefit to diminish relative to current levels, but not be eliminated entirely.
Morocco should benefit from its downgrade
As we highlighted in our previous research, Morocco's downgrade was expected and is likely to be supportive for the market as it moves from being a negligible 0.1% of the EM index to a more meaningful 3.4% of the frontier market (FM) index (this assumes that Maroc Telecom is acquired and de-listed by year-end; including Maroc, Morocco's weight would be 6.7%.)
Moreover, EM funds have a near zero allocation to Morocco (according to EPFR data), which suggests negligible outflows as a result of this downgrade. But its more meaningful weight in the frontier market index should attract both passive and active flows, particularly since recent underperformance has brought Morocco's valuations below the MSCI FM (see Figure 3). We do not have Morocco under coverage, but would expect a re-rating until its inclusion date in November 2013.
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