Impact On GCC Most Pronounced In Banking And Petchem Sectors;All Indices Plunge As Mkts Open After Weekend

Posted: August 11, 2011 in GCC, Iraqi Dinar/Politics, US Economy
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KUWAIT CITY, Aug 10: Previously what was thought unthinkable happened. On 5 August 11 evening, Standard & Poor’s lowered the U.S. long-term rating by one level to AA+, while keeping the outlook at “negative” as the agency becomes less confident that Congress will end Bush-era tax cuts or tackle entitlements. S&P also said the U.S. rating may be reduced to AA within two years if spending reductions are lower than agreed to, interest rates rise or “new fiscal pressures” result in higher general government debt.

GCC & World Indices – Day 1 Impact
All the GCC indices retreated as the markets opened after their respective weekend. While TASI had a 5.5% fall on Saturday, a similar story was repeated for other GCC indices on Sunday when they opened with DFMGI falling by 3.7%, ADSMI and DSM falling by 2.5% each, Oman 1.9%, Kuwait 1.6% and Bahrain 0.3%. Ditto was the case with Asia, Europe and US markets when they opened on Monday.

The S&P GSCI index of 24 commodities dropped 0.7%. Oil (WTI) declined as much as USD5.60, or 6.9%, to USD81.31 a barrel, the lowest price since 23 Nov 10. Gold jumped as much as 3.3% to a record USD1,719.53 an ounce (USD1753.55 as of 10 Aug 11) while the VIX, as the Chicago Board Options Exchange Volatility Index is known, advanced to its highest level of 48 since March 2009.

Is that the only reason?
The world economy remains in doldrums. First it was GDP for the U.S. economy growing at an annualized rate of less than 1% in the first half of the year while Europe battling its own debt crisis. It was followed by the global Purchasing Manufacturing Index (PMI) displaying poor numbers. The PMI in July fell to its lowest level in the last two years. The factors that have conspired together to stall output growth are supply chain problems on account of Japanese tsunami, high commodity prices and austerity measures squeezing household incomes. To make things worse, other indices of economic growth and employment growth has contracted as well. This douses any hope of a pickup in the near term. What is worrying is that even major Asian economies like China and India are a part of the downturn.

What could be the impact on oil prices?
The prices of all benchmark oil prices have witnessed massive decline, where WTI registered a largest decline of 14.3% followed by 11.1% decline in UK Brent and a decline of 9.9% in OPEC prices, during 1 Aug 11 – 8 Aug 11. We believe, at present, the decline in benchmark crude oil prices is mainly associated with the negative sentiments and fear of recession in the U.S. economy. While we already expected a downward trend in the average prices of benchmark crude oil in 3Q11, we believe WTI may remain in the range of USD90/bbl – USD95/bbl for 3Q11 and stay stable QoQ in the last quarter. On half yearly basis, we believe the average price of WTI benchmark crude oil in 2H11 wi ll remain in the range of USD90/bbl – USD95/bbl as compared to the average prices of USD98.2/bbl recorded in 1H11. We, therefore, expect the average prices of WTI crude oil will remain in the range of USD92bbl to USD97/bbl in 2011.

Furthermore, we cannot rule out the possibility of a recession in the US and further economic turmoil in European Union, which will have impact on the crude oil prices. However, we are not anticipating the average prices of benchmark oil to touch levels seen in 2008. We see the average prices of WTI crude oil to remain in the range of USD70/bbl to USD75/bbl in 2011. The average prices of other benchmark crude oil in 2011 i.e. UK Brent and OPEC may drop a further 20%-25% below our current expectations in case the US enters recession. While the average prices of WTI, UK Brent and OPEC could be lower by 10%-15% against our current expected price range for 2012. Despite this, as long as oil prices remain above USD70/bbl, GCC countries are likely to remain in comfortable position and would be able to maintain their fiscal spending.

What could happen to U.S. treasury yields and why?
U.S. treasury yields may increase as an impact of a ratings downgrade with selling pressure from investors leading to a decline in prices and consequently an increase in yields. This goes for currently traded securities. Moreover, with the recent economic turmoil in the U.S., also signified by a ratings cut, bidders will expect to be paid a higher yield for new treasury issues (U.S. plans to float USD2.4tr of which). Currently trading issues will of course also have a profound effect in shaping bidder-expectations, leading to an eventual increase in yields.

While this seems to be the most likely scenario, there are other factors in play which could actually lead to a decline in yields. With a crazy jump in stock volatility, investors are likely to exit their stock positions and park liquidity in the safest, most liquid investment available i.e. stills the U.S. Treasury. While European bonds (or rather bonds in any other geographical region) never had the capacity to absorb liquidity, like U.S. treasury securities do, current economic conditions in the Euro-zone have also not offered any ray of hope. Investors are likely to choose U.S. bills and bonds over any other counterpart. Demand for these securities may therefore lead to a rise in prices and a drop in yields.
In the third scenario, if the desperation of the U.S. to raise debt matches the desperation of investors in finding a safe haven, we could just see the yields stagnant at current levels. It will be interesting to see how the FED, as per its recent remarks, keeps interest rates unchanged until mid-2013. With a dire need to raise debt from investors who would now require higher yields will be a challenge that the U.S. will need to overcome. The other option of course is printing more money, but that is a totally separate issue with its own set of problems.

What happens to GCC stocks if U.S. yields change?
Since the cost of equity/WACC for our valuation models is derived from U.S. treasury yields, any change in it is bound to have an impact on our valuations. Now, these yields can take any direction: increase, decrease or remain unchanged, as explained earlier. If U.S. treasury yields increase, we will be prompted to increase our cost of equity/WACC figures leading to a decline in fair values for stocks under our coverage. In the other 2 scenarios, albeit U.S. treasury yields will have a favorable (or no) impact on cost of equity/WACC, we believe that market volatility and conditions on ground truly justify an increase in the risk premium, thereby leading to a rise in COE/WACC.

What could be the other impact of rising yields?
The rise in sovereign yields will push up interest rates in the overall economy. The consumer credit outstanding in the U.S. currently stands at around USD2.43 trillion, or USD22,000 per household. Higher interest rates mean higher EMIs (equated monthly installments) and thus lower money to spend on other things. This will slow down the U.S. economy even further. It will also slow down other economies like China, which make a major portion of their money by exporting things to the U.S.

So what will be the impact on the GCC stock markets?
World markets, especially the emerging markets have grown increasingly correlated with the developed markets. The GCC region fares no differently with ripples emanating from events in the international arena reaching them. As was observed from the financials crisis in end 2008 and then time again to date, regional financial markets react strongly to any negative news in Europe and the U.S. It is no wonder that regional markets have reacted in the manner that they did, taking strong cues and sometimes anticipating market pressure in the West. While economic linkages explain it largely, one aspect of investor behavior i.e. herd-mentality has become increasingly important as another major factor. Local investors have become overly jittery over global issues and tend to set off panic selling if any adverse news from that corner of world is heard. Therefore, it is prudent to observe that as long as international markets do not rationalize, it will be difficult to expect local markets to do the same, no matter how attractive valuations become.

Impacted Sectors – Who gets hit and why?
The impact of the events described earlier should be most pronounced on regional banking and petrochemical sectors. GCC interest rates follow that of the US, the currency peg being the main reason for that. Since Bloomberg consensus estimates earlier had hinted at an increasing trend in US LIBOR rates starting end 2011, analysts had incorporated a rise in local interest rates into financial models albeit with a 3 – 4 quarter delay. With the latest statement from the FED, we believe that any positivity arising from this will need to be delayed for at least another year which will lead to a reduction in top-line and bottom-line estimates over the projection period. As for the petrochemical sector, the decline in IEA estimates for oil demand will simply put sector profits under pressure especially since some of the companies had undergone capacity enhancements eyeing growing demand. The impact on the operations of these two sectors may effectively lead analysts to revise their fair values for the stocks, in expectation and in consequence of which banking and petrochemical stocks may remain under pressure.

To peg or not to peg?
The recent action by S&P has negatively affected the USD. The dollar is getting pushed further down by the day. Dollar declined by 20.4% YTD against CHF and by 3.1% since S&P downgrade. GCC currencies with the exception of Kuwait are fully exposed to this risk given the peg to the dollar. Although the Kuwaiti Dinar is the only currency in the GCC linked to a basket of international currencies it is believed to be heavily weighted towards dollars, placing it more or less in the same position as the currency of other GCC countries’.

Despite the downgrade and its obvious effect on the dollar and its potential risk to GCC currencies, UAE and Bahrain already announced that they will maintain the dollar peg. Those countries are of the opinion that current fluctuations in the USD are normal due to the circumstances and do not indicate the beginning of the dollar collapse.

What will be the impact on inflation?
GCC countries are heavily reliant on imports and the weakness in the USD will potentially aggravate GCC inflation by pushing up cost of importing goods to the region. GCC will not only be exposed to its currency dropping against other currencies it will also be exposed to cost push inflation as well. The downgrade will undoubtedly increase pressure to de-peg the GCC currencies so as to contain inflationary pressures in the region however it a difficult decision to be made and one which involves other important factors that need consideration.

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