What does Fed stand mean for Capital markets and the GCC?

During the past three months, investors were pricing in the first interest rate rise in almost a decade, although the expectations were scaled back in the month of August due to extreme global market volatility on the back of slowing growth in China. In the Federal Open Market Committee’s (FOMC) two-day meeting in September, the fed decided to keep the interest rates unchanged as volatility in financial markets and a slowdown in global economy is likely to restrain economic activity and put further downward pressure on inflation. One thing was clear from the meeting that both the initiation and the pace of tightening will depend on global growth and financial market stability, a new variable for the Fed’s decision, which the Fed has limited power to influence and probably even less to forecast.

In June 2015, the Fed’s decision to keep the interest rate unchanged was not perceived as constructive for the capital markets as the tone suggested that economic momentum has improved after a weak first quarter but policymakers would want to see firmer evidence of strengthened recovery before normalising the rates. Moreover, domestic factors such as employment and inflation were edging closer to the Fed’s target and therefore, the decision was largely centred on global factors, which could slowdown domestic economic activity going forward. Given that investors were anticipating an interest rate rise to restore confidence amid global market volatility, the status quo was perceived more destructive rather than constructive by the markets as this added to the scepticism in turbulent financial markets and a possibility that the Fed is not likely to raise interest rates any time soon. Clearly, investors do not like uncertainty and fear — factors that were largely transpired from the Fed’s statement. This means increased volatility in the short term and more cautious to negative outlook for the capital markets in the long term.

Sigh of relief

For the GCC, the Fed’s decision to hold the process of normalisation is positive in the short term but negative in the long term as they have only delayed the process of lift off but not cancelled it. The GCC governments might have taken a sigh of relief on the Fed’s decision because a lift off at this stage would have led to an array of problems for the region that is already rattling through slower growth due to lower oil prices. Firstly, the GCC would be compelled to follow the rise in Fed rates due to the US dollar peg that the GCC has been following for decades. Secondly, it would have increased the borrowing cost for governments, especially Saudi Arabia, to fund their budget deficits and corporates that have borrowed large amount of debts in US dollar. Lastly, the rise in rates would make the US even more of a preferred destination for investors than it already is, boosting capital outflows from EMs and further strengthening the US dollar.

The GCC equity markets will take the Fed’s decision as positive in the short term as it will enable them to focus on realigning their existing portfolios and reduce volatility during an uncertain environment. Asset and portfolio managers will focus on sectors and stocks that are fundamentally strong and driven by domestic factors rather than global factors. In the short term, valuations will catch up with fundamentals and smart money will chase companies with sound business models, healthy balance sheets and low gearing ratios that have been battered due to the ongoing sell-off in the global markets. In the long term, the outlook for equity markets is likely to be negative as the Fed will normalise rates sooner or later, which will be challenging for the region as they are already adjusting to lower oil prices and stretched budgets and given the region’s peg to the US dollar, it will be obligated to follow suit. Accordingly, raising of benchmark rates will be detrimental to the overall growth of the region, especially the non-oil sector which has become an engine of growth.

The bond markets will continue to remain under pressure in the short term and long term. Additionally, corporates might opt for local funding from banks rather than raising from the debt markets. US dollar denominated bonds would increase the cost of funding for issuing parties immediately after the Fed starts the normalisation (likely in the next three to six months), while the cost of funding in the local markets (banks and other financial institutions in local currency) would mirror the benchmark rates in domestic markets, which normally has a lag period. The GCC regulators may also consider not following the Fed’s normalisation process as the GDP growth dynamics in the GCC are very different from the US.

Private Equity activity

The real estate sector is likely to remain stable in the short term, however it would continue to face selling pressure from foreign investors. The stronger dollar will continue to benefit foreign investors who would like to sell and capitalise on the currency differential in their respective countries as the GCC is mostly pegged to the dollar. In the long term, real estate is likely to remain under pressure as liquidity is likely to dry up and the cost of capital may rise going forward. Private Equity activity is expected to remain lacklustre as investors will be cautious due to an uncertain environment. Additionally, valuations are expected to drop as the cost of capital rises in the long term.

In conclusion, the Fed’s decision to delay the normalisation process augers well for the GCC in the short term. However, there are a number of headwinds for the region in the long term. Given the currency peg in the GCC, more than the timing of the Fed’s decision, the pace of normalisation will be critical for the region. Therefore, investors should take this window and focus on rebalancing their existing portfolios to be better prepared for a more challenging environment for the region going forward.

Shailesh Dash, Founder and CEO, Al Masah Capital Management Limited