Riyadh: The stimulus-driven "everything rally" has sidestepped Saudi Arabian stocks.
The world's seventh-biggest equity market is underperforming its emerging-market peers by a factor of one to seven as investors fret over the kingdom's growth outlook. They're betting the government's tax increases and cuts to worker allowances will crimp consumer demand and cause the deepest recession since 1987.
A year since Saudi Arabia's upgrade to an emerging market in MSCI Inc.'s indexes, the coronavirus and crude-market turmoil are forcing a painful fiscal adjustment. That's threatening corporate earnings and the nation's investment case.
"Weaker consumption and private capex, and fiscal austerity, render the profit outlook bleak," said Tarek Fadlallah, CEO of the Middle East unit of Nomura Asset Management. "Economic recovery will be more difficult as output is lost from firms that will shutter over the coming months and as government revenues remain under strain."
Fast adjustments needed
"The kingdom has to adjust more rapidly to the new low oil price," said Sabrina Khanniche, a senior economist at Pictet Asset Management in Geneva. "The fiscal deficit could therefore remain large despite the fiscal consolidation."
Saudi Arabia's choice to pursue fiscal stability means it has less space for economic stimulus - despite enjoying low public debt and ample foreign-exchange reserves.
The IMF predicts a 6.8 per cent contraction this year. The Tadawul All Share Index had added 1.8 per cent since the end of May, compared with a 12 per cent jump for the MSCI Emerging Markets Index. The Saudi gauge is still down 12 per cent for the year, more than double the losses in the broader measure. It was little changed Thursday.
Analysts are cutting earnings estimates for Tadawul members even as they resume upgrades for other emerging markets. The Saudi gauge's average profit projection fell to a record low last last month and has failed to bounce back: it's still stuck 35 per cent below its lifetime average.
That means Saudi stocks are getting increasingly expensive. While they have historically traded at a valuation premium to peers in the developing world, the gap has widened, reaching a peak at the end of May. Any further turmoil in crude prices, and investors may demand a lower valuation for the shares.
Check out the bonds
Even investors who are bullish on Saudi Arabia may be better off investing in the government's dollar bonds, which are witnessing one of the best rallies in the Middle East.
The extra return offered by Saudi stocks to get investors to own them rather than the nation's sovereign dollar bonds has been narrowing. The spread between the equity earnings yield (profits as a percentage of stock prices) and the yield on the 2046 dollar bond has fallen to 1.6 percentage points, compared with 4.3 points earlier this year. This is near the lowest relative return since 2016, leaving investors with little incentive to buy stocks.
In the longer term, Saudi Arabia will have to reduce its dependence on oil. For now, it would help if crude prices recovered to the break-even level.
"It is all about assumptions on the crude price upside from here," said Slava Breusov, a New York-based senior analyst at AllianceBernstein, which manages about $542 billion. "Earnings growth of Saudi companies won't be sufficient to justify their current valuation premium in the absence of supporting index-related flows."