Saudi Arabia is far and away the best performing equity market in large emerging markets over the last year, up over 40%. And year-to-date, it is up 11%, second only to Brazil among large EM peers.
Saudi accounts for 3.7% of the MSCI EM index – the 6th largest country weight, behind Brazil and ahead of South Africa. This is clearly not a market that any active EM managers can ignore.
So much is going in favour of the investment case in absolute and relative terms – see below for a recap. However, Saudi is now the most expensive market versus 5-year average among the large EM group.
There are two ways to look at this. Either any pull back in oil price or the Tadawul index should be viewed as a buying opportunity because these favourable drivers are sustainable. Or, as we argue, this is as good as it gets for Saudi equities, there is better value elsewhere, relative to well understood risks, in the other commodity-export dependent parts of large EM (eg Brazil and Russia).
All of Saudi's stars are aligned
Oil price, at over US$90 – and the institutionalisation of Saudi-Russian cooperation on oil output as well as the resolution of intra-OPEC dissent, eg from the UAE, which has underpinned the oil price recovery – is a strong tailwind for growth, investment in non-oil diversification, fiscal budget balance, current account balance, and foreign reserves (effectively, completely de-risking the currency peg).
While the global transition to renewable energy is underway, it is a long-term one that means there is plenty of demand for oil in the interim. Saudi is likely to be one of the last surviving producers because of its very low cost of extraction, its ability to continue funding capex (because it is less reliant on the vicissitudes of the capital markets, compared, for example, to US Shale producers), its insulation from ESG activists, and its enduring global strategic value as the only large producer able to quickly ramp up (or down) output.
US diplomatic relations have fared much better than feared at the start of the Biden administration, with its initial human rights-laden rhetoric on foreign policy – the Russia-Ukraine crisis, politically painful gasoline prices in the US, and the effort to renegotiate the Iran Nuclear deal have all forced the Biden administration to engage with Saudi more than its posture suggested.
Structural economic reform, under "Vision 2030", has been stuttering (eg greater mobilisation of investment in the non-oil sectors, but no solution yet for the key problem of low productivity, greater female employment but higher male youth unemployment too, new taxes and fees to improve fiscal sustainability but still an overwhelming reliance on oil revenues). However, the elimination of dissent, popular social reforms, the provision of fiscal support during Covid, and sufficient containment of any blowback from the Yemen war have cemented the succession path and reduced regime risk.
Large Cap Saudi equities are dominated by Banks, which benefit from rising US policy rates (large volume of interest-free deposits, and large volume of interest-rate sensitive assets, ie corporate loans), Oil (Aramco), and Chemicals, which benefit from the knock-on effect on petrochemical and fertiliser prices from high oil prices. Small Cap Saudi equities in Consumer, Healthcare, Real Estate, and Travel benefit from the social and economic reform (eg job creation, mortgage growth, private insurance, domestic tourism).
From a relative perspective, Saudi equity performance has benefited from a lack of Technology exposure, shielding it from the sort of regulatory and valuation concerns that have impacted that sector globally, from a lack of currency risk, because very high FX reserves shield Saudi from the tougher backdrop for capital flows into most of EM as US rates increase, and its net export of commodities at a time of high prices.
Saudi's 'Vision 2030' five years in, Apr 2021
Saudi's massive investment program does not fix key problem of low productivity, Mar 2021
Oil price rally turns GCC fiscal balances positive for now, reform still a must, Mar 2021
Saudi: Ambition and obstacles to attracting FDI (and realising Vision 2030), Feb 2020
Oman personal income tax a precedent for others in the GCC, Nov 2020
Oil and ESG
International Energy Agency calls time on Oil, May 2021
Lithium mine, echo of Chile – renewables reality check, Jan 2022
ESG needs to focus on countries, not just companies, Oct 2021