Matthew Craig finds political upheaval in the MENA region generating volatility, opportunity and a new appreciation of risk

When we look back on 2011, it is likely to be remembered alongside 1968, when western Europe and the US were gripped by violent protests, or 1989, when the Berlin Wall came down and the former Soviet Union collapsed, as an inflection point in the march of history.

This time it is happening in the Middle East and North Africa (MENA) region. The ferment created by youthful populations, a lack of employment opportunity, rising food prices, together with the use of instant communications and online activism, has led to long-established regimes falling in Tunisia and Egypt, a violent uprising in Libya and protests in some of the Gulf Co-operation Council (GCC) states.

These upheavals coincide with global markets finding a new equilibrium. The most powerful emerging markets had recovered so strongly since the global financial crisis that investors had already started to retrench in late 2010, deciding that developed markets were offering more attractive valuations. At the same time, the search is on for the next set of promotion candidates from the less developed emerging markets and the so-called frontier markets. Several countries in the MENA region - Bahrain (0.2%), Jordan (1%), Kuwait (31.3%), Lebanon (2%), Qatar (12.5%), Tunisia (0.8%) and UAE (8.5%) - are part of the MSCI Frontier Markets index (weightings as at the end of 2010). Qatar and UAE may be moved up into the emerging market category at the end of May. Meanwhile, Egypt and Morocco already have very small weightings in the MSCI Emerging Markets index.

In the short term, when markets are volatile they tend to over-shoot, according to chief strategist Graham Stock at Middle East and Africa specialist Insparo Asset Management: “There have been short-term trading opportunities for faster money; hedge funds are better placed to take advantage of that.” Russell Investments’ executive managing director for Europe, the Middle East and Africa, Pascal Duval, says that investors are faced with short-term instability and adds: “In some of the countries, the economic situation could create fiscal problems because they have to implement emergency spending packages. Bahrain doesn’t have large central bank foreign exchange reserves or a sovereign wealth fund it can tap, as is the case in Egypt and Tunisia.”

Egypt’s stock exchange had to reopen within 40 days to avoid it losing its place in the emerging market index after its sojourn in the wilderness, but closed almost immediately when a 10% fall triggered automatic circuit breakers. However, Stock says that after a 30% fall from its peak, investors now feel that there is value in Egypt, giving grounds for optimism. In the medium term, Stock says: “We see the changes as positive for the region. Political risk has always been there, but masked by the longevity of the regimes in Egypt and Tunisia in particular, but also in Bahrain and Saudi Arabia.” He adds that more representative governments could create more space for investment, with less crony capitalism.

For most investment experts with an eye on the MENA region, there are subtle differences between the events in North Africa and those in the GCC. A common view is that the uprisings in Tunisia and Egypt were driven by poverty and desperation, along with aspirations for a better life. Wahid Chammas, co-portfolio manager of the Janus Emerging Markets Strategy at Janus Capital comments: “In North Africa, the people could not take it any more. The regimes had been there too long, and when inflation escalated, they reached the brink and grew simply fed up with waiting for change.”

By contrast, in the GCC states, outright poverty is less of an issue and most governments have the resources to write cheques for the discontented. It can also be argued that the division between Sunni and Shia is a critical element here. Chammas argues that an important question in Yemen, Bahrain and Saudi Arabia is whether Iran, by proxy through the Shia population, can exert its influence.

“It is no longer just about protest or inflation in the Gulf States,” he says. “The issues have become sectarian, and Saudi Arabia is not going to allow this proxy owner to get bigger and it is trying to gag it.”

At the same time, historians of the future will no doubt point to a desire for greater freedom as a common thread running through current events. “In North Africa, there is no doubt that rising food prices and high unemployment are causes, but the lack of political space for expression is a common theme across the whole region,” says Stock.

Ultimately, everyone acknowledges that each country is different. Schroders’ head of Middle East investments, Rami Sidani, notes that while Qatar and UAE have small populations and extremely high living standards, Saudi Arabia has a population of 28m with a large proportion of young people, imbalances in wealth and high youth unemployment, many of the ingredients behind popular uprisings elsewhere. “[But] Saudi Arabia has implemented a $35bn social welfare package to tackle all the problems,” he says. “The Gulf countries have the resources to meet the demands of their people.” As a result, Sidani observes that investors are differentiating between countries and some markets have returned to pre-crisis levels.

T Rowe Price portfolio manager Joseph Rohm agrees: “Contagion from North Africa is unlikely to spread to the GCC, with the exceptions of Bahrain and Yemen - and they are special cases.”

While stability returning to the GCC states might be the base-line scenario, if the governments of major oil producers lose control, the economic impact could be severe.
“It is the worst-case scenario but if disruption spreads to Saudi Arabia then everybody has a real problem,” says Duval. “So far, Saudi has been quite stable, but we have seen things we were not expecting.” And Stock adds: “The danger is that we have long-lasting disruption to oil prices, which slows global recovery as the price of oil is driven higher.”

Although posing the greatest downside risk, Saudi Arabia is also arguably the market with the most potential. “The consumer story in Saudi Arabia is one, if not the best in the emerging markets,” argues BlackRock managing director Sam Vecht. “It has a very young population and a very fragmented retail market, so there are good opportunities there.” Equities that would be priced at 20-30-times earnings in India or Brazil are priced at eight-times earnings in Saudi, with high dividend yield to boot, he says. “It reflects the risks, which should not be understated.”

In terms of companies, Chammas picks out the Saudi Basic Industries Corporation (Sabic), as strategically well-placed as a petrochemical industrial with cheap feedstock and sustainable competitive advantages. Rohm picks Orascom Construction, active in Egypt, which he said was incredibly cheap in a global context, and Dubai Ports World, a beneficiary of trade in the region. Rohm also mentions Sabic as another position he had topped up following market volatility. Sidani points to investment opportunities in companies that can take advantage of increased government spending, as the GCC governments seek to diversify their economies and create jobs in service industries such as tourism and financial services.

One possible consequence of the ‘Jasmine Revolution’ is a re-rating of the MENA region. Ashmore head of research, Jerome Booth, says the default risk in these countries is far lower than in some Western Europe countries. “This is not about sovereign risk increasing but about exchange movements, fiscal slippage and short-term movements of capital,” he comments.

A wider question is possible convergence between the MENA region and Europe. “Having a layer of North African countries with much closer co-operation with Western Europe is a definite policy objective [for Europe],” says Booth. “I would expect more diplomatic and economic linkage - but that does not mean fast convergence.” Booth adds that one effect of a crisis is that it should make investors think about sovereign and political risk. “Very few people understand what risk is - it is not volatility and it is not uncertainty. If it makes people think about risk, that’s a good thing.”

Assessing the consequences of recent changes in the Middle East and North Africa is problematic, particularly as events are still unfolding. Just as countries in Eastern Europe and the old Soviet Union did after 1989, individual MENA countries will almost certainly progress at different speeds following the Arab Spring, but investors and others will hope that what is mostly a positive political story so far can create long-term value within and without the region.