|By Matein Khalid|
I had written an article titled “six reasons to be bullish Saudi equities in 2018, published in the KT on January 28. Yet I was surprised to see Saudi Arabian equities become the world’s second best performing stock market in 2018 after Egypt. The Saudi equity index fund (KSA) I recommended in my column is up 18% at a time when the MSCI emerging markets is down 7% and small GCC stock exchanges remain mired in vicious bear market downtrends. The reasons I was so bullish on Saudi equities late last year was my conviction that the kingdom’s liquidity and credit cycle had bottomed after the traumas of the oil crash, the banking credit crunch, the contractor debt crisis and the political convulsions that culminated in the arrests of senior prices, ex-ministers and business magnates at the Ritz Carlton hotel in Riyadh. Bull market are born in despair and die in greed – and all the ingredients of a bull market in Saudi equities seemed in place to me.
The spectacular rise of Brent crude from below $30 a barrel in February 2016 to $74 now is a testament to the kingdom’s policy U-turn it resumed the role of OPEC’s swing producer and brokered an output cut pact with Russia that has removed 1.8 million barrels a day (MBD) of crude oil from the wet-barrel market a time of tightening global inventories, robust Asian demand and geopolitical risk/supply shocks in Venezuela, Libya, Nigeria, Iran and Yemen. As the world’s largest oil producer, Saudi Arabia is the ultimate beneficiary of $74 Brent, a price both the House of Saud and the Kremlin needed to ensure in 2018.
Saudi Arabia is one of the most underleveraged economies in the Arab world, with a public debt/GDP ratio of only 17%, in contrast to above 100% for regional states as diverse as Libya, Bahrain, Sudan and Morocco. While the kingdom has borrowed heavily on the Saudi money markets, it can easily float sovereign debt on the international debt market to ease its domestic credit crunch. This is exactly what has happened in 2018.
I was amazed at the scale of the 2018 State Budget announced by the Royal Court in Riyadh. The $261 billion in spending makes it the most expansionary fiscal budget in the modern history of the Saudi kingdom. Fiscal stimulus at a time of sharply higher oil prices and a $106 billion windfall from the Ritz Carlton arrests argued for an embryonic bull market in Saudi equities. The planned privatization IPO of Aramco (and even the Tadawul index itself!) is a game changer for the Saudi capital markets. This prospect was simply not priced into Saudi equities in January, particularly since the MSCI and FTSE decision to upgrade Saudi Arabia from frontier to emerging guaranteed at least $35 billion in index “tracker” money earmarked to buy Saudi equities.
Financials are 40% of the Tadawul index and the economic reforms envisaged by the Crown Prince has led to a valuation rerating of Saudi bank shares. The petrochemical/materials sector, 32% of the index, benefits from the white hot world commodities market. The $20 billion joint venture between Saudi Aramco and Dow Chemical or the $9 billion deal with Total signed in the Élysée Palace during the Crown Prince’s last state visit to France are only the tip of the iceberg in the kingdom’s pipeline of transformational economic initiatives in technology, finance and even entertainment.
Saudi Arabia is the economic superpower of the Middle East but foreign direct investment has been a miniscule 1% of the kingdom’s GDP, far below major emerging markets norms. The Saudi private sector also needs to dramatically increase its share of national output. The Vision 2030 economic reform agenda aims to boost both FDI and entrepreneurship, while the anti-corruption crackdown, the new bankruptcy law and cuts in petrol/electricity subsidies will consolidate state power, marginalize minor rent-seeking elites and control wasteful extravagance in resource consumption.
Since I expect oil prices to rise and MSCI to include Saudi Arabia in its indices next month, I expect the bull run in Saudi equities has room to run, though valuations are no longer cheap at 18 times earnings. Geopolitics is another risk factor in Saudi Arabia. The Houthi rebels in Yemen have launched ballistic missiles on Riyadh. Iran and Israel’s escalating proxy war in Syria or Argentina/Turkey’s currency crises could also threaten the kingdom’s bull market.
Wall Street – What next for New York money center banks
Money center bank shares were the classic beneficiaries of the Trump reflation trade in 2017. The prospect of faster economic growth, fiscal stimulus, a rollback of Dodd Frank, a steeper yield curve and thus higher net interest rate margins and better loan growth were a steroid shot to the valuation of financial shares. However, as the ten-year US Treasury bond yield has risen to 2.95% on fears of inflation risk and aggressive Fed tightening, money center banks have failed to benefit. The S&P 500 Financial Index has actually fallen 8% since January 2018.
This implies that Wall Street is now worried that the surge in short (the two year Treasury note is at 2.50%, its highest level since 2008) and long term Treasury bond yields will choke economic growth and thus raise future recession risk, a disaster scenario for bank earnings and asset quality. This is exactly what happened during the “taper tantrum” of 2013, when the Bernanke Fed suggested it would reduce the amount of bonds it was buying and reverse the almost fivefold expansion of its balance sheet, albeit at a glacial pace. Yet once the financial markets realized that the Federal Reserve had no intension to nudge the economy into the cliff edge of recession, bank shares stabilized and the Volatility Index (VIX) resumed its longer term downtrend.
I believe a similar scenario will play out for money center banks in 2008. Trump’s tax cuts and the rise in capital spending preclude imminent recession threat. There is no 2006 style excessive leverage or risk taking in the property market and strategic deals, not speculative leveraged buyouts, define merger mania. Despite the risk of a Democratic victory in the midterm Congressional elections, there is no real risk of another Obama era regulatory squeeze. In fact, I believe that bank litigation costs, a legacy of the financial crisis, peaked in 2016 except for outliers like the $1 billion fine on Wells Fargo for product misselling in its wealth management division. History tells me that loan growth, interest rates and credit trends are the key drivers of a valuation rerating in bank shares – and valuations are not excessive, though the case for further rerating is now over. Stock selection, not a mere sector bet, will be the catalyst to make money in US money center banks in this uncertain macro zeitgeist.
Ironically, the Big Six US money center banks all beat Street consensus in their first quarter results. Net interest income was a blowout, thanks to higher interest rates and firmer loan pricing. The tax cuts were a nirvana for the bottom line. The rise in volatility has benefited trading results in fixed income, foreign exchange and derivatives. Credit costs and loan growth trends point to a Goldilocks economic milieu. Yet apart from Morgan Stanley and Bank of America, bank shares actually fell after their earnings growth as the Street is uncertain whether this earnings growth can last since tax benefits are a one time boost. In any case, the 19% rise in the S&P 500 financial index in 2017 front loaded the anticipated benefits from Trump’s promise to “do a number” on Dodd Frank regulatory rollbacks. The real test of Big Bank operating performance will come if earnings growth continues amid a trade war with China or higher US wage inflation. Bank outperformance is not necessarily a given in a less “kinder, gentler” phase of the global economic cycle.
Citigroup has been my favourite US money centre bank since 2012, when Michael Corbat replaced Vikram Pandit in a boardroom palace coup. Citi shares, profiled at least a dozen times in this column, were 25 then and are 68 as I write. At 68, Citi trades at just below book value and a reasonable 12 times earnings at a time when it will return at least $20 billion in dividends and share buybacks in the next two years. I envisage Citi in a 65 – 80 trading range.
Morgan Stanley has been my favourite Wall Street investment bank since early 2016, when the shares bottomed at 24 after the Chinese yuan devaluation. First quarter profits rose 19% to $2.58 billion. Morgan Stanley has built the world’s preeminent wealth management advisory business, with a margin of 26.5%. Trading revenues were the highest since the financial crisis, thanks to the spike in 1Q volatility. However, Morgan Stanley is highly leveraged to the bull market and lending revenue growth is will slow in 2018. The ideal entry point for new money in Morgan Stanley is 45 – 46 for a 60 target.
Stock Pick – The value and growth case for Google shares
Alphabet/Google has been a disappointment as an investment in 2018, down almost 3% for the year at $1024 as I write. The financial markets, stung by the Facebook/Cambridge Analytica data privacy scandal, fear the impact of the EU and US Congress’s regulatory backlash on the firm that has a virtual monopoly on the global paid search business. Unlike Facebook, Alphabet has committed no outrageous breach of consumer trust but this will probably not save it from tougher data privacy scrutiny from governments anxious about losing control of the Internet and using the threat of regulatory fines to impose compliance. This has the potential to negatively impact Search, YouTube and Network.
After all, EU regulators slapped a $2.7 billion fine on Alphabet for alleged antitrust violations in online shopping – and are now reviewing Android. The Street is also fearful about a deceleration in search spend this summer. This could hurt revenue growth in Google’s Web Sites Division, the key ballast in its wildly profitable search engine business. Advertisers face budget pressures on their spend in both paid search and YouTube. These are all reasons why I would not be surprised to see Alphabet/Google trade down to $940 – 960 a share, $250 below its 52 week peak at $1198 a share.
However, at these levels, I believe compelling value will exist to buy the shares of one of Silicon Valley’s most iconic businesses. This is one of history’s great growth companies, a global brand name franchise with a track record of stellar execution and innovation, now on sale. I recommended Google as a must own share for investors in the UAE on the day of its IPO in 2004. Even though its shares have risen more than ten times since its IPO, I still believe Google has a place in any sophisticated investor’s portfolio.
Google now trades at a 24 times its $42 estimated EPS. Yet this is not expensive given the sheer scale of its revenues ($110 billion) and its 16 – 18% annual EPS growth potential in each of the next three years. The Google search engine generates 86% of its parent’s revenues. This business is embedded in the world service economy and defines the online search market that is growing at 15% per annum – and Google dominates it with a 65% market share!
It is crucial that investors adjust Google’s price earnings ratio for $4 EPS losses in Waymo (self driving cars and other bets) and its $100 billion cash hoard. Adjusted for executive stock options, the valuation multiple falls to 19 times forward earnings.
It is difficult to value Google’s parent, given the losses in Waymo but its addressable market (auto/transportation) is a game changer. Morgan Stanley values Alphabet on a sum of the parts basis at $1400 a share or a trillion dollars. Wall Street analyst calculate YouTube alone could be worth $150 billion, a scenario not captured in the current market cap. Waymo has an “options” value that could be north of $50 billion. Artificial intelligence, robotics, quantum computing, cloud – the most exciting trends in tech are all in Google’s future growth constellation.
The April payroll data was pure Goldilocks. Job growth was not too hot at 164,000 while wage inflation growth was muted. Yet the real catalyst for Friday’s rally on Wall Street was the news that Warren Buffet’s Berkshire Hathaway had purchased 74 million shares of Apple. However, the 3.9% unemployment rate and rising core inflation means the Powell Fed will raise the Fed Funds rate at the June FOMC. This is the reason the US dollar closed at its highest levels in 2018 even though payroll growth and average hourly earnings both missed Street forecasts. The mediocre Eurozone retail and service data has awakened growth fears and made it impossible for the Bundesbank’s monetary hawks on the ECB to argue for an end to Dr. Mario Draghi’s bond purchasing program, in September, given that core inflation is well below 1%. This means the Euro can well fall to 1.15 this summer, especially since the free falls in the Turkish lira (a sovereign credit downgrade, political risk on President Erdogan’s snap election) and the Argentine peso (the central bank has been forced to raise rates to 40% to defend the peso from a speculative assault) morphs into a full blown emerging market currency crisis.
If the emerging markets crisis escalates, the Fed will have to scale back its monetary tightening timeline. After all, tight money from the Greenspan Fed triggered the 1994 Mexican peso crisis and the 1997 Asian flu. This could create a 1999 style bubble in NASDAQ.
Also published on Medium.