iShares MSCI UAE ETF (NASDAQ: WATER) is an approximately $44 million passively managed fund with a portfolio of 32 UAE stocks from the MSCI All UAE Capped Index.
The UAE price is down around 3.8% since the start of the year at the time of writing, the total return is about 1.7% below zero. It has certainly held up much better against the aggressive bearish forces circulating around the world, as its single-digit retreat contrasts sharply with flagship US stocks including the iShares Core S&P 500 ETF (IVV), which are down 23%, already officially in a bear market zone, although failing to keep pace with its Middle Eastern counterpart, the iShares MSCI Saudi Arabia ETF (Saudi Arabia) which is up in the single digits. It should be noted that the UAE started this tumultuous year on a high note, surprising investors on the upside until April, but things suddenly turned south and earlier gains were erased.
Speaking of positives, I appreciate the fund’s low correlation to the US market, as well as a seemingly adequate valuation with a P/E of around 14.6x according to iShares data. This combination might seem close to ideal to prepare for another contraction in overvalued stock growth premiums, which the global stock market will experience as hawks do what is necessary. I also like the short-term trends in the country’s financial sector, mainly in terms of loan growth thanks to healthy economic activity, which can support the performance of the ETF both in terms of capital gains and dividends.
Among the weaknesses, I highlight its concentration (the two main positions represent nearly 44% of net assets in total) and totally lackluster risk-adjusted historical returns.
I am also of the view that the UAE is clearly not invulnerable to global macroeconomic risks, particularly in the event that the already pervasive aggressive rate hikes catalyze a recession in major economies, triggering the fall in international growth and dragging thus likely the oil price reset, not to mention other ripple effects related to capital flows and global tourism, the importance of which is indisputable for Dubai. That is to say, I think it doesn’t make sense to resist a US stagflation of UAE stocks if that were to materialize.
Then, in the longer term, regardless of how the current oil and gas crisis plays out, the shift to greener energy alternatives away from fossil fuels over the next few decades looks like a risk to UAE’s revenues, which can potentially lead to weaker economic growth and subsequently lower equity returns, particularly for the financial sector, which is the fund’s primary allocation.
That said, while appreciating the strength of the Emirates economy discussed below, I would opt for a Hold rating given the downside risks.
The economic context: key issues worth discussing
The main macro themes for investors in the UAE to watch are economic expansion and inflation, which have been a major concern for investors in emerging and developed markets this year, causing regulators to drop their dovish stance and thus eroded the rich pandemic gains in asset prices. .
In the April 2022 World Economic Outlook, the International Monetary Fund projected the UAE’s real gross domestic product to expand by 4.2%, followed by a growth rate of 3.8% in 2023. For a better context, in 2020 its economy was dragged into a recession by the coronavirus crisis, with real GDP down 6.1%; 2021 was a year of nascent recovery, with a 2.3% improvement.
Meanwhile, the central bank of the United Arab Emirates is of the view that real GDP growth can reach 5.4% this year, followed by an expansion of 4.2% in 2023. This is a improvement over a previous forecast of only 3.3%. To add a little more color, OPEC data shows that “about 30% of the country’s gross domestic product is directly based on oil and gas production”, as of 2020. So the premise according to which high oil prices are among the main contributors to the rosier outlook seems rational.
At the same time, inflation, the measure that causes a lot of concern globally, is kept at bay. The IMF forecast is for a change in consumer prices of 3.7% this year and 2.8% in 2023, a perfectly adequate level. It should be recalled that in 2019 the UAE plunged into outright deflation, the main reason being falling rents amid an oversupply of property. Deflation persisted in 2020 mainly due to coronavirus restrictions which hampered global travel and also caused the departure of foreign workers. Nevertheless, the Emirates eventually escaped the deflationary spiral, staging a strong recovery from the Covid recession in 2021, benefiting from the revival of tourism and rising oil revenues.
Inflation and the strength of the national currency are intimately linked. Higher prices mean higher rates, which should boost demand for sovereign debt and support currency gains. However, investors in the UAE should remember that the dirham is pegged to the US dollar, so with US interest rates climbing, the possibility that the UAE central bank will follow suit inevitably increases. It just raised the rate by 75 basis points, mimicking the Fed’s recent historic decision.
A closer look at assets
Overall, we see the UAE economy growing at a solid pace, with consumer prices moving comfortably, at least for now. This is a favorable backdrop for the financial sector, the one in which the United Arab Emirates fund has invested heavily, with an allocation of more than 47%, and First Abu Dhabi Bank alone represents 23.1% of the sector. ‘net assets. Communications takes second place, with Emirates Telecom being the key position with a weighting of 20.5%.
It should be noted that Saudi Arabia is also significantly overweight in financials; this is also the case with the iShares MSCI Kuwait (KWT) ETF.
With demand for credit in the UAE boiling over this year, conditions for banks in the Emirates appear to be timely. However, we find that this alone is not enough to spark investor optimism, as the price of ADX-listed shares of First Abu Dhabi Bank has been steadily declining since April, down around 11 % in three months ; the sector’s median price performance is (16.2)%, so his case is not unique. For context, the bank is trading with a TTM P/E of around 14.2x, while the financial sector median is 9.44x.
Performance: Apparently stable in 2022, after a bullish 2021 and a soft decade
Despite being seen as a possible beneficiary of the longer oil price hold, the UAE has not produced a performance this year that would clearly illustrate that demand for crude is contributing much to its appreciation. We see that the fund’s price is down 1.7% year-to-date, while Exxon Mobil (XOM), a supermajor highly correlated to the price of oil, is up almost 41%.
Curiously, we don’t even see double-digit gains from Saudi Arabia, which is up around 3.8%. That is to say, I am strongly against treating the UAE and Saudi Arabia as funds simply to expose themselves to the dynamics of oil prices and therefore a bet on the continuation imbalances between supply and demand.
Speaking of historical risk-adjusted returns, the Sortino ratio that the fund provided over the period May 2014 to May 2022 is 0.06. The optimal level is 2. The result of IVV over the same period is 1.63. And that’s despite the UAE’s frantic run last year, when it rewarded investors with a total return of more than 44%.
Additionally, in 2020 the ETF faced a 3-year maximum drawdown of almost 50% compared to IVV’s 33.9%, so we had already seen the downsides of its heaviest strategy in the middle of the global economic crisis.
The UAE has demonstrated an objectively low correlation with the US market (a coefficient of 0.43 based on daily returns since May 2014), which adds to its appeal in an environment where investors’ woes in expensive equities are apparently far from over as the Fed works. the walk.
However, as noted above, the ETF’s historical risk-adjusted returns are simply lackluster, and the decline it has faced in 2020 is clearly horrific. Thus, there is a risk that if global economic conditions deteriorate further, the UAE price will be disproportionately affected.
Furthermore, we are already seeing signs of suppressing demand for oil through a decline in the supply of capital. This is bearish for crude benchmarks globally and, albeit indirectly, also bearish for ETFs in the United Arab Emirates and Saudi Arabia, due to the countries’ dependence on oil revenue. Considering all these risks and inconveniences, the UAE is a holdover.