Tadawul suffers as Saudi Arabia struggles

If 2015 was a torrid year for global stock markets, the next twelve months look set to be equally challenging. As the combination of China’s cooling economy and tumbling commodity prices heap downward pressure on indices around the world, investor confidence is quickly evaporating. 

Nowhere are these difficulties more apparent than in Saudi Arabia’s Tadawul, the Middle East region’s largest stock exchange, with a total market capitalisation of $421.1bn. The country is currently grappling with a host of economic challenges, as well as regional political tensions, all of which have hit the country’s stock market hard. Over the course of 2015, the Tadawul All Shares Index (TASI) fell by about 17%.

Multiple challenges 

More worryingly, this downward trajectory has continued in 2016, with a further 20% being wiped off the market’s value by mid-January. "The challenging times are not yet over. The fall in the TASI is a reflection of the impact of lower oil prices on the domestic economy. It is likely to continue as we don't see oil making a quick recovery. [In addition] negative global developments will also reflect on the market's performance," says Fahad Al Turki, chief economist and head of research at Jadwa Investment, a Saudi Arabian investment and financial services firm. 

These developments include a number of regional political and security challenges that have weighed heavily on the exchange. In particular, conflicts in Syria and Yemen, which both involve the direct or indirect participation of Saudi Arabia, have negatively impacted investor sentiment. Yet, it has been the gradual rapprochement between Iran and the international community that has hit the Saudi stock market hardest. 

The lifting of nuclear-related sanctions on Iran pummelled stock markets across the Middle East, with the TASI falling by 5.4% on January 17. That Iran plans to boost its oil production by 500,000 barrels per day in the coming months has not helped to instil confidence in the country's oil-dependent economy. 

"The development of the geopolitical factors in the region has and will continue to have a big say on how investors allocate their resources," says Wael Ziada, head of research at EFG Hermes, an investment bank headquartered in Cairo. "The [country] is, for the first time, trading at a discount to emerging market peers. Pretty soon we could see the Saudi market trading at single-digit forward earnings."

Foreign investment

This difficult environment has emerged as the Tadawul is being steered on a course towards greater liberalisation, in line with Saudi Arabia’s broader plans to encourage economic diversification and foreign investment over the coming years. In June 2015, the exchange was officially opened to qualified foreign institutional investors for the first time. 

Though subject to various restrictions, including that investors must have a minimum of $5bn of assets under management, the move was greeted with enthusiasm by the global investment community. With an eye on an eventual inclusion in the Morgan Stanley Capital International (MSCI) emerging market index, it was widely viewed as a positive first step. 

For the Tadawul, progress of this kind is particularly important given that about 90% of all of its monthly trading activity is conducted by retail investors. Overcoming the volatility associated with the dominant presence of retail investors is a key concern for the Saudi authorities. Encouragingly, there is yet little evidence that the market’s recent troubles have led to an exodus of foreign investors. 

"As a share of the total, we haven't seen a marked decline in foreign investors. They have remained constant since the Tadawul was opened midway through 2015. Institutional investors tend to consider the longer term fundamentals of a market. As such, I expect that the government's programme of economic reform will be a source of confidence in the coming years," says Mr Al Turki.

Slow progress 

Nevertheless, both the institutional and retail investors that populate the TASI have been keeping a close eye on events that might impact the trajectory of the index. For one, much will depend on the outlook for the Saudi economy. Given the realities of the new oil price environment, as well as the government’s commitment to longer term economic reform, it is not clear that the country will be quick to return to the kind of gross domestic product growth enjoyed in recent years. 

"There have been two important points to consider in recent months; one being the price of oil and the other being the size of [Saudi Arabia's] budget deficit. The [2016] budget is a clear indication that the government is looking to cut spending in a number of areas," says Mr Ziada. 

Indeed, while the budget has been hailed as a promising step on the road to reform, and includes various measures to raise revenues and cut expenditure, these changes are likely to hit a number of the country's dominant economic sectors. Steep hikes in the cost of key feedstocks, including ethane and methane, have all but wiped out the price advantages enjoyed by Saudi Arabia’s petrochemical sector over the years. Accordingly, the Tadawul’s petrochemical industries index had fallen by about 18% between the start of 2016 and the middle of January. 

Moreover, as the price of oil continues to fall, the size of Saudi Arabia’s projected budget deficit remains sizeable, at 13.5%, despite these cutbacks bringing new revenue raising measures. Nevertheless, some observers see scope for longer term optimism in these numbers. "On the upside, I think the government's commitment to maintain high spending – by recording the largest deficit in nominal terms in its history – will elevate sentiment," says Mr Al Turki.

IPO possibility 

Beyond these budgetary considerations, in recent weeks the Saudi government has publicly discussed a potential initial public offering (IPO) of state oil giant Saudi Aramco. If executed, any listing would most likely be partial and focus on one of the company’s subsidiary units. It would nevertheless mark a momentous step in the gradual liberalisation of the Saudi economy and is more than likely to exceed the Arab world’s largest IPO to date, the $4bn listing of Jeddah-based National Commercial Bank (NCB) in 2014. According to Mr Al Turki, it would also add considerable depth to the Tadawul while making it a more attractive place to invest. 

Yet, the fact that such a move is under consideration also points to the difficulties imposed by the lower oil price environment. "If it goes ahead then the government is envisaging a prolonged period of oil price pressure. Therefore, the authorities are looking at different ways of funding expected budget deficits," says Mr Ziada. 

This potential IPO is one of a number of developmental milestones on the road ahead for the Tadawul. For one, the exchange’s authorities are pushing hard for its inclusion in the MSCI Emerging Market Index in 2017. Feedback from institutional investors who have engaged with the country's investment framework will be sought by the MSCI before any decision is made, although the first opportunity for the Tadawul’s inclusion will be in June of that year. 

Should Saudi Arabia be included in the index, the consensus view, for now, is that it will have a weighting of between 1.5% and 2%. This figure is determined by the size of the market as well as the ease of access for foreign investors. 

Research from HSBC suggests that if Saudi Arabia were classified as an emerging market on global benchmark indices the total value of passive and active inflows could reach about $24bn. However, much will depend on further improvements to the operational efficiency of the Tadawul, as well as the rules governing foreign investments, in the coming months.

Potential still present 

Meanwhile, in line with this vision of greater foreign participation in the Saudi economy, the authorities are lining up an initial public offering of the Tadawul itself in 2018. This is expected to attract significant international interest, while being a major milestone on Saudi Arabia’s road to greater privatisation. 

Though the Tadawul is facing a difficult year ahead, its position as the Middle East region’s largest stock exchange, as well as its role in the Saudi economy more generally, point to its longer term growth potential. As the government continues to implement much-needed economic reforms, many analysts are hopeful that the strong fundamentals underpinning the country's economy will ensure the exchange experiences a recovery before long. 

For now, however, much will depend on the government’s commitment to change, as well as its willingness to endure the growing pains that come with it. "Throughout history, most major economic reforms have occurred during difficult times. Saudi Arabia will be no exception," says Mr Al Turki.