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March 2013

Economic Monitor

Contents

Highlights 1

Global Economic Growth & Inflation 2

Global Financial Markets 9

Oil & Commodity Markets 16

Saudi Arabia 19 UAE 24

Economics Department Samba Financial Group

P.O. Box 833, Riyadh 11421

Saudi Arabia

ChiefEconomist@samba.com

+4420-7659-8200 (London)

Highlights (as of March 13, 2013)

Global economic activity is gathering pace, with the US and China at the forefront, though risks have not disappeared. US firms appear to have largely ignored the Congressional fiscal battles and are hiring with renewed vigour. China’s economy is recovering from last year’s slowdown, with exports bouncing back forcefully, though import growth has continued to sag. The performance of Emerging Markets is more uneven with robust expansion in East Asia offset to some extent by policy uncertainty in Latin America. Globally, the main area of weakness remains the Eurozone: ongoing deleveraging and fiscal tightening point to a further decline in output this year.

Financial markets seem content to ignore the poor outlook for

European growth and have largely focused on the positive data from the US and China. Though some feel that US equities markets are now overvalued, inflows from retail investors are only now gathering momentum and the rally probably has further to run. The main doubt concerns the timing of the US Fed’s exit from quantitative easing. Although most expect it to stay in place for this year at least, bond markets are uneasy and yields have ticked up in recent weeks.

Oil markets have lost steam, with Brent prices dipping back to

below $110/b from a $119/b high in February. Concerns over weaker fundamentals are likely to continue to drag on prices, despite a sharp cut in Saudi output, and we project Brent to average $107/b this year and $103/b in 2014.

Saudi oil production has been cut sharply, possibly in response to new global supply realities. These realities constitute a headwind for government spending, and public investment is likely to grow at a more modest pace than in the past few years. However, for the moment Saudi firms are continuing to do well.

Dubai’s non-oil sectors are performing well, with real estate finally showing concrete signs of recovery. Combined with robust public spending in Abu Dhabi, this has helped deliver estimated real GDP growth of 4.2 percent for the UAE as a whole in 2012. This is expected to moderate to 3.3 percent this year as the boost from rising oil output recedes.

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Global Economic Growth and Inflation Improving activity, though divergences are marked

There are signs of an acceleration in global economic activity, though performance remains extremely uneven across regions. The main source of optimism is the US economy, where investors and consumers appear largely untroubled by uncertainty in the government sector. Despite a significant fiscal drag and higher payroll taxes, private momentum should be enough to keep the US economy growing at around 2 percent this year. China’s economy is also gathering pace again, and exports have surged. There are some stresses, not least in the consumer credit sector, but GDP growth seems set to recover to around the 8 percent mark this year. The story is very different in the Eurozone where fiscal retrenchment and weak bank lending continue to sap private activity. With even “core” countries suffering, a further year of recession is in prospect.

GDP data show US investors shrugged off the Fiscal Cliff debate

In the US, the main data release was for fourth quarter GDP, which grew by just 0.1 percent (quarterly seasonally adjusted annualised rate). The outturn, which represented the worst quarter since the second of 2009, was something of a shock, given the generally upbeat tone of other private activity indicators. Yet this dichotomy was in some senses underscored by the data, which showed a relatively strong performance from firms and households, offset by slumping government consumption, particularly of defence goods. Overall GDP for 2012 grew by 2.2 percent, up from 1.8 percent in 2011.

Federal military outlays declined at a 22 percent annual pace, the fastest contraction since 1972 when the Vietnam War was being wound down. The contribution of net exports was positive, but this mainly reflected a sharp contraction in import spending; exports also shrank, but at a softer pace. A substantial decline in inventories also contributed to the weak growth performance, and this should be reversed in the first quarter of this year.

Fixed investment showed a very encouraging rebound from the 3rd quarter, growing by almost 10 percent, and confounding fears that the fiscal cliff imbroglio would deter firms from spending. Instead, firms appear to have put the large amount of cash on their balance sheets to good use. Subsequent surveys of business confidence have been generally upbeat, and the underlying trend in capital goods orders—after stripping out volatile aircraft purchases—has been positive. If businesses were largely unfazed by the Fiscal Cliff negotiations, then they are likely to be sanguine about the automatic federal spending cuts (the sequester, see below) and further budget and debt battles set for March.

2011 2012 2013f 2014f 2015f

World 3.9 3.1 3.2 3.6 3.9

US 1.8 2.2 2.1 2.8 3.2

Japan -0.7 1.9 1.2 0.5 1.5

Euro area 0.6 -0.5 -0.5 0.8 1.4

China 9.2 7.8 8.0 7.5 7.5

Emerging Markets 6.2 5.1 5.6 5.8 6.0

US 0.25 0.25 0.25 0.25 0.75

Japan 0.10 0.10 0.10 0.10 0.10

Euro area 1.00 0.75 0.50 0.50 1.00

Brent 111.8 111.0 107.0 103.0 98.0

Samba estimates and forecasts

(Oil Price $/b period average)

World Economic Outlook

Real GDP growth (percent, annual)

Official policy rate (end period)

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Consumption has held up despite higher taxes

Rising auto sales spearheaded the advance in consumer spending, which was underpinned by a drop in gasoline prices and the largest income gain in four quarters (largely owing to early payment of bonus and dividends in order to avoid new tax measures), as well as secular improvements to housing and other assets. This enabled the biggest component of the economy to shrug off the effects of Superstorm Sandy and the Fiscal Cliff battles. Private consumption growth is still weak in historical terms, but it now appears to be gaining some momentum. Its course over 2013 will depend partly on the outlook for housing, which is positive, but more directly on the effect of policy initiatives. Higher payroll taxes have already come into effect, and these put a big dent in disposable incomes in January. Yet personal expenditure held up, indicating that savings have been drawn down or fresh debt taken on.

The impact of the sequester is likely to be limited

A further headwind for consumption lies in the $85 billion of automatic spending cuts to be rolled out between March 1 and the end of the financial year on September 30, known as the sequester. The cuts are fairly arbitrary, and are likely to affect Federal programmes from teaching to defence. There is a good deal of uncertainty about how the cuts will impact the economy, though it should be noted that the $85bn refers to spending “authority” not actual spending; the actual net effect of the cuts is more likely to be in the region of $45 billion for the remainder of this fiscal year and $85-$110 billion a year thereafter. It is difficult to estimate the multiplier of these cuts (that is, the extent to which job losses feed through into reduced consumption) but their impact is on balance likely to be modest, shaving at most 0.5 percentage points off GDP growth.

There is also a good chance that the cuts will be overturned if a new mini-budget for the remainder of the fiscal year can be agreed by a March 27 deadline. Even if the sequester remains in place, the impact is likely to be akin to a “speed bump” for the economy. Granted, there is plenty of scope for further political discord: if the mini budget cannot be agreed by the deadline then the Federal government is facing a shutdown. The debt ceiling must also be raised again and the 2014 budget will need to be passed by October. Yet an increasingly confident private sector seems more than willing to take up the slack of public sector retrenchment.

Payrolls give upside surprise in February

Private sector strength was underscored by the February jobs report, which posted an unexpectedly high gain of 236,000 (consensus 165,000), following a lower-than-initially-estimated gain of 119,000 in January. The jobless rate fell two ticks to 7.7

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percent, though this was in part due to a weaker participation rate (that is, fewer people looking for work). There were particularly strong gains for the construction sector, which has now added more than 150,000 jobs since September. The construction gain dwarfed the 10,000 decline in government employment during February.

The three month average gain in payrolls for December-February was 183,000, up slightly on the 181,500 for the September-November period (all figures are seasonally adjusted). Though the pickup in jobs growth has been frustratingly slow, the December-February rate actually compares quite well with conditions in the “boom” years: average monthly jobs growth was 208,000 in 2005 and 172,000 in 2006.

Of equal encouragement was the surge in hours worked, up by 0.5 percent on the previous month. This is a good leading indicator of additional employment gains since employers often ask existing employees to work longer hours before they start hiring additional staff. The boost to worker incomes might also help to offset the drag from higher payroll taxes.

Employment growth is key to monetary policy stance

The level of employment has extra significance given that the chairman of the Federal Reserve, Ben Bernanke, has explicitly linked changes in monetary policy to the rate of employment growth. Specifically, Mr Bernanke said that the Fed Funds target rate, which anchors short-term interest rates, will be raised once unemployment falls to 6.5 percent, or if the Fed’s forecast for inflation exceeds 2.5 percent. Inflation is currently low, at about 2 percent, and inflation expectations are well grounded. There is little evidence of wage or cost pressures outside of isolated sectors and the Fed has signalled that it does not expect its own inflation forecast to exceed the 2.5 percent threshold any time soon.

Thus, the rate of employment growth appears to be the key variable. Extrapolating from the current rate of jobs growth, the unemployment rate could well breach the 6.5 percent threshold as early as late 2014. However, most expect that even if this were to happen, the Fed would resist raising rates at least until the middle of 2015, if only to make sure that the sub-6.5 percent rate was durable. Indeed, in early March Mr Bernanke told a conference that a “premature” rise in policy rates would carry the risk of “short circuiting the recovery”.

The employment variable is also at play with regard to quantitative easing (QE). A third round of QE was launched in December, when the Fed announced that it would start purchasing $85 billion a month of Federal securities until there was a “substantial improvement” in the employment situation. The ambiguity of this

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Influential Fed member outlines his concerns about QE

formulation is probably necessary to give the Fed more flexibility on the timing of an exit from QE.

Markets ponder timing of Fed exit from QE

This timing is now a key concern for market participants, who have been poring over the minutes of recent Federal Open Market Committee Meetings (the branch of the Fed responsible for setting monetary policy). January’s FOMC minutes revealed a split between those like Mr Bernanke who favour keeping policy accommodative for an extended period, and others who are beginning to worry about the “efficacy, costs and risks” associated with a policy that has seen the Fed’s balance sheet balloon to more than $3 trillion. Indeed, the minutes suggested that “a number of participants” judged that these risks might well lead the committee to “taper or end its purchases before it judged that a substantial improvement in the outlook for the labour market had occurred” [our emphasis]. Note, however, that “participants” includes those on the committee who do not have a vote; “members” refers to the twelve who do.

The risks that are starting to worry some participants can be divided into two broad groups. One centres on the difficulties in achieving a “smooth” exit from QE. The dissenters are concerned that the eventual exit will mean losses for the Fed, and more importantly might destabilize financial markets as investors quickly move out of bonds. The second group of concerns is more far-reaching, and include worries that artificially low interest rates actually deter investment since lenders become less willing to lend long at low rates, and that capital tends to be misallocated. Market interest rates are a useful way of pricing risk, but if all interest rates are artificially suppressed, then risks might become disguised (this problem was at the core of the financial crisis). Additional concerns include the prospects for inflation, either consumer price or asset price, and the effect of low interest rates on savers.

Influential Fed member, Jeremy Stein, highlights risks of QE

A speech by the respected economist and Federal Reserve Board member, Jeremy Stein, highlighted the quantity of investment being made in risky assets, such as junk bonds (see Credit Markets, below). Mr Stein believes that the rising share of high yield in total issuance, and increased amounts of subordination at any given credit spread, suggest that markets are “over-reaching” for yield, with dangers that a bubble might soon develop.

Yet QE unlikely to be unwound this year

For all this, the FOMC seems set to keep QE in place for at least the remainder of this year. The economy has still to achieve “escape velocity” and will probably not do so before jobs growth is consistently above 200,000 per month. It is notable that there was only one vote against current policy in the January meeting and

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that was from long-time hawk, Esther George; Jeremy Stein voted in favour. In his testimony to Congress, which followed the FOMC meeting, Ben Bernanke said simply that the costs of more QE did “not outweigh the benefits” of a stronger economic recovery.

Ben Bernanke is likely to retire in January 2014 following the completion of his second term, but his likely successor, Janet Yellen (the current vice-chair) appears equally dovish. In a speech made after the January FOMC meeting, Ms Yellen said that “at this stage, I do not see any risks that would cause me to advocate a curtailment of our asset purchase programme”. Both Bernanke and Yellen would likely argue that a) monetary policy should continue to be directed towards supporting growth, especially when fiscal policy is likely to be a drag (as it will be this year) and b) that it is up to the regulators to prevent bubbles in the financial system.

Eurozone markets stable despite Italian election concern

Eurozone financial markets have shrugged off the inconclusive Italian elections in February which produced a divided government in which anti-austerity factions feature strongly, and resulted in roughly 56 percent of votes going to parties that favoured leaving the Euro. Italian bond yields did spike temporarily, but have since tightened and were back around 4.5 percent for the 10 year in early March. There are also few signs of contagion with most peripheral bond yields unchanged or slightly down on the start of the year. However, some residual investor unease may be seen in the reversal of the steady increase in German short-term yields as safe haven flows increased. The euro has also slipped against the dollar, although it remains relatively strong following a steep appreciation against both the dollar and the yen over the past 9 months.

Strong official support but EZ debt strains remain

The backstop of ECB support under its unlimited bond buying program (Outright Monetary Transaction—OMT) continues to reassure markets. There is also a perception that official creditors (EU/ECB/IMF) will be flexible with fiscal targets at a time of continued economic weakness, and that support will remain forthcoming as needed, and debt terms potentially eased. Both of these factors have substantially reduced tail risks in the Eurozone. However, the crisis is not over, and we think political stresses, fuelled by massive unemployment, will hamper attempts at addressing still-challenging debt burdens. The sustained pursuit of (albeit moderating) fiscal austerity will likely be questioned more vocally, and strains could further intensify at various points in the coming 18 months.

While official borrowing costs have come down compared to last year, the prolonged economic recession in peripheral countries continues to push up debt/GDP ratios. In the short term, this could

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prompt Cyprus into some form of debt restructuring as part of a new Troika programme; while still-elevated debt and deficit positions, aligned with contracting economies, might see Spain, Portugal, and Ireland seek continued support via the OMT later in the year. In the longer term, Eurozone officials will probably need to consider options to reduce debt levels in Greece, Portugal and Spain.

Eurozone growth prospects remain dim

Easier financial conditions have not fed through to growth and available data continue to point to weakness in the Eurozone economy. Final data show that real GDP for the zone as a whole contracted by 0.5 percent in 2012, with activity particularly weak in the fourth quarter, including for the larger economies of Germany, France and Italy. Declining exports and investment weighed heavily on growth, which was also not helped by a further surge in unemployment to 11.9 percent for the zone as a whole, with devastatingly higher rates (40 percent and over) for youth unemployment in peripheral countries. Available data also show sharp declines in bank lending in peripheral countries, despite lower official financing costs.

More recent data point to continued sluggishness in the first quarter, consistent with a contraction in GDP. The Eurozone composite February PMI slipped back to 47.9, while the contraction in retail sales continued, albeit at a slower pace of 1.3 percent year-on-year. Euro-area industrial production seems to have bottomed out late last year and managed a 0.7 percent month-on-month increase in December, although production was still down year-on-year. Sentiment indicators are improving, and the worst of the recession seems to be over, but another economic contraction is on the cards and we project that real GDP will decline by another 0.5 percent overall in 2013. Any growth in the region will come almost exclusively from Germany, which is projected to grow by 1 percent this year, while France will probably stagnate, and Italy contract along with all peripheral countries except Ireland. Prospects for 2014 rest heavily on avoiding undue political and financial strains. Absent these, a return to muted growth seems possible.

Eurozone inflation dips below target

In February, Eurozone inflation fell below the ECB’s 2 percent ceiling to 1.8 percent, for the first time since late 2010, increasing the possibility of a more dovish stance from its president, Mario Draghi. The downward trend has mainly been driven by a falling contribution from energy price inflation, which should be sustained. The recent strength of the euro may also see some easing of imported consumer prices, and with demand pressures low, we expect that inflation will continue to trend down this year. The ECB’s own projections have inflation falling to 1.6 percent

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this year and to 1.3 percent in 2014.

A new direction for Japan?

Japan’s new LDP government, led by Prime Minister Abe, appears intent on reflating the economy through aggressive monetary easing to try to break the cycle of deflation, aligned with further fiscal stimulus, despite the already elevated debt burden. The yen has fallen sharply in response to the announced policy direction, including a new explicit 2 percent inflation target for the BOJ and anticipated larger asset purchases under the newly appointed governor. It has lost about 12 percent against the dollar and 16 percent against the euro since the elections were called last November, providing a significant boost to Japan’s export orientated economy. This has also provided a strong boost to share prices, with the Nikkei index surging 23 percent last year.

Looking ahead, we expect that favourable market sentiment, improving consumer confidence, the recently announced $116bn fiscal stimulus package, and the weaker yen, will all help spur private investment and growth. Already there is some indication that industry is benefiting with production indices firming in recent months, and forward looking surveys positive. The manufacturing PMI has also revived strongly so far this year, although at 48.5 in February it is not yet in expansionary territory.

Japanese growth should revive and monetary policy loosen

As these high frequency data remind us, the economy is just emerging from a technical recession and it needs to be noted that external challenges remain, including from the sustained recession in Europe and tensions with China. Thus, while the economy is expected to recover, the rate of real GDP growth for the year as a whole is likely to remain relatively muted at around 1 percent, down on the 1.9 percent estimate for 2012 which was driven by the strong reconstruction-led rebound in the earlier part of the year, before the contraction set in. Meanwhile deflation continues (the CPI declined 0.3 percent in January) leaving the BOJ plenty of room to pursue the new open ended asset purchase program. This will likely see the yen hold at around current levels, although bouts of global risk aversion could see some temporary appreciation on the back of safe haven flows.

China’s economic data are mixed

There have been mixed messages from Chinese data regarding the state of the world’s second largest economy. In general terms, the economy is picking up from the third quarter of last year when growth sagged to 7.4 percent. Growth accelerated to 7.9 percent in the final quarter, and exports—which remain a major component of the economy—have bounced back with some vigour. Combined exports in January and February grew by 23.6

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percent compared to a year earlier, as against 6.8 percent growth in the corresponding period of 2012. This suggests that demand from the US—China’s biggest market—is hardening, while demand from the Eurozone (the second largest) might have at least stopped falling.

Less encouraging are imports, where the rate of growth slowed in January-February combined. Although volatile, the general trend in import growth has been downward since 2010, indicating that domestic demand is not as robust as some had hoped. Retail sales and PMI data support the contention that domestic demand is softening. However, some caution that seasonal factors caused by the timing of the Chinese New Year are distorting the data, and that the economy is still in a cyclical upturn. Most economists continue to expect real GDP growth of 8 percent or more this year, notwithstanding an “official growth target” that is likely to be set at 7.5 percent.

China’s new leadership—which is due to take power this month—finds itself in something of a quandary. They are keen to support domestic demand and effect a transition away from export-led growth towards a consumption-based model. This, they hope, will boost living standards and orient the economy more towards services and “better quality” growth. However, they are also conscious that house prices are rising sharply again, and the authorities have been obliged to remove liquidity from the local market. They have also taken steps to rein in the “shadow banking” sector, the large and largely unregulated consumer loan market that might be carrying significant bad debt.

Asian economies helped by burgeoning domestic demand

Other Asian economies have largely shrugged off the impact of weaker Chinese import demand thanks to strong domestic demand. Inflationary pressures are for the most part contained (Indonesia is the main exception) and decent GDP growth rates of around the 5 percent mark are likely for most countries in the ASEAN bloc. However, more trade-dependent economies, such as Korea, Hong Kong, Singapore and Taiwan are set to record lower growth rates (albeit higher than last year).

Global Financial Markets

Investors are generally bullish, though there are worries about credit markets

Financial markets have been broadly Risk On since our last Monitor, with investors buoyed by receding tail risks in the Eurozone, signs that the US economy is finally gathering momentum and, perhaps most importantly, that US quantitative

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easing seems set to continue for this year at least. Yet despite—or perhaps because of—the more optimistic mood, there are signs that the long bull run in US bond markets is running out of steam, with many investors concerned that with yields so low, there is plenty of downside risk and not much upside, especially in the High Grade segment. Any hints that the US Fed might be considering winding down QE could see a major selloff in bonds and a sharp spike in yields.

Equity Markets

Equity markets have touched new highs, with market sentiment supported by receding tail risks and a further round of quantitative easing. In the US, sentiment has also been bolstered by better-than-expected corporate results.

Dow Jones hits new record

In early March the Dow Jones Industrial Average rose to its highest ever level, thereby erasing the losses experienced since the onset of the financial crisis. The more representative S&P 500 is only less than 3 percent below its record, reached the same day as the Dow in October 2007. Despite the economic severity and duration of the “Great Recession”, US equities have bounced back much more quickly than in previous crashes. It has taken the Dow less than 65 months to rise above its previous high, more than a year faster than the recovery from the dotcom bubble.

S&P does not appear overvalued…

Are US markets overvalued? Tobin Q analysis, which measures equity valuations as a proportion of companies’ net worth (i.e. the replacement cost of physical and other assets) suggests that the S&P is indeed overvalued. The ratio is currently 1, against an historical average of 0.64. However, this is based on a trend dating from 1900, which might be unfair. Much has changed in recent decades, including better reporting of depreciation, lower inflation (which reduces investors’ required returns on equity) and much lower taxation of corporate equity. Moreover a ratio of 1 does not look especially worrisome given that the ratio at the height of the dotcom bubble was 1.8.

…but profit forecasts might be too optimistic

More straightforward valuation techniques measure profits against equity, and on this metric the S&P appears fair value, with a trailing price/earnings ratio of about 15—slightly below the level recorded at end-2010. All sectors in the index, bar telecommunications, posted stronger-than-expected net earnings in the fourth quarter. The consensus suggests that net profits in the first quarter of this year will be down compared to the same period of 2012, largely reflecting the impact of tax changes. However, Wall Street then expects robust growth in profits in the

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remainder of the year, culminating in 12 percent growth in the final quarter. This is despite fairly weak sales projections, implying further cost savings and productivity growth. Yet some analysts argue there is little room for additional savings and point out that the average operating margin for S&P 500 companies appears to have peaked at 20.7% in August last year and is now down to 19.9%. They feel that the current rally is simply a response to increased liquidity stemming from QE and worry that once QE is wound down, there might be a major sell-off.

As it stands, the rally probably has further to run, particularly as retail investors are beginning to favour equities. Money flows into stock mutual funds were positive in January for the first time in 11 months and the highest in nine years, while investor deposits with global equity mutual funds in the first week of January were higher than any other period except one. Increased flows into equities at the beginning of calendar years are typical, though the size of increase this time around might be significant.

European equity markets shrug off Italian risk

European stock markets have shrugged off renewed political risk fears sparked by the Italian election which produced a divided government, and seem impervious to sustained economic weakness in much of the periphery. The Euro Stoxx index initially dropped about 6 percent on the Italian election result, but has since regained lost ground, driven along by a general strengthening in global sentiment on the back of improving economic indicators in the US and China, and expectations of sustained, and in cases enhanced, policy support from global central banks. Untethered by the euro, and benefiting from Bank of England quantitative easing, the UK market has done especially well, with the FTSE 100 now back above its pre-crisis peak in 2007, and up around 10 percent so far this year (March). Gains have been much more modest for the Euro Stoxx index which is still nearly 40 percent down on its 2007 high, and which was up around 3.5 percent year-to-date in March.

Eurozone equity markets appear to remain attractively valued from a historical perspective and certainly have scope for catch-up. However, at some point central bank policy support for asset markets may need to give way to the traditional influence of economic fundamentals. This would suggest an expanding differentiation between stronger economies, such as Germany, and the weaker debt laden periphery. Given current market sentiment, though, such a shift does not appear on the cards this year, as weak Eurozone growth favours sustained policy support.

Weaker yen and new policy impetus drives Japanese equities higher

After a strong performance in 2012 spurred by expectation of looser monetary policy and an associated sharp depreciation in the

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Yields have backed up recently in response to countervailing factors

yen, the uptrend in the Japanese equity market has continued this year. The Nikkei was up 15 percent as of March 7 and appears set to stay strong through the spring as the economy improves and foreign demand remains healthy. In addition, with bond yields staying low, Japanese investors are reportedly increasingly turning their attention to high-yield stocks as a substitute. However, given the scale of the gains since October, a correction cannot be discounted as the year progresses, and the Nikkei will be sensitive to movements in the yen where the room for further depreciation seems limited.

EM equities have seen some divergence

Emerging Market bourses have seen a modest sell-off in recent weeks, reflecting policy uncertainty in Latin America and worsening growth prospects in Emerging Europe. Emerging Asia has continued to do well, with the Thai and Philippines bourses particularly in vogue.

Equity flows to emerging markets in January were the strongest since 2008 (pre-Crisis). Inflows have been particularly robust to Emerging Asia, where macroeconomic fundamentals (low debt, strong demographics, recovering export sectors, contained inflation) are especially supportive. Monetary policy is set to remain accommodative and with US QE likely to remain in place, a pickup in flows during the course of the year seems likely.

GCC markets attract little in the way of foreign inflows, largely owing to statutory limits, but also because of investor concerns about transparency in some bourses. The UAE’s markets have done well on the back of safe haven flows from a region where political tensions are clearly running high (Dubai has also benefited from a firm recovery underway in its nonoil economy). Conversely, other bourses have tended to trade sideways, reflecting both regional political concerns and the slight drift in oil prices since February.

Credit Markets

Credit markets have seen some back up of yields

Credit markets have been broadly stable since our last report, but there has been a recent back-up in bond yields. This reflects both renewed confidence in the global economy, but also lingering concerns about when the Fed might decide to wind down its programme of quantitative easing. There are valid concerns that without the Fed acting as “buyer of first resort” bonds will suddenly appear very expensive, given the low yields on offer. Put another way, many feel that the bond rally has become too indiscriminate and that the flood of central bank liquidity has merely disguised risks, rather than eliminated them.

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There are concerns that High Grade offers little more than downside risk now

Yields on the benchmark US Ten Year treasury have edged up over the past few months, and broke through 2 percent in mid-March, from around 1.6 percent in December. The uptick in yields is in many respects a natural corollary of the “animal spirits” unleashed by QE, and equities markets have consequently rallied. But QE also helps bond markets: after all, QE underpins the US Federal debt market and by extension, all bond markets. Thus, while equities markets have certainly done better than bond markets in recent months, there is no sign of a “great rotation” out of bonds and into equities. A Ten Year yield of 2 percent is, in any event, extremely low by historical standards.

Bond investors find it difficult to relax

Yet the outlook for bonds is increasingly cloudy. Having picked over the minutes of the FOMC meetings for December and January (there was no February meeting) and the speeches of key FOMC members, bond investors appear broadly confident that QE will remain in place for this year at least. But it has been difficult for investors to completely shake off the fear that the Fed might suddenly change course. In this sense, the positive US employment number for February (see Global Growth and Inflation, above) was greeted with some consternation by bond investors, who worry that each positive jobs report brings forward the day when the Fed will exit QE. Yields on the Ten Year ticked up noticeably following the release.

There are justifiable concerns that the long bull run in bonds has become too indiscriminate

There are related concerns about the state of the bond market, many which were articulated by FOMC member, Jeremy Stein (see above). The flood of central bank liquidity has encouraged a “reach for yield” that has lulled investors into glossing over (or just ignoring) the risks associated with high yield securities. For example, the option adjusted spread on US High-Yield corporate debt had slid to about 4.5 percent (Barclays index) by mid-March, from around 5.2 percent at end-December. For junk-rated debt—where the risks of default are by definition high—to be yielding under 5 percent seems to many to be a sign that the bond rally has overreached itself.

Signs of concern are—ironically—more obvious in the High Grade space. Here yields have been pushed down so far that they have little room to fall much further and investors can only see downside risk. Many High Grade funds have edged down this year, and there were net outflows from this segment in February. Other signs that all is not well include the fact that bond issues by major multinationals, such as Philip Morris and United Health Group, were sold at higher yields than the levels their older bonds were trading at in the secondary market.

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The bond market has tended to defy the doubters

Other factors have also weighed on High Grade credit

There are other factors at play aside from the nagging concern that the Fed might pull the plug. The wave of leveraged buyouts in recent months, which have loaded debt onto some firms, has raised the possibility of ratings downgrades (and hence higher yields). Tougher capital rules for banks have also had an impact on secondary market liquidity. The amount of bonds currently held by banks is less than a quarter of their $235 billion peak, achieved in 2007. Portfolio managers are less willing to buy new issues if they think it will be difficult to sell them in the secondary market. This lower liquidity could amplify distressed selling in a rising rate scenario.

Attempting to predict when changing sentiment might achieve “critical mass” and lead to a sell-off is futile, but it is likely that High Grade would be sold off before High Yield since spreads on the former are more compressed. Fitch estimates that if interest rates were to revert rapidly to early 2011 levels (a 200 bps rise), a typical investment grade US corporate bond (ten-year BBB) could lose 15 percent of its market value. Losses would likewise be higher along the curve (26% for an equivalent 30 year bond).

Despite this, the end of the bond rally has been called—wrongly—many times before

For all these concerns, many observers have been calling the end of the bond bull market for three or four years now, and yet yields have—generally speaking—continued to fall. Those who believe that the bond rally has further to run argue that the Fed is locked in to supporting the market for the long term. They contend that any “disorderly” sell-off in the bond markets would simply push the Fed back into the market and bring yields down again. There is some merit in this argument since the Fed would clearly like to avoid any surge in yields that would imperil the US (and global) economic recovery, and it might well restart its bond-buying programme in these circumstances.

Ideally, the Fed would like to see a “natural” move out of bonds and into equities, the consequence of a broad-based economic recovery. As confidence in the recovery became more deep-rooted, so the Fed could gradually wind down its asset-purchase programme and allow yields to drift gently higher and back to more normal levels. Unfortunately, with such a large holding of bonds on its books, it might not be this simple.

ECB will do whatever it takes

We continue to think that the ECB will do whatever it takes to save the euro, and will activate OMT for countries as required (as long as they have an ESM-backed program in place) while also supporting bank liquidity. Given the sustained weakness in the Eurozone economy, falling inflation, and the unhelpful strength of

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the euro, it also seems likely that the ECB will cut rates sometime this year. The bank has also made clear its intention to maintain an easy monetary policy for “as long as needed”. The supportive monetary policy and low interest rate environment will help anchor bond yields in the Eurozone, although significant divergences still exist between peripheral and core countries, and spreads seem more likely to widen.

European bank credit markets remain calm

Despite initiation of early LTRO repayment (emergency ECB loans to banks) and potential contagion from political risks in Italy, European credit markets have remained calm and liquidity ample. There was a brief spike in interbank rates around the time of the first LTRO repayments in December, but rates have steadied since then, albeit at slightly higher levels. Meanwhile, three month deposit rates have shown some upward volatility so far this year, but remain at near record lows, supported by a revival of deposit flows and confidence in euro area banks. However, there remain significant cross country differences in bank lending rates to households and companies.

Less room for improvement in European corporate bond markets

European corporate bond yields and spreads tightened through most of 2012 as market confidence in the ECB’s ability to support the euro strengthened, and the search for yield in a highly liquid global market saw investors buy into both high yield and high grade corporate debt. Last year ended with record low corporate bond yields, suggesting the outlook for investor returns this year might be much more subdued, particularly as political instability in Italy, and possible concerns around the Cyprus bail-out, may begin to temper the risk-on buying seen since the middle of last year. European high yield corporate spreads have already started to edge up, and this has been mirrored in movements in CDS spreads.

However, the prevailing view appears to be that the outlook in Europe is too weak to threaten any kind of withdrawal of policy stimulus and an associated rise in rates this year. Instead, the ultra-low policy interest rate environment and record low borrowing costs should continue to provide support to bond markets, with abundant liquidity and scarcity of yields driving sustained, albeit moderating, demand for European corporate credit. That said, bond yields globally are likely to be more volatile, especially when the US Fed begins to scale back QE, the timing of which remains uncertain. Fixed income investors will be on the watch for any deflating of the existing “bond bubble”, and herding could accentuate yield movements as they seek to minimise potential market losses from any falls in bond prices.

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EM sovereign yields drift higher

The Embig spread has widened since late January, reflecting some uptick in EM sovereign yields. Yields have spiked up a bit in Mexico (USD denominated, 10 year), though they remain low compared to a year earlier. Yields have moved higher on the equivalent debt in Brazil, as inflation has picked up, a trend that has been in play since November, and a similar pattern is visible in Colombia. Russia has also seen yields rise (quite sharply in January) though there has been some stabilization since then. The sharpest spike in EM dollar denominated debt came in Venezuela where the death of the president, Hugo Chavez, though long expected, has increased policy uncertainty. A different trend is evident in the UAE where yields on Dubai’s debt have moved lower on a perception that the recovery in the nonoil economy, and especially the property sector, is gaining traction. A January sukuk offering was heavily oversubscribed (see UAE, below).

Oil and Commodity Markets

Oil markets

Early oil price strength has faltered

Oil prices strengthened in the first two months of the year, bolstered by optimism that major tail risks to the global economy have receded, including the full US fiscal cliff, a potential hard landing in China and the break-up of the Eurozone, some positive growth momentum, and a sharp drop in Saudi oil production. Geopolitical concerns have also continued to support a risk premium, while sustained quantitative easing from major central banks has pushed more money into the futures market. However, although dated Brent hit a high of $119/b on February 14, it quickly dropped back to below $110/b in March. With little change in fundamentals over this period, the retrenchment is largely thought to reflect a less rosy reassessment by financial investors on future market fundamentals. Nonetheless, the average year-to-date price ($113/b on March 11) remains up slightly on the 2012 annual average.

Fundamental support is relatively weak

While the oil market has been buoyed by the general improvement in global sentiment, prices did appear to be higher than justified by fundamentals given that global crude stocks are undergoing a contra-seasonal build, spare capacity is being rebuilt, and demand prospects remain relatively muted. While the outlook in China may have improved with Beijing continuing to fill strategic tanks, the IEA revised down its 2013 global demand forecast again in February. This is now projected at 90.76mb/d, an increase of

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840,000 b/d, principally driven by Chinese and the Middle Eastern demand. It is widely expected that non-OPEC crude and NGL supply growth will cover most, if not all of this incremental increase, driven in large part by sustained gains in the US—where output rose 812,000b/d last year and now tops 7mb/d—and Canada, and the likely return of Sudanese supply. Growing OPEC NGL output and projected strong gains in Iraqi production, which could hit 3.7mb/d this year, will also add to an apparently ample supply position.

But supply uncertainty remains elevated

However, complicating any assessment of oil market prospects is the increasingly volatile supply outlook which faces both downside and upside risks, although the short-term burden appears to be on the downside. Geopolitical risks are especially elevated and now weigh on much of North African supply following the attack on a gas installation in Algeria, conflict in Mali, and sustained tensions in Libya. Nigeria is also not immune, and political disagreements in Sudan may well delay the return of supply there. The sustained Syrian conflict, combined with internal strains, could also threaten the expected growth in Iraqi supply. Meanwhile tightening sanctions on Iran may squeeze supply there further, although there does now appear to be slightly more chance that a compromise can be reached on the nuclear impasse.

Saudi production drops sharply

In the midst of the clouded oil market outlook, Saudi Arabia unexpectedly cut production sharply to 9m/d in December, according to PFC data, from levels near 10mb/d for much of 2012. Given that OPEC output exceeds the estimated and projected call on its supply as well as its own target (see chart), a reduction in the unusually elevated Saudi production was always expected this year. But not so suddenly and sharply, and this has led to a temporary tightening in the markets which has helped support prices. However, we expect that Saudi supply will begin to rise again over the year in response to domestic demand, and possibly to satisfy export orders to cover any potential further loss in Iranian supply, such that average Saudi output for the year should thus hold at around 9.4mb/d, compared with 9.8mb/d in 2012.

Oil market looks set to weaken

Although prone to bouts of upward pressure from financial markets and geopolitical developments, our inclination is to stick with the view that weaker market fundamentals will eventually be a drag on prices this year. Key will be the expected gains in North American and Iraqi production which should keep global supplies elevated at a time of still modest demand growth. In addition, challenges remain in the global economy with budget spending cuts in the US, and political fragility in parts of Europe (i.e. Italy)

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posing downside threats to demand. We would not be surprised to see prices weaken in the spring similar to last year, but expect that Saudi-led OPEC supply management will ensure that average Brent prices hold at around $107/b for the year as a whole, with some slippage to $103/b in 2014.

Metals and petrochemicals

The recent trend in oil prices has been mirrored in almost all other commodity markets. Up until mid-February, generalised investor enthusiasm spurred by the waning of global tails risks, sustained quantitative easing, and a weaker dollar, drove a steady increase in commodity prices which has subsequently been reversed as a more sober assessment of supply and demand conditions took hold. While equity markets have continued to surge, the S&P/GSCI industrial metals index has dropped 7.7 percent from its high in mid-February, and is down nearly 4 percent year-to-date. Similar trends are apparent for Steel Rebar (down 8.6% and 1% y-t-d) and Polyethylene (down 9.7% and 1.4% y-t-d).

The main issue facing many commodity markets is that previously high prices have led to an increase in supply and build up in stocks (particularly steel and other metals in China). In contrast, expectations of global commodity demand growth have become more uncertain, with the recent mixed Chinese data, and lower imports in particular, giving pause for thought. There is considerable disagreement on how much demand for commodities will rise based on current global, and in particular Chinese, growth projections. According to recent research by Barclays PLC, supply is expected to outpace demand for 12 out of 18 metals and agricultural goods, and research show that investors have recently pulled billions out of commodities. However, the slump in metals and petrochemicals markets may be overdone, and prices should begin to stabilises and pick up over the over the next 6 months. A key driver will be expectations of improving Chinese demand.

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Saudi Arabia Saudi Arabia: Economic Indicators 2011 2012 2013f 2014f 2015f

Nominal GDP ($bn) 727 781 802 837 869

Real GDP growth (% change) 8.5 6.8 3.0 3.8 3.2

Inflation (average %) 5.0 4.5 4.7 4.8 4.9

Current account (% GDP) 21.8 22.5 14.4 10.7 7.3

Fiscal balance (% GDP) 10.7 13.2 6.2 2.5 -1.2

Net foreign assets ($bn) 571 747 862 952 1015

Bank deposits (% change) 12.1 10.1 14.5 13.0 12.0

Private sector credit (% ch) 10.2 16.6 13.0 10.0 8.0

Sources: national authorities, IMF, Samba

The Saudi economy remains in fairly good shape, and some key sectors, such as petrochemicals, should benefit from an improving global environment. Yet there are headwinds, not least on the fiscal side, and these might begin to impinge on growth as we move through the forecast period.

Oil production cut highlights supply challenge

The main recent development has been the reining back of oil production. The Kingdom has trimmed crude output to around 9 million barrels/day (b/d) in the past few months, from some 10 m b/d in the middle of 2012. The authorities insist that this is a response merely to seasonal domestic demand, which falls in the winter months. Yet some doubt that this explains the scale of the cut, and think that it might be more of a response to increased supply from both Iraq and, more significantly, North America. The shale gas and oil revolution is likely to see an additional 12 million b/d of liquids from the continent by 2020.

In the nonoil economy, projects delayed in 2012 should be rolled out this year

The cut in oil output (unless reversed, which seems unlikely) will make a big dent in headline GDP for 2013. We estimate that real hydrocarbons GDP will decline by 3 percent this year. What is less clear is how this might affect activity in the nonoil sector. In general, we think that projects delayed in 2012 will be released this year, and this will keep activity fairly firm. However, new fiscal realities (encapsulated by the cut in oil production) might weigh on nonoil activity in 2014-15.

2012 turned out to be a year of delays, at least in the project sector. Personnel changes in key ministries, along with sequencing issues meant that there were few new projects in the second half of 2012. Now however, with more bureaucratic clarity, it might be that the flow of projects will restart. Certainly, there are still challenges, not least on the financing side. The withdrawal of most French banks from the regional project finance market has left a

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hole that has not been adequately filled. In addition, new capital rules are likely to crimp further the ability and willingness of international banks to lend, particularly long term. While Saudi banks have adequate capital buffers, they are said to be shifting towards a more conservative stance this year, having generally booked quite large assets in 2012. Project bonds and the local sukuk market (along with international export credit agencies) might fill some of the gap, but with demand for capital continuing to outstrip supply, it seems that only the most attractive projects (those with premium sponsors) will attract money.

The contracting sector has had to field other challenges as well. Contractors have been facing intense competition from Chinese firms, most of whom import all their labour and material, leaving little for Saudi subcontractors. Anecdotal evidence suggests that the imposition of new labour regulations, along with higher commodities prices, has also put downward pressure on margins. Nevertheless, the latter have eased in recent weeks partly in response to a strengthening euro, which reduces the appeal of dollar denominated assets—such as commodities—to non-dollar investors.

Saudi firms still doing well

Notwithstanding these constraints, Saudi Arabia’s corporate sector is continuing to prosper. The latest purchasing managers’ index (PMI) from Markit shows that Saudi firms are still expanding, with a headline number of 58.5 for the overall index in February, up from 58.1 in January (any number above 50 denotes expansion). Output and new order growth remained solid and employment levels continued to rise. New orders posted a further small rise in February, which Markit attributed to increased sales and marketing activity. New orders have been holding in a very healthy range of 65-70 for well over a year. New export orders (mainly petrochemicals) showed a modest pickup. This component suffered something of a soft patch in the second half of 2012 (though they continued to expand) owing mainly to a slowdown in China’s economy.

The PMI data do not give a breakdown by sector, but some sense of relative sectoral performance can be gleaned from stock market data. Admittedly, the stock market is a small universe (the vast majority of Saudi firms are unlisted family concerns) but the profit performance of listed firms does give a sense of the general health of various sectors. The dominant sectors of the Saudi economy (aside from oil production and government services) are Finance, Petrochemicals, Construction and Trade.

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Banks more focused on retail side

Taking these in turn we see that banks have enjoyed decent year-on-year profit growth since 2010 (a year of retrenchment). Nevertheless, low interest rates have meant increasingly weak returns from project lending and most of the growth is coming from retail activity. The most profitable area on the retail side is credit cards, but there is also considerable potential growth in mortgages. Most banks already offer mortgages to higher income Saudis and mortgage lending has certainly accelerated over the past year. Enabling legislation for three of the five parts of the new mortgage law—passed last year—has recently been released, and it is hoped that this will spur greater lending to the middle and lower income segments. The final parts of the enabling legislation, covering (crucially) foreclosures, as well as mortgage registrations, are expected by the end of March.

As noted above, petrochemicals firms suffered something of a rough patch in 2012 as prices and volumes declined in line with the slowdown in China’s economy. The revival of activity in China should herald an improved performance in 2013, though the strength of Chinese demand might be constrained by government efforts to tame inflation in various sectors, not least property.

Retail sector underpinned by strong nominal wage growth

Retail firms, by contrast, have continued to post resolutely firm profit growth. They have not suffered a profit downturn since the first quarter of 2009, and have been buoyed by the consistently strong growth in sales since then (points of sale transactions, a proxy for retail sales, have continued to grow at 25-30 percent year on year in volume terms). Sales have been supported by strong nominal wage growth, as well as the rapid take-up of unemployment benefit—trends that are expected to continue.

Finally, construction and real estate firms have seen their profits recover following a rocky 2009-11. Again it should be emphasised that listed construction firms (many of which are focused on basic manufacturing) are few and there are many family-owned contractors that have done much better than these figures indicate. Yet it bears restating that contracting is facing significant headwinds from increased competition and new labour regulations.

Government spending growth set to cool

The level of activity in the Saudi nonoil sector is intimately linked to government spending, and it is here that the outlook becomes somewhat cloudy, especially as we move into 2014-15. As noted above, it seems likely that a number of the projects that were delayed in 2012 are likely to be rolled out this year (spending that has already been “made” in budgetary terms). This should help to keep real nonoil growth in excess of 5 percent this year.

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The government is well aware of the changing fiscal outlook and will likely seek to curb public investment growth

Nevertheless, it was notable that investment spending by the central government contracted in 2012 (at least, that is the implication of the limited fiscal results released by the Ministry of Finance). We do not believe that investment spending will be cut again in 2013, but we do think that much weaker growth in central government investment spending will be the pattern for the next few years.

On one level, the government’s fiscal position is extremely robust. Oil prices are currently around $110/barrel (Brent) and although oil production has been trimmed, we expect some SR960 billion of oil revenue this year. This represents a decline on 2012 but is still some 41 percent higher than oil earnings in 2010, for example. Moreover, years of high oil prices have allowed the authorities to build up savings, which currently exceed 100 percent of GDP. These savings would be enough to fund fiscal deficits (were they to materialise) for many years.

Government’s share of GDP has surged over past decade

So why do we think that government investment growth will slow? The answer relates to both the magnitude and structure of government spending over the past decade. Since the current bull run in oil prices began in 2003 real government spending has increased its share of real GDP from around 38 percent to some 63 percent in 2012. As government spending has increased, so the “breakeven” oil price—that is the minimum price to achieve fiscal balance—has climbed from around $20/barrel (Brent) in 2003 to some $87/b in 2013, according to our estimates. (This “breakeven” price depends on a number of variables, but it is useful as a rough test of fiscal vulnerability.)

This in turn speaks to the build-up of spending commitments made by the government over the intervening decade: for example supposedly one-off salary adjustments made for inflation, increases in subsidy spending to counter rising food inflation, and the extension of unemployment benefit—again, ostensibly conceived as a time-limited measure, but recently extended. These spending commitments are easily made in an environment of high and rising oil prices, but difficult to unwind for political reasons. Capital spending (that is, investment) is much easier to rein in or reduce.

The government might decide to keep spending high and fund any deficits that might materialise by drawing down savings, as it did in 2009. But we think that last year’s cut in capital spending is instructive: the government is well aware of the shifting fiscal equation and knows that drawing down savings does not provide a long term solution. Rather, we think that it will continue to keep capital spending growth in check, with an annual growth rate of some 3-4 percent in the next few years, as compared with the double digit growth registered in the previous decade.

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It is important to emphasise that capital spending will continue to increase—at least in nominal terms—which will fuel continued expansion in the Saudi nonoil sector. But the pace of this spending is likely to slow. As such, we think that real nonoil growth will be capped at around 4 percent in 2014-15—a decent performance in global terms, but some way below the 5-6 percent rate that the nonoil has been accustomed to in recent years.

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The UAE

UAE: Economic Indicators (a) 2011 2012e 2013f 2014f

Nominal GDP ($bn) 345.7 378.3 395.8 414.1

Real GDP growth (% change) 4.9 4.2 3.3 3.1

Hydrocarbon 9.4 5.9 1.5 0.0

Non-hydrocarbon 2.7 3.5 4.1 4.5

Inflation (average %) 1.0 0.7 2.0 3.0

Current account (% GDP) 10.7 10.5 9.6 2.3

Fiscal balance (% GDP) 3.2 5.4 3.8 2.8

M2 (y-on-y %)* 5.0 3.9

Private sector credit (y-on-y %)* 3.4 1.5

* Sept, sources: national authorities, Samba

Economic activity is robust

In Dubai the core economic activities of transport, tourism, logistics and trade have all performed well, aided by growth in emerging markets and high public spending levels in GCC neighbours which benefited from exceptionally large oil revenues last year. Evidence of robust non-oil private sector activity in the UAE more generally comes from the PMI survey indices which have shown healthy rates of expansion. The overall index jumped to 55.6 at the end of last year and has held up close to this level through February (any number over 50 represents an expansion). Encouragingly the new orders sub-index has been particularly strong (over 60) and includes growth in export orders. This bodes well for sustained expansion as we move through 2013.

The UAE as a whole has also benefited from its ‘safe haven’ position given the unrest in much of the broader MENA region. This has encouraged capital flows and helped boost confidence, particular as it coincided with higher oil prices and a healthy increase in both oil (4.6 percent) and NGL (9.8 percent) production in Abu Dhabi last year. Together with strong public spending, this helped boost overall UAE real GDP growth to an estimated 4.2 percent in 2012. Looking ahead, the push from rising hydrocarbons output will drop off sharply, but sustained improvements in Dubai’s traditional activities and rising public spending should help maintain positive momentum. This will be aided by the recent recovery in real estate and confidence, although the debt overhang and weak credit growth will remain headwinds. Overall we expect the UAE economy to grow by another 3.3 percent this year.

Increases in public spending are planned

Since 2009 consolidated government spending in the UAE has been affected by the need to provide funding to troubled GREs both in Dubai and Abu Dhabi. Together with efforts at fiscal consolidation in Dubai, which has been running a fiscal deficit, this has somewhat

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constrained the room to boost capital spending. However, we expect an increasing shift towards higher capital (including off budget) and social spending as the UAE responds to both strong revenues and reduced requirements for GRE support. Overall consolidated spending may not increase by much this year, but the economy should feel the benefits of it more strongly.

This includes progress with the raft of development projects approved by the Abu Dhabi executive council last year (see table), as well as a resumption of capital spending in Dubai where the government has recently announced the restart of $1.1 billion worth of previously postponed projects, and plans to develop Mohammed bin Rashid City which will include the world’s largest shopping mall and hotels. Oil revenues will be impacted by likely production declines and a possible dip in prices, but will remain large and bolstered by revenues from increased external assets, mainly held by ADIA. The consolidated fiscal accounts should remain comfortably in surplus, albeit dipping from an estimated 4.7 percent of GDP in 2012 to around 3 percent this year, although the sharp increase in the estimated break-even oil price to around $90/b for 2013 is a concern.

Real estate is recovering, but faces mortgage law headwinds

Increasing evidence is emerging that the property market in the UAE, and Dubai in particular, has bottomed out and that a strong recovery is apparent in certain segments. Indices compiled by Cluttons suggest that prices for mid-range villas and apartments in Dubai were up between 30 percent and 20 percent respectively year-on-year in January (see chart). There is also evidence that the volume of property transactions is on the rise. Safe haven inflows have certainly provided a boost to the residential market, and rising prices have helped boost the balance sheets of Dubai’s GREs, most of which have significant stakes in the property market. This has helped revive confidence, as evidenced by the announcement of bold new projects including a luxury hotel replica of the Taj Mahal. However, the recovery is unevenly spread, and we worry that it could yet be dented by the continuing supply overhang. New mortgage laws this year (including for the first time loan-to-value limits for expatriate and locals) may also dampen the recovery.

Financial markets are happy

The UAE has benefited from a general easing of risk aversion during 2013 and its perception as a safe haven in a turbulent region given Abu Dhabi’s oil wealth, Dubai’s recovering non-oil economy, and political stability within both emirates. The generalised global search for yield has seen UAE entities’ bond yields come down, and CDS spreads have similarly declined as investor confidence firmed. Spreads on the Dubai 5-year sovereign have more than halved since early 2012, and currently stand at

Infrastructure & Economy Housing & community

Khal i fa Port & Industria l Zone Numerous res identia l projects

Abu Dhabi International Airport 7,608 vi l las for nationals in 2012

2 major road projects 24 new schools

Dra inage systems Healthcare

2 new industria l zones 14 new healthcare faci l i ties

Auto City Rehabi l i tation centres

Renewable energy projects Cleveland Cl inic

Museums

Zayed, Louvre, Guggenheim

Development Projects Approved by Abu Dhabi

Executive Council January 2012

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around 225, against a similar Abu Dhabi spread of 67, down from an intra-year high of 150 in July 2012.

The strong market appetite for the UAE was reflected in the massive oversubscription for the Dubai government’s January Sukuk issuance. Following $15 billion in orders, the issue was raised to $1.25 billion to include a $500 million 30 years component on market request. The 10 year component was priced to yield 3.875 percent and the 30 year 5.375 percent.

Improving investor sentiment, both global and local, and the steady improvement in economic activity has also seen stock markets in the UAE perform well. Dubai’s bourse was up nearly 20 percent last year, and Abu Dhabi’s nearly 10 percent, with both significantly outperforming the MSCI Emerging Markets index. The positive momentum has continued into this year with both stock exchanges up between 15-18 percent as of mid-March.

Policy rates to remain low but lending legislation has tightened

There seems little prospect of a change in the exchange rate peg to the US dollar. As such, UAE policy rates will broadly follows those in the US which are set to remain low through end-2014. This will suit the UAE, which does not face undue inflationary pressures and wants to revive lending to support growth. However, while interest rates are expected to remain low, the authorities are determined to prevent a repeat of the earlier unsustainable credit boom, particularly one that inflates another property bubble. As such the central bank has and is introducing legislation to tighten lending practises. This includes new laws on personal and automotive loans, limits on lending to local governments and GREs, and the more recent new mortgage legislation. There may well be some delays in implementation given push back from banks, but the trend is clear.

Inflationary pressures are muted

Official data confirm that inflation remains low in the UAE, with the end-2012 rate coming in at under 1 percent. Rents remain a major dampening influence and registered another 1.1 percent decline over same period. That said, inflationary pressures were muted for most items in the consumer price index (CPI). The heavily weighted food price index was up around 2 percent, while most other components rose by less than 1 percent. The low weighted beverages and tobacco index was an outlier, rising by 17 percent. Looking ahead, we expect price pressures to remain muted, although the disinflationary impact from housing is likely to ease, pushing average inflation to around 2 percent in 2013. However, it needs to be noted that the official CPI reflects prices paid by the local Emirati population which benefits from substantial subsidies. Price inflation will thus be considerably higher for the dominant expatriate population.

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Bank deposits have recovered

After a surprise dip in the first half of last year, bank deposits revived strongly in the latter months and were up by 12.3 percent year-on-year in November. Non-resident deposits grew an impressive 20.3 percent to $36.8 billion, while resident deposits were up 9.4 percent to $285.5 billion. Partly reflecting the improved liquidity position, interbank rates trended down during 2012 and are currently holding at around 1.3 percent for 3 months. Meanwhile, central bank data show that money supply growth (M2) picked up to 3.9 percent in September year-on-year, having contracted in the first half.

But credit growth is weak

Despite improving liquidity conditions, lower aggregate loan-to-deposit ratios (94 percent) and sound capital adequacy ratios (21.2 percent as of September 2012), domestic credit growth remains weak, held back by large provisioning requirements (much of which stems from GRE restructuring) and tighter lending regulations. Total bank provisions were up another 18 percent in the year to November 2012 at $22.8 billion, while total bank loans grew by 3.1 percent. However, more detailed data from the central bank show that credit to the private sector (excluding financial institutions) actually declined in the year to September (0.3 percent). In contrast, credit to the public sector continued to grow strongly (16.1 percent), leading to some suggestions that the private sector is being “crowded out”. Looking ahead we expect some revival in credit growth to the private sector as economic activity strengthens and the drag from GREs debt restructuring wanes. But overall domestic credit growth is likely to remain muted at around 5 percent.

And debt remains a nagging concern

While Dubai GRE restructuring deals are mainly on track, three international financial institutions have launched legal proceeding against Dubai Group to recover claims, and debt and refinancing issues in general remain a headwind to growth. As noted earlier financial markets are currently favourably inclined towards the UAE, and will take heart from the recovering real estate sector. This suggests that refinancing needs will continue to be met, although the scale of the needs continue to present some roll over risks, particularly if the global financial markets/economy were to take a turn for the worse.

Dubai faces projected financing needs of $9.5 billion this year, down from $14.6 billion last year, while Abu Dhabi needs to raise $18.8 billion according to IMF data (see charts). The requirements surge in 2014 when the Dubai government is due to repay $20 billion borrowed from Abu Dhabi and the federal authorities.

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However, it is widely expected by markets that the bulk of this debt will be rolled over with maybe some partial repayments.

While the debt outstanding is relatively large, particularly for Dubai, the UAE as a whole continues to benefit from large external assets which will have built up further last year as high oil production and prices boosted the current account surplus. Although somewhat smaller, another surplus is projected this year and, while available data on external savings is incomplete, particularly regarding ADIA’s assets, the IIF projects that the UAE’s total foreign assets will exceed its external obligations by $480 billion at end-2013. The bulk of these assets are owned by Abu Dhabi, but given its record of providing financial support to other emirates and the federal government, they provide a reassuring buffer to the UAE as a whole.

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James Reeve Deputy Chief Economist James.Reeve@samba.com Andrew Gilmour Deputy Chief Economist Andrew.Gilmour@samba.com

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