Pressures for Increased Transparency resulting from MSCI’s Reclassification of UAE from Frontier to Emerging Market

Pressures for Increased Transparency resulting from MSCI’s Reclassification of UAE from Frontier to Emerging Market
Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited
Analysis by Ryan Mahoney, Portfolio Manager at Dalma Capital Management Limited

Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC; the company’s core business is hedge fund management.

MSCI (Morgan Stanley Capital International Indices) is no longer part of Morgan Stanley but is a worldwide, influential and leading provider of investment decision support tools.
On 14 May 2014 MSCI announced the results of its semi-annual review meeting. As expected, the UAE and Qatar indices were reclassified from Frontier Markets to Emerging Markets.
This brings positive news to the market in terms of increased investor confidence, greater visibility of UAE companies to sophisticated investors worldwide, increase in foreign portfolio investment directed towards the UAE and improvement in overall market efficiency. The upgrade and the assets that come with it are also likely to lead to pressures for increased transparency in order to achieve consistency with the market accessibility criteria set forth by MSCI for constituents of its Emerging Markets Index.
A country’s market accessibility is judged on the basis of four factors that include: openness to foreign ownership; ease of capital inflows and outflows; efficiency of the operational framework, and stability of the institutional framework. “To remain consistent with the Emerging Markets criterion and gradually move towards the ultimate goal of being classified as a Developed Market, the UAE and Qatar will need to deliver the required improvements in all four factors assessing market accessibility,” concludes Elliot Carol, portfolio strategist at Dalma Capital Management Limited.
With regard to openness to foreign ownership, the MSCI upgrade will require local markets to have an increased focus on providing a level playing field for both international and local investors. Foreign ownership limit levels will inevitably need to be enhanced, with equal economic and voting rights being provided to foreign investors. In addition, the upgrade will necessitate that equal rights are provided to all minority shareholders.
The UAE is largely compliant with the ease of capital inflows and outflows factor; the country has already implemented a high degree of foreign exchange market liberalisation due to the existence of a developed onshore and offshore forex market. There are also no restrictions, as such, on inflows and outflows of foreign capital to and from the local stock market. Minimal restrictions are applicable to repatriation of foreign direct investment as well.
The key challenge will be improving efficiency of the operational framework and, just as importantly, maintaining it.  Barriers to entry for investors will need to be lowered significantly, by minimizing the registration requirements for international investors as well as documentation/approvals required for setting up local accounts in order to decrease the overall time required for opening and funding an account. The legal and regulatory framework governing the financial market, stock exchanges and the various other financial markets participants will need to be improved, including ease of access to information (particularly in English), reduction of ambiguity and prompt enforcement of laws and regulations, as well as consistency amongst all of these factors over time.
A competitive landscape that encourages unrestricted investor access to derived stock market information, data and investment products will also be required; for example the provision of independently calculated indices or the creation of baskets of securities used in the creation of financial products. Likely the most important factor in improving transparency will be increased pressure for the timely disclosure of complete stock market information in English and under reasonable commercial terms to all market participants as well as the robustness and enforcement of accounting standards. These improvements will likely lead to reduced information asymmetry amongst investors and other market participants.
Constant improvements will be considered necessary in the market infrastructure as the UAE continues its path to “developed market” status. A well-functioning clearing and settlement system, based on international standards including delivery versus payment, the absence of pre-funding requirements and the possibility to use overdrafts will need to be in place. Availability of omnibus structures will be a key consideration. An efficient mechanism that prevents brokers from having unlimited access to an investor’s accounts, in order to guarantee the safe keeping of its assets will in all likelihood become mandatory and would require competition amongst local custodian banks as well as the presence of global custodian banks.
In addition, to ensure high quality of services offered to investors – such as cost efficient trading and ability to execute block trades at the same price for the various accounts of a fund manager – steps to increase competition amongst brokers will be inevitable. A framework for off-exchange transactions and in-kind transfers will likely be needed. Finally, there will be pressures to put in place an efficient mechanism to allow short selling as well as extensive use of stock lending, along with a robust but practical regulatory framework governing those activities.
Concerning the stability of the institutional framework – which deals with basic institutional principles such as the rule of law and its enforcement, the stability of the "free-market" economic system and track record of government intervention with regards to foreign investors – the requirements remain modest for countries classified as both Emerging and Frontier Markets. 
Any country aiming to acquire the Developed Market status in the long term inevitably needs to focus on improving the stability of its institutional framework as well.

MSCI Emerging Markets Upgrade for the UAE and Qatar: Likely Effects

MSCI Emerging Markets Upgrade for the UAE and Qatar:  Likely Effects

Written by Zachary Cefaratti - Risk Officer at Dalma Capital Management Limited, a DFSA regulated Hedge Fund Manager in DIFC

The decision by MSCI to upgrade UAE and Qatar to Emerging Markets status from Frontier Markets status is likely to have profound, positive effects on domestic equity markets.  The upgrade will cause the investor base in domestic equities to broaden widely and could significantly increase liquidity of domestic stocks, such as DP World.

There are several factors that will cause these positive effects - firstly, Exchange Traded Funds (ETFs’) that track indices are highly popular investment tools utilised by investors around the world, primarily in the United States and Europe.  BlackRock, the world’s largest asset manager, operates 18 ETFs that track MSCI Emerging Markets under the iShares brand.  The combined average daily trading volume of iShares’ Emerging Market ETFs exceeds $3 billion and combined assets under management exceeds $44 billion, which compares to only $11 million daily trading volume and $825 million under management for the single iShares equivalent Frontier Markets ETF.  This means that constituency in the MSCI Emerging Markets countries should automatically create increased liquidity and a broader investor base for the UAE and Qatar. 

This may be just the tip of the iceberg; many ETFs, Closed End Funds (CEFs’), Mutual Funds and other globally held investment products track countries defined as “Emerging Markets" by MSCI, S&P and Dow Jones compared to very limited holdings of “Frontier Markets” countries.  Furthermore, many global institutions (such as foreign sovereign wealth funds, pension funds and endowments) have investment mandates, which define their maximum allocations to Emerging Markets, Frontier Markets and so on.  These large institutional investors typically have much larger allocations to Emerging Markets than to Frontier Markets and rely on MSCI, S&P and Dow Jones to define which countries are “Emerging Markets".

With the broader and larger investor base that is caused by the MSCI upgrade, equities in the UAE and Qatar are likely to see greater average daily trading volumes, decreased average volatility, decreased gap risk, more resilience to internal and external shocks or black swan events and greater transparency.  All of these market factors have the potential to improve overall domestic market efficiency. 

One possible negative effect of the upgrade, however, is increased correlation to foreign equity markets; particularly other "Emerging Market" constituents. 
Events in other Emerging market countries, even those with little relation to the UAE, may incite broad selloffs in emerging market assets and funds. For example, a catastrophe in a Latin American country that is also included in the MSCI Emerging Markets index could cause adverse trading activity in emerging market products that would include the UAE and Qatar.  This, in effect, could depress domestic equity markets temporarily even if the foreign event has little or no effect on the UAE or Qatar.
That stated, it will likely be observed that the positive effects of the ‘Emerging Markets status upgrade’ have the potential to outweigh any negative effects.
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Financial Sector Phase Shift – Hedge Fund Investing Leads the Way

Financial Sector Phase Shift – Hedge Fund Investing Leads the Way
Written by Zachary Cefaratti – Risk Officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in the DIFC

The financial services sector is rapidly developing within the GCC.  Following the setup of the DIFC (Dubai International Finance Centre) in 2004, the sector as a whole has progressed in the region substantially – with an increasing number of new firms offering a wider range of services.  The most recent acceleration over the last two years is stimulating a phase shift for the market.   Supply is moving swiftly to meet growing investor interest and is being supported by a favourable economic environment, sizeable capital inflows and regulatory reforms. 
At present, hedge funds are the increasingly popular choice for smart heavyweight investors from across the globe and the trend is building.  One of the most notable examples is the Abu Dhabi Investment Authority (ADIA), which currently invests more in hedge funds than any other organisation in the world.  According to research conducted by Preqin, the sovereign wealth fund currently has over $47 billion committed to hedge fund investments. 
In the post financial crisis climate, savvy investors worldwide are choosing to allocate their capital to elegant risk-adjusted strategies that hedge funds offer.  Increasingly sophisticated investors in the GCC are following ADIA’s lead, with the number of investors allocating to hedge funds more than doubling since the crisis according to Preqin.  Hedge Fund investments are primarily stemming from sovereign wealth funds, ultra high net worth individuals, pensions and astute family offices that have identified hedge funds as delivering the efficient and uncorrelated returns demanded by smart money.  Hedge fund activity in the GCC is expanding to meet the needs of investors who are seeking active management expertise and exposure to strategic asset classes.  This growth represents a new phase in the development of the UAE financial market.
The first major phase of development for the Gulf region’s financial services sector came in the 1970s.  The massive influx of petrodollars into the GCC throughout the decade created a seismic shift in power for global finance.  Central banks of the Gulf region emerged as significant providers of funds to the global banking system through petrodollar recycling and, in 1975, the Bahrain Monetary Authority created a new offshore banking centre to service the developing financial needs in the region. 
The next significant phase of development for the financial sector came about as assets from the petrodollar influx were placed into diversified holdings – spanning a much wider range of domestic and foreign industries and asset classes.  Diversification was the impetus of this phase change and the Gulf region broadly expanded its presence as a buyer within the global marketplace.  The financial sector evolved further in 2004 with the opening of the DIFC, which was designed to create a modern financial centre capable of servicing the financial needs of the regional economy.
We are now entering the next major phase of development for the region’s financial sector.  In April 2006 Argent Financial Group International LLP launched the first Dubai domiciled hedge fund under the leadership of Howard Leedham MBE – now CEO of Dalma Capital Management. The market is expanding and generating wider activity that is pushing forward development at a rapid pace.  New investment structures and strategies, flourishing investor interest and premier expertise are fuelling industry growth.  Furthermore, an evolving infrastructure is allowing the sector to strengthen consistently.  Stable regulation and strong economic fundamentals are further contributing towards creating the next chapter of financial sector development for the region.
Erudite investors from across the globe have been moving quickly to adopt the strategies hedge funds offer.   In particular large sovereign wealth funds alongside knowledgeable, experienced family offices and private investors have been investing heavily in the sector.  Investor interest is only increasing as 2014 progresses - stellar but recently wavering domestic equity market performance has reminded investors of the benefits of uncorrelated, diversified investments with shorting capabilities and absolute return profiles, such as those delivered by many hedge funds.
The role of the UAE in the global market is growing and conditions are in place for continued hedge fund growth in the region.  The robust regulation and business friendly attitude of the DIFC make it a likely candidate for attracting the significant financial resources and talent hedge funds provide.  Consequently, many industry participants are forecasting Dubai to be one of global financial powerhouses of the future.


                        

The Effects of US Monetary Policy on UAE Investors and Borrowers

Written by Zachary Cefaratti – Risk Officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in the DIFC.
What is really driving the DFMGI index?

www.dalmacapital.com

The DFMGI (Dubai Financial Market General Index) has been one of the best performing indices globally in 2014.  As of June 16, 2014 the index was up 88% year-over-year.  This outperformance is driven by a combination of factors, many of which are influenced from abroad.
The continued historically low interest rates in the US and a strong rebound in domestic economic growth following the 2008-2010 financial crisis can be viewed as the main drivers of the recent rally in the index.  Additionally, the UAE has been a major beneficiary of private capital flows due to its political stability following the Arab Spring.

According to the Institute of International Finance (IIF) real GDP growth in 2014 is forecast to be 4.2%, driven by growth in tourism, transportation and trade.  Hence, in comparison to the developed world, the UAE has benefitted from a more robust recovery post 2010.  This strong underlying economic recovery has translated into a rebound in asset prices for both equity and real estate markets.  Furthermore, the completion of previously stalled projects and preparations for the World Expo in 2020 provide a compelling backdrop for economic growth in the coming years.
The other primary driver of asset prices has been the maintenance of exceptionally low interest rates in the developed world, which has caused investors to search for yield in the faster growing frontier/emerging markets.  With the 10-year US Swap rate currently hovering below 2.8%, investors are implicitly assuming that the United States Federal Reserve (the Fed) will remain accommodative in terms of interest rate policy.  With such low yields available, foreign investors have been attracted to valuations in emerging markets – the DFGMI is no exception.

Figure : 10 Year USD Historical Swap Rate

Figure : USD Swap Curve

Why the US Fed Funds Rate matter for UAE borrowers?

Due to the currency peg between the US Dollar and UAE Dirham, the UAE effectively imports the monetary policy set by the US Federal Reserve.  Although there are many benefits to pegging the UAE Dirham to the world’s reserve currency, a major repercussion of the peg is that the UAE central bank cannot maintain independent monetary policy.
The currency peg forces local interest rates to follow those in the US, even when the economy economic outlooks of the two countries diverge.  The optimal monetary policy of the United States is not necessarily that of the UAE – GDP growth in the UAE has outstripped GDP growth in the US by a large margin and is expected to continue to do so for the foreseeable future.  The combination of strong GDP growth and ultra-loose monetary policy imported from the US has resulted in a strong increase in asset prices.  Given the inability of the UAE central bank to raise interest rates independently of the US, local regulators are forced to rely on macro-prudential regulation, such as limiting borrowing capacity to control overall credit growth in the economy.
“Given the robust outlook for economic growth in the UAE, our view is that the major risk for the local stock market remains a normalization in US interest rates,” notes Elliot Carol, portfolio strategist at Dalma Capital, “The issue of rising interest rates is not a question of ‘if’ but ‘when’.”
When will interest rates rise?

Following the 2008 financial crisis the Federal Reserve has maintained extraordinarily accommodative interest rate policy as measured by the Fed Funds rate.  With the Fed already reducing their monthly purchases of bonds through quantitative easing, effectively making monetary policy ‘less loose’, the next question facing investors is when they will begin tightening and normalize interest rates.

Figure : Effective Federal Funds Rate

The Federal Reserve has publicly stated that they are targeting a long-term inflation rate of 2%.  The most commonly used measure of inflation that the Fed utilizes is Personal Consumption Expenditures (PCE) as measured by the Department of Commerce.  The Fed uses the PCE index because it covers a wide range of household spending.  The chart of the current year-over-year change in PCE demonstrates that the Fed’s key measure of inflation is well below the target of 2%.

Figure : Personal Consumption Expenditures Index y-o-y % change

“Despite inflation remaining below the Fed’s target, the discussion of the normalization of interest rates has recently been discussed in the Fed minutes,” comments Ryan Mahoney, portfolio manager at Dalma Capital, “Current Eurodollar futures point to a 2.1% Fed Funds rate at the end of 2016 and a 2.9% rate at the end of 2017.  Although the tightening cycle will not likely start in 2014, local UAE investors must prepare for a rising interest rate environment.”

The inevitable monetary tightening will probably be the trigger for earnings multiple contractions in equity markets.  Over 60% of the price gains seen in local stock markets over the last year are the result of earnings multiple expansion – meaning local markets would suffer in an environment when earnings multiples are contracting.  Higher interest rates also translate into higher borrowing costs for UAE companies and ultimately lower profitability.  Additionally, higher interest rates would make corporate bonds and sukuks more attractive relative to equities as the equity risk premium is reduced by higher bond yields.  Although there is limited risk for an immediate normalization in US interest rates, prudent local investors will undoubtedly begin considering the exposure of their portfolio allocation to rising rates.

The Dubai Financial Market: Bear Market or Correction?

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited – a DIFC Hedge Fund Manager
www.dalmacapital.com

July 1, 2014
 As of July 1st, 2014 the Dubai Financial Market General Index (DFGMI) is down 24.3% from its recent peak of 5,374.11, which was reached on May 6, 2014. Clearly, the market has corrected significantly but the question as to whether we have now entered a bear market remains debatable. Although there is no single definition, many market participants consider a correction of more than (20%) over a two month period to be a bear market. Based on this definition, it would appear superficially that DFGMI is now in a bear market.

However, the DFGMI is still up 23.33% on a year-to-date basis and up 83.1% on a y-o-y basis. From our perspective, the current downturn is simply a correction following an extremely strong period performance by the index in 2013.

We continue to believe that the underlying growth outlook for the UAE is positive. The economy continues to grow due to strength in the tourism, trade and real estate sectors. The DFGMI posted a blistering 108% increase in 2013 due to a combination of factors. However, inclusion in the Emerging Market index by MSCI was one of the primary catalysts for the strong price performance of the market as a whole.
“From our perspective, valuation levels were overextended especially in comparison to other emerging markets” notes Ryan Mahoney, portfolio manager at Dalma Capital, “Ultimately, corporate profitability and economic growth will be the key drivers of the market going forward.“
Why Valuations Matter?
We continue to believe that the outlook is positive for the DFGMI. The recent correction reflected a normalization of valuation levels. In general, we view price multiples such as the P/E ratio to be mean reverting. In a sense, valuation levels are like a pendulum. Periodically valuations levels will overshoot their historical average and conversely undershoot, but will ultimately return to their baseline level.

Observing valuation data, we can see that at the beginning of 2013 the TTM (Trailing Twelve Month) P/E ratio for the DFGMI (blue line) was far above that of the MSCI Emerging Market Index (MXEF) (grey line). However, as the DFGMI marched upward throughout 2013 and the first half of 2014 the valuation premium became excessive. The overvaluation of the DFMGI becomes even more apparent when comparing directly to the Abu Dhabi Securities Market General Index (ADSMI, orange line).
“Although a valuation premium for the DFGMI relative to the MXEF is warranted, the discrepancy became too large to be sustainable,” observes Elliot Carol, portfolio strategist at Dalma Capital, “Given the recent correction in the market, we view the DFMGI as being much more attractively valued at current levels”
What are the future prospects for the Dubai Financial Market?
The IMF is currently forecasting that the UAE will achieve 4.75% GDP growth in 2014. The growth backdrop is positive with both the tourism and hospitality sectors performing strongly. While Abu Dhabi’s economy is supported by public spending projects, Dubai’s services sector has been the main driver of the rebound.
While the performance of the DFMGI has been exceptional, the recent correction will bring valuation levels back in alignment with other emerging markets. Overall, we maintain a positive bias on the UAE economy and the DFGMI, although we did view the rapid rise of the market in 2013 and the first half of 2014 to be unsustainable from a valuation perspective. We believe the market will consolidate at current levels and expect improved corporate earnings growth to be the catalyst to drive the market higher as opposed to an expansion in valuation multiples.