KSA: Positioned To Outperform Other Emerging Markets

Opportunity Overview

Saudi Arabia's economy will likely be a bright spot among emerging markets this decade, and equities are also positioned to continue outperforming.

However, Saudi Arabia's continued outperformance this decade hinges upon higher oil prices ($80/barrel or higher) and its economic diversification. Initial efforts to diversify its economy have been successful, as it recently ranked 6th among all emerging markets in terms of FDI confidence. The economy has acceptable levels of risk, and the main factor that makes the equity markets less appealing is its current premium to MSCI Emerging Markets.

Economic Outlook

The combination of economic reforms and higher oil prices could allow Saudi Arabia's economy to have rapid growth this decade. Saudi Arabia's economy has grown at an average rate of 3.7% since 1969, which has largely been driven by favorable oil price movements. Saudi Arabia's economy grew much stronger in 2022 on the back of higher oil prices.

Saudi Arabia is the most logical first place to look if you are bullish on oil, as it is the world's second-largest producer of oil. Moreover, Saudi Arabia is strongly focused on both diversifying its economy to be less dependent on oil and exploring new energy sources. For example, Saudi Arabia is exploring ways to become the world's largest hydrogen producer.

Inflation in Saudi Arabia has remained under control, while other emerging markets have struggled with higher inflation. Inflation has averaged around 2% since 2020 and very quickly recovered from its peak of over 6% in 2021.

Inflation in Saudi Arabia

Saudi Arabia's economy grew by 3.8% in Q1 2023, and the outlook for this year is relatively favorable, even with slightly lower oil prices. Saudi Arabia's economy grew by 8.7% last year, but will only grow by 2.5% this year, according to the World Bank.

The IMF recently noted that Saudi Arabia will need oil prices to be $80/barrel or higher to avoid a fiscal deficit. Oil remained well above $80/barrel in 2022, which helped the country deliver record growth.

China's economic rebound has surprised some economists and may help to keep prices above $80/barrel later this year if this trend continues. Moreover, India's oil demand is also rising, and its total demand for oil may soon exceed China's oil demand.

The country's public debt as a % of GDP is also much lower relative to that of other emerging markets, at only 30% of GDP. Saudi is easily positioned to outperform if oil stays in the $70-90/barrel range.

Vision 2030

Saudi Arabia's economic diversification and other measures implemented under its Vision 2030 may help deliver sustained growth this decade. The country plans to take some of the following steps under this plan:

Geopolitical advantage: The country's geography is also an important characteristic, as Saudi has the potential to boost exports by increasing cooperation with Europe, Africa, and Asia. At the moment, its top five export destinations include China, Japan, India, South Korea, and the UAE. Boosting relations further with countries like China and India will help Saudi Arabia boost is global hegemony.

Diversify Economy: If Saudi Arabia is going to fully exploit its strategic geography, it will need to diversify away from oil. The country wants its non-oil exports as a % of total exports to rise from 16% to 50% by 2030. Saudi Arabia could also be a solid manufacturing destination, as companies like the EV company Human Horizons recently signed a $5.6 billion manufacturing deal with Saudi Arabia.

Becoming a Leading Economy: The combination of oil and non-oil based growth will help Saudi Arabia reach its goal of becoming a regional powerhouse. PWC predicts that Saudi Arabia will be the world's 13th-largest economy by 2030.

Privatization: Saudi Arabia also has very ambitious privatization plans, which could help drive increased capital to its local stock market. There is also not much pressure for the country to rush, as its public debt levels are comparatively low and oil prices are still relatively high.

The country's sovereign wealth fund has helped to increase economic diversification in the country. Saudi Arabia's Public Investment Fund is currently the world's 7th largest sovereign wealth fund.

Moreover, the government has made reforms to help attract FDI to boost its economy. The realization of these goals this decade should not be that difficult.

Equity Markets

Saudi Arabian equities have outperformed the MSCI Emerging Markets index in the past two years. Equities only declined by 5% in 2022, while emerging markets declined by 20% in the same period.

ETF Overview

The iShares MSCI Saudi Arabia ETF (NYSEARCA:KSA) invests in a basket of 110 companies in Saudi Arabia. The management fee is 0.74%, which is slightly higher than that of the Franklin FTSE Saudi Arabia ETF (KLSA).

The ETF mainly invests in banking and materials companies, and has very low exposure to themes like healthcare, energy, consumer staples and consumer discretionary stocks.

The valuation for the ETF is not that compelling, especially since it mainly invests in banking companies, which do not typically trade at a premium to the index. Moreover, the ETF is extremely underweight consumer and healthcare companies.

Banks in Saudi Arabia have had consistent loan growth, so having strong exposure to banks could be a solid strategy.

BCG projects that banks in Saudi Arabia will have loan growth of 8.5%/year through 2027.

Benchmarks

I have been comparing this ETF to regional peers in MENA, as well as other oil exporting countries.

This ETF has substantially outperformed other major oil exporting countries like Nigeria and Colombia, which both have higher political risks and have had poor performance in recent years.

If you are aiming for higher upside in emerging markets it can actually make more sense to aim for some of the distressed markets where perceived risk is greater than the actual risk.

Equities in Nigeria trade at 9x earnings and have a 7% dividend yield, while Colombian equities trade at 4.5x earnings and 0.75x book value. These markets are better high risk, high return markets, while Saudi Arabia merely offers acceptable returns with lower levels of risk.

Saudi Arabia has outperformed most of its MENA peers by over 10 percentage points in the past five years.

Source: MSCI

Saudi Arabia still trades at a premium to most of its MENA peers, and also has the lowest dividend yield. The market does deserve a slight premium to MSCI MENA markets, but the current premium may be a bit too steep, especially with oil prices still hovering below $70/barrel.

I am personally more focused on cheaper MENA peers like Egypt, which trades at a substantial discount to MSCI Emerging markets. Colombia also provides similar exposure to positive oil price movements, at much lower valuation.