QAT - KSA ETF: Susceptible To More Weakness

2023-09-27 08:21:14 ET

Summary

• iShares MSCI Saudi Arabia ETF is not as cost competitive as other alternatives in this space.
• Reduced crude production is likely to weigh heavily on the GDP landscape whilst non-oil metrics are slowing too.
• The lag effects of higher cost of funding are likely to put pressure on the NIM trajectory of Saudi banks which comprise 40% of the portfolio.
• P/E valuations look pricey and the risk-reward on the charts don't look favorable.

ETF Profile

Investors looking for diversified equity exposure to the largest economy in the Middle East- Saudi Arabia, may consider looking at the iShares MSCI Saudi Arabia ETF ( KSA ), a product that focuses on Saudi equities. KSA is by no means, the only ETF in the market that focuses on this region (you also have the Franklin FTSE Saudi Arabia ETF), but it is the most popular and most liquid option around, with an AUM of almost a billion dollars, and fairly tight spreads of $0.01. These tight spreads also enhance its positioning as a suitable trading play, with a decent proportion of bears currently betting against it (the current short interest as a function of the total shares outstanding of KSA is rather elevated at over 14% ).

Nonetheless, KSA's popularity is somewhat ironic, given that the Franklin FTSE Saudi Arabia ETF ( FLSA ) is a lot more cost-efficient (FLSA’s expense ratio is almost half as much as KSA’s expense ratio of 0.74%). Also consider that other country-specific ETFs focussing on neighboring regions such as Qatar ( QAT ) or UAE ( UAE ) are a lot cheaper with expense ratios of 0.58%. Perhaps investors are also attracted to KSA’s wider reach; FLSA only focuses on 58 Saudi stocks, whereas KSA’s portfolio encompasses 122 names.

Macro Commentary

After a stellar 2022 where Saudi proved to be one of the fastest-growing G-20 nations (growth of 8.7%), it was always going to be a tough task to keep the strong momentum going for yet another year. Unsurprisingly, the wheels appear to have come off, with the most recent Q2 data highlighting that the economy only grew by 1.1% on an annual basis (in Q1 growth stood at 3.8%) the lowest rate since 2021. For context over a year ago, the economy was growing at double-digit levels.

Now, looking ahead, things aren’t expected to be too resilient; a couple of months back, the IMF had published its latest WEO report, and in that report, the Saudi region received the most pronounced cut in FY GDP estimates amongst most other regions. Previously, the IMF felt that Saudi would grow by over 3%, but now, that figure has been curtailed even further to 1.9%, even lower than the expected GDP growth of the Middle East and Central Asia regions.

Some institutions like Bloomberg Economics would say that expecting positive economic growth this year may even be a stretch, given what’s happening with crude production.

For context note that last year, the Saudi economy was pumping crude output of 10.5 million barrels per day, but this year, the economy has been implementing production cuts of 1 million barrels per day, which are now also likely to extend till the end of the year. Khalij Economics suggests that this could translate to a production drop of 9% for the year, which would represent the biggest drop in 15 years. Meanwhile, oil prices which averaged over $100 a barrel last year have come off this year. Even though, as part of the Vision 2030 plan, Saudi has been pulling out the stops to diversify away from oil, it is asking for a lot for this segment to hold things together, even as non-oil metrics such as The Riyad Bank Saudi Arabia Purchasing Managers' Index drops to its lowest level in a year.

Meanwhile, investors should also consider that the outlook for Saudi banks (they dominate KSA’s portfolio, accounting for 40% of all holdings) isn’t the most resilient either. In recent quarters, the gap between the yield on loans and the cost of funding has been narrowing, and this trend will persist as the latter typically reacts to higher policy rates with a lag. All in all, the net interest margin ((NIM)) trajectory of Saudi banks is likely to compress even further in the quarters ahead.

Closing Thoughts

When it comes to the valuation and technical sub-plots, it’s hard to be too excited about KSA right now.

Firstly, on a P/E basis, this is not a particularly cheap product to own; Morningstar data shows that it is priced at an elevated multiple of 18x, a 35% premium over the average of other country-specific ETFs from the Arab region. One could perhaps consider paying the premium if you were getting solid long-term earnings growth, but that is not the case with an expected growth rate of only 8% .

Then on KSA's weekly chart, we can see that since it peaked at the $51 levels in April last year, the price action has largely followed a descending channel pattern. There were some attempts to break past the upper boundary of the channel in late July this year, but that did not materialize, and the ETF has continued to demonstrate weakness since then (as noted earlier, this ETF also has a significant chunk of short interest pressure riding behind it). Even though we've seen the price drift away from the upper boundary of the channel, when you consider where the lower boundary is currently perched, the reward-to-risk equation at current levels still does not look enticing.

Finally, also consider that relative to the broad emerging markets universe, KSA is still trading above the mid-point of its long-term range, increasing the probability of further mean-reversion in the periods ahead.

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