Interview with Faisal Hasan, Senior VP of Investment Research Department at KAMCO

We are in the middle of a very interesting period. We’ve seen a significant drop in oil prices, globally. How is it going to affect Kuwait? What is your general assessment/outlook for the economy?

Kuwait is an oil related economy, with the energy sector dominating the economy. Oil and oil related products constitute about 55 to 60% of Kuwait’s GDP. A sharp drop in oil prices, like a 40% drop, is going to affect the economy. The nominal GDP will get affected. Real GDP will depend on how OPEC reacts about 6 months down the line. Right now they have said they will not cut production, so real GDP change may not occur in 2014. But in 2015, OPEC’s production decisions will have an effect on Kuwait as well. Overall, we foresee flat GDP growth, or marginally positive, for Kuwait in 2015. The curve will probably go up in 2016 as oil prices rebound, likely starting in the second half of 2015. So, in terms of real GDP we are expecting a flattish to marginally positive growth for Kuwait. However, the non-oil GDP, a component that is increasing, might have an increased effect in 2015.

We expect non-oil GDP growth to be in the region of 4 to 5%.

Kuwait is trying to diversify its economy, to prop up the non-oil economy, because the government always knew that oil prices are subject to volatility and they have to diversify the economy by improving the non-oil sector. We have been seeing growth in the non-oil sector over the last few years. The non-oil growth in the GDP is always outperforming the oil sector growth. In 2015 we are expecting the non-oil GDP to show a 3 to 5% growth.

What is the outlook for Kuwait’s Current Account?

In the last decade, Kuwait has reaped huge benefits in its current account. The current account surplus in Kuwait has been in the range of 25 to 40%, probably the highest in the GCC region. Any movement in oil prices, positive or negative, has a profound effect on the current account. For 2014 we expect it to remain high, as oil prices have averaged about $75 a barrel, as it has only gone down in the last couple of months.

But if oil prices continue to dip, it will affect the current account, because the break-even price for Kuwait is about $54 to $60 per barrel, which is among the lowest in the oil producing countries. It will have an effect on fiscal spending and current account surplus, but I don’t think it is a major issue right now, because in the last 9 to 10 years Kuwait has accumulated a good amount of surplus from the high oil prices. It can withstand any sort of decline in oil prices for the next 2 to 3 years.

Current account surplus may be flattish, but they still have the accumulated surplus of the past decade. Even if oil prices fall under the break-even price per barrel, it is not an indicator of major problems. Kuwait has the surpluses to continue with the capital expenditures needed to keep economic growth going. Also, Kuwait has an excellent credit rating, so it has the option of tapping the debt market. Kuwait has great financial flexibility, a very minimal debt as a percentage of GDP. So they can borrow from the markets. But I don’t think Kuwait will need to borrow even if oil prices remain low for the next couple of years. So even if the current account surplus declines, there won’t be any major issue.

How do these developments reflect on particular investment sectors? Which sectors do you think will emerge as the winners and losers?

Kuwait has been focusing on public spending. This is very important for two reasons. One is to stimulate diversification. Secondly, it is important for creating job opportunities. The demographic profile of Kuwait shows a huge number of young people, those ready to join the workforce and those who will be ready to join it within the next decade. Unless there is large scale public spending, public-private partnerships and mega projects, the economy cannot diversify and new jobs will not be created. That kind of investment spending is the biggest need. The government is moving in the right direction to accomplish this.

According to different estimates, there are about $200 billion worth of projects, which are either planned or under way, in many different sectors including the energy sector. One of these is a clean fuel initiative from the oil and energy industry. There are huge public works housing projects, there are airport expansion projects, large projects in the utilities sector etc. These projects have the ability to increase the liquidity in the markets. Once a project is assigned, it has many needs. It needs project financing, insurance, underwriting, investment banking etc. A mega project has the ability to churn a liquidity of about 7 to 8 times its size.

So if you’re considering a $200 billion project, over a period of 5 to 10 years, you will see a liquidity of about $800 billion or a trillion dollars.

Government should not reduce its capital expenditure projects even with declining oil prices, because these projects will give benefits over a medium to long term period.

In terms of investments and asset classes, some are looking good. One of the best asset classes now is the Fixed Income market because in the last two months or so we have seen a lot of volatility in the equity market. This hasn’t been good for institutional or retail investors. As equity markets declined in line with the decline in oil prices, fixed income markets did not move down that much. The main reason is the Sovereign Wealth funds. They are backed by the governments. Governments in the region have good financial flexibility and strength.

So the CDS market of the GCC has not declined much. Fixed income securities haven’t seen too much volatility. That asset class is a good opportunity for institutional investors that are looking for GCC or Kuwait exposure. The bonds are giving a good yield. They are backed by good ratings and the good macroeconomic fundamentals of Kuwait. Additionally, it is a chance to diversify your portfolio with fixed income assets. So the fixed income asset class and some of the fixed income funds are looking good, in my view.

In terms of the different sectors of the economy, banking, industrial, oil and gas, telecommunications etc., which do you consider will be the winners and losers? Can you give us an overview of each of the major sectors of the Kuwait economy?

About oil and gas, which is the predominant sector of the economy, I think the sector will diversify more into downstream projects. We are seeing refinery projects. These are good in terms of profit margins. Refined products give good margins. The sector will obviously depend on the price of oil. But we do expect an upturn sometime in the second half of 2015. We will see increased demand from emerging markets. The oil market looks neutral for now.

Another big sector of the Kuwait economy is the banking sector. The banking sector is growing. The credit market is growing at a lower single digit pace. But the profitability in the banking sector is high. In the past 9 month period, the banking sector was up about 18 to 20%. Overall, on the Kuwait Stock market, corporate earnings were up only 2%.

That shows the banking sector is doing well. There is also a huge scope in the near future for the banking sector in project financing. As i mentioned earlier there are a large number of projects that are coming up. The Kuwait banking sector will probably have to align with international banks to provide that scale of financing. Kuwaiti banks are also now looking outwards. They have acquired banks in the GCC and MENA regions. They are looking for an entry into bigger economies. Their revenue stream will be more diversified and they will be looking at inorganic growth.

I am positive about the banking sector. There is increased competition even in Islamic banking. They have new products and they are competing on level ground with the conventional banking sector. That is another area of growth as many people look more towards the Islamic banking sector. There are more products available from this sector now, for example, the sukuk. A lot of sukuks are emerging in the region. Markets have a tremendously increased ability to absorb sukuks.

As for the real estate sector, it is a very important sector. It is intimately correlated with economic growth and macroeconomic fundamentals. However, the yields in this sector are still good in Kuwait. There is a lot of construction activity, particularly on the high end, which is the malls and retails. The yields in this segment are very good. I am not so positive on residential real estate, not so much because of oversupply but because there is a demand-supply mismatch that can potentially happen in the future. I am sure there will be a positive outlook for the commercial and logistics segments of the real estate sector.

In Telecommunications, the penetration rate in Kuwait is above 100%. There is not much scope for further growth for telecom companies within Kuwait itself. The companies are looking outwards, into other markets. For example, Zain formed Zain Saudi Arabia. All the telecom companies are looking at other telecom markets to increase their revenues and subscriber bases. There will be churn in the telecom sector in Kuwait. We have new players like Viva entering the market. They are making inroads into the market share of the other 2 major players. There is churn between the prepaid and postpaid segments. But major growth will come from the outside markets or inorganic growth, because penetration level in Kuwait is already very high.

The investment sector is very dependent on the stock markets and their related products. The investment sector, investment banking sector, financial services sector and the insurance sector, will all benefit from the planned mega projects, where their expertise will be required. However, stock market volatility will affect them strongly. Investment companies will have to develop a more stable cash flow, investment banking activities, and brokerage services. Any movement in the stock market will directly affect them.

Consumer spending is high in Kuwait. But the consumer goods sector, discretionary or non-discretionary, has a range-bound growth in Kuwait. However, as the GCC moves closer to a common market, there are a lot of opportunities for Kuwaiti companies, whether they are banks, consumer goods companies or telecom companies.

If Kuwaiti companies move to the markets in GCC or MENA regions, they have access to a huge population of consumers. Or even if they spread into a single, bigger economy, like Saudi Arabia, Egypt or other North African economies. So Kuwaiti companies can grow by inorganic growth, alliances or expansion.

What about the industrial sector?

The growth of the industrial sector is related to the petrochemical sector. The construction sector dictates the growth of the construction materials industry, like cement. Real growth will depend on how they can expand into the GCC, MENA or international regions. That growth will be in line with the GDP growth we will see for the region per se.

What about the big family owned conglomerates in Kuwait? Do you think that the current drop in oil prices, or the current economic environment can cause first time bankruptcies in Kuwait?

No I don’t think so. It will be different from the financial crisis of 2008. There has been a lot of de-leveraging since then. There are fewer corporations, investment companies or even retail company investors that do trading on stock markets by leveraging. Decline in oil prices will have an impact on liquidity but it will not result in corporate bankruptcies because companies and family groups have learned from the past. Their businesses are now on a more stable cash flow rather than using leveraging to get above average market returns. We don’t expect any major bankruptcies. I think we will be able to tide over this decline in oil prices because the financial profile of the government and corporations in in much better shape.

Please tell us your personal opinion on the state of the global economy. Do you foresee growth or a global recession? What will happen in 2015 and 2016?

First of all, I don’t foresee a global recession at all. This is based on the fact that the USA is still the leading economy in the world. The growth in the American economy has beaten our expectations. In the US, unemployment is down, though the wage rate has not increased which is a cause for concern. But GDP in the US will have an effect on other economies.

There was a question of whether China would have a hard landing or a soft landing. I think the Chinese are managing their economy pretty well. When we say the Chinese economy is slowing down, we must remember that it is slowing down from a very high 8% or 9% to about 6%. That is a good growth considering the size of the Chinese economy, and it will be good for the rest of the world too. Even in India, the sentiment has improved with the change in government. There was a sort of policy paralysis with the former government. The new government is providing some economic stimulus and there are many new projects, a good sign from one of the largest emerging economies.

Europe is an issue that causes us some concern. There might be some deflationary pressure. This is a global issue, inflation is not picking up as it was expected to. We are perhaps entering a deflationary phase. This will raise the debt of those economies that are indebted. That is an area of concern.

The emerging markets are doing all right but if the US dollar becomes stronger there will be pressure on their currencies. The US dollar has rallied over the past 2 months or so by about 5 to 10%. That is of concern to the emerging economies. But overall we foresee growth in the global economy, led by the US and China and the other emerging markets. I do not see a major growth story on the global front. We are cautiously optimistic about global economic growth, mainly based on the fact that the US economy will grow, China will not have a hard landing and there will be growth in the emerging markets.

Do you see any parallel to the situation in 1997, in relation to what is going on in Russia right now? That crisis trickled down into the US economy with the dot com bubble bursting in 2001. Do you see this happening again?

I hope not. If we are to draw comparisons, in that crisis a lot of hot money had flowed into the emerging markets. The trickle-down effect over a period of time caused that crisis. There was LTCM, the Asian financial crisis, the dot com bubble. A lot of problems happened within that decade. I don’t see that now mainly because we have seen a lot of de-leveraging happen in the US, though not that much in Europe.

The de-leveraging in the US only transferred the debt from the household to the government. The Fed‘s balance sheet is skyrocketing.

Yes but the Quantitative Easing worked, it helped household debt, though they have stopped it now. The emerging markets now have more tools at hand to control things. For example emerging markets still have the capacity to cut rates, which the US and Europe probably don’t have. Today’s emerging markets have some extra tools that were not available earlier. If we are comparing, today’s Russian debt, stock market effect and it’s part of the international asset allocation is not as big as the Asian financial markets in 1997. In that crisis, all the emerging Asian currencies crashed.

The financial structure of emerging markets has changed a lot. They have tried to engage the FDIs (Foreign Direct Investment) rather than the Foreign Institution Investors (FII), which is the hot money. So I don’t foresee a major crisis. When commodity prices go down, commodity exporters like Indonesia, Brazil, Russia or the GCC region will be affected. But I’m not sure if it will become a full blown financial crisis.

What do you think are the biggest challenges to Kuwait’s economy?

I think the biggest challenge is diversifying the economy and job creation. It will be a challenge to execute the many projects that have been announced to diversify the economy. We have seen some delays in execution in the past 15 years or so. There hasn’t been a very fast paced execution of plans. There have been delays, some projects were scrapped, some were re-tendered. But this time we are seeing some positive signs that things will go ahead smoothly. There are signs that PPP, Public-Private partnership model is now being used. Also there are infrastructure projects. We will see much faster execution this time around. If this doesn’t happen, then it is a major challenge for the economy because these are the projects that will diversify the economy and create long term jobs. It is required. If it gets delayed for any reason, it will be a big challenge for the economy.

Lastly we would like to talk about the attractiveness of MENA as an investment opportunity compared to other emerging markets. In relation to real estate or fixed income investment opportunities, it is a logical question to ask, why not invest in Hong Kong, and get a higher return on investment? Why invest in MENA or Kuwait? I mean Russia is now yielding more than any other country. Why not invest there? What are the yields here?

The MENA region has a huge population, roughly the size of the US. Also, investors can reap the benefit of demographic dividends. While Europe and other areas have an aging population, MENA has a young population. The potential economic growth and productivity of the next 20 years or so is immense. The MENA region is growing at about 4 to 5%, in a world where 2% growth is considered very good. MENA’s growth rate will continue to be good. GDP growth and economic opportunities in the MENA region will continue to outperform global averages.

Talking of fixed income funds, the MENA region has countries with very high investment grade ratings which have very high yield bonds. MENA has very good coupons, yields and excess returns which can be generated, where good investing can make good yields. The profitability growth for the corporate sector is good. The money supply in the GCC region is probably in double digit growth. Corporate profitability is also growing again in the MENA, after the disruptions of the Arab Spring. There was a slight economic downturn and a lowering of growth estimates. But it is growing again. Investors can look to MENA for long term potential as it is a diversified economy.

Within the GCC region, there are great opportunities within different sectors. There are also different pockets of growth, ranging from the real estate sector to the petrochemical industry. Oil is a great benefit to the region. Inflation in the region is very benign. Inflation in Kuwait has been about 3 to 4%. It’s the same for the GCC. The inflation situation is good, economic growth has been good. Overall the economic scenario has been positive. The region, specially the GCC, has a major surplus on hand, which can be utilised to continue economic growth.

This model will make it easy for any investor to set up base. Most of the countries in the region are opening up their economies. They are setting up financial centers in order to attract foreign banks and foreign financial institutions. They are opening up their non-oil sector, privatising some of the energy sector. There is scope for international investors in both upstream and downstream projects. It will be easy for big companies and private players to set up base in the MENA region, in the GCC, and especially in Kuwait.