A photograph of the son of slain Saudi journalist Jamal Khashoggi shaking hands with Saudi Arabia’s Crown Prince Mohammed bin Salman was released earlier this week. The image was difficult for many in the international community to process given the Saudis’ shifting narrative on the killing and the fact the son, Salah Khashoggi, had been banned by the Saudis from leaving the country for months due to his father’s criticisms of the regime — he was finally allowed to travel to the U.S. this week after the handshake.
The Khashoggi killing came after a period of time when Crown Prince MBS had consolidated power over Saudi Arabia and had been on a global charm offensive. Earlier in 2018, it was other images of greetings being published, as MBS met with Silicon Valley titans like Google’s founders and the Queen Elizabeth II. While the Crown Prince has not been implicated, and this week called the killing a “heinous crime”, his international credibility has taken a hit. So have his plans to transition the Saudi economy from an oil-dependent kingdom to a diversified economy in the decades ahead with the help of an increased flow of foreign investment.
The story won’t go away. On Saturday, U.S. Defense Secretary James Mattis said the murder threatened stability in the Middle East, though he stopped short of blaming the Saudi leadership or implicating Crown Prince MBS. At the same conference in Bahrain where Mattis spoke, Saudi Foreign Minister Adel al-Jubeir called the reaction to Khashoggi’s death “hysterical.”
As the Khashoggi killing headlines continue, there is a hard stock market truth about this story’s persistence. While the Saudis played up the more than $50 billion committed this week, primarily from U.S. institutions, at the conference in Riyadh that many global business leaders and politicians pulled out of after the Khashoggi killing, regional experts are questioning whether the foreign investment sought by Saudi Arabia from global institutions ultimately will flow into the kingdom.
“My gut is that this was a watershed moment,” said Jean-François Seznec, a member of the Middle East Institute and adjunct professor at the McDonough School of Business at Georgetown and Johns Hopkins’ School of Advanced International Studies, who spent years as an investment banker in the Middle East. “I think until now there was great deal of hope that the reforms would really result in change. Now foreign investors are realizing all of a sudden that the millions of dollars in ventures is at mercy of one guy. This will translate into investors being very wary of doing anything in kingdom.”
But many individual investors who have diversified equity asset allocations that include emerging markets will soon be investing more, not less, in Saudi Arabia, and if they stick with their investment plans, won’t be able to do anything about it. A fortuitous market event occurred for Saudi Arabia in 2018: major stock market index creators, FTSE Russell and MSCI, announced they would be adding Saudi Arabia to emerging markets benchmarks that form the basis of trillions of dollars in investment funds around the world, including in the U.S., mutual funds and exchange-traded funds that are used in individual investment plans from 401(k)s to IRAs and retail brokerage accounts.
There already are two ETFs that track the Saudi Arabian stock market, the iShares MSCI Saudi Arabia ETF (KSA) and, in a fund launch that was unfortunately timed, the Franklin FTSE Saudi Arabia ETF (FLSA), which launched this month. But these funds aren’t where the real money is. Even as Saudi Arabia has been one of the only global stock markets to generate high returns in 2018, the iShares ETF has about $200 million in assets and the new Franklin ETF only a little over $2 million. The Wisdomtree Middle East Dividend Fund (GULF), which has a 26 percent weighting to Saudi Arabia, its biggest market, has $17 million in assets. The big money is in the broad emerging market index funds and ETFs that are used for emerging markets exposure in many investment plans created by financial advisors and asset management firms.
EFG-Hermes Holding has estimated that the upgrades to emerging markets status by FTSE and MSCI could bring between $30 billion and $45 billion into Saudi stocks. There was $1. 9 trillion benchmarked against the MSCI Emerging Markets Indexes as of year-end 2017. The two main iShares emerging markets ETFs that use the MSCI benchmarks (IEMG and EEM) have roughly $70 billion in assets, while the Vanguard FTSE Emerging Markets ETF (VWO), has near $80 billion in assets. New York City’s chief pension fund official this week asked the index providers to reconsider their decisions.
FTSE, MSCI, BlackRock’s iShares and Franklin Templeton declined to comment.
The underlying story is that upgrades to emerging market index status tend to be very bullish for equities, said Charlie Robertson, global chief economist, emerging and frontier markets specialist at London-based Renaissance Capital. “What history tells us that in the 18 months up to an upgrade, stocks do well. If oil and currency stability were the most important issues, Nigeria would have done well too,” Robertson said of the recent run in Saudi performance, where the stock market is still up 16 percent this year, versus a decline of 15 percent in the Nigerian market. “The base case probably remains that the Saudi market still has gains to come.”
Steven Holden, founder of Copley Fund Research, which tracks how fund managers around the world invest, said the passive impact of the Saudi market inclusion into the emerging market indexes is “still a big deal and shouldn’t be underestimated.” He said ownership of Saudi stocks by the actively managed emerging market fund universe his firm tracks will continue to rise, and the current buying is “just the start. It is definitely an index tailwind and provides support to the market.”
Holden said that his firm’s data shows that, on average, 60 percent of fund managers try to match an index weighting to markets, and Saudi Arabia’s weighting presence among global emerging fund managers is currently at 7.2 percent. “No other region the size of Saudi Arabia has anything less than 60 percent of fund ownership, and currently at 7.2 percent, it represents a massive underinvestment,” Holden said. “The Saudi market is guaranteed to attract greater international investment due to its inclusion in the emerging markets index next year.”
He said the index providers, FTSE and MSCI, are in a difficult position, because their entire business is based on an index process driven by a broad methodology. “Countries go in and out of indexes through a methodical process, not on the basis of one political event. That process is fairly well-defined and MSCI and FTSE don’t make decisions lightly and it takes a long time to go through,” Holden said.
“The recent event may have dampened foreign interest in investing in the kingdom, but there is at least a short term tailwind rather than headwind for Saudi stock market,” said Garbis Iradian, chief economist for the MENA region at the Institute of International Finance in Washington D.C. He said it is the more ambitious elements of the Crown Prince’s plan that are most threatened, such as the plan to build a $500 billion megacity (Neom) and the broad objectives set in the Saudi Vision 2030 plan which are “overly” ambitious.
“But that was true before the recent global backlash, and more so due to the challenge of implementing deeper structural reforms to diversify the Saudi economy away from oil and achieve sustained, rapid private sector growth,” Iradian said. “MBS has already consolidated his power and the recent event will not weaken his power unless the U.S. Congress imposes strong sanctions.”
Neom and the creation of a new global financial district were already stalled, and “a failure waiting to happen, a train wreck waiting to happen,” Seznec said. “You can’t have one person from the top dictating everything.” Seznec said it is the “more logical reforms, not the Neom city and stuff,” that need to be the focus and be properly managed.
Some U.S. politicians have been calling for sanctions, but barring a strong and unlikely move against MBS, Iradian said it is going to be his job to convince investors to stick with the kingdom and see through reforms, and he remains highly popular within the country, where he received a standing ovation this past week at the Future Investment Initiative. “MBS has already consolidated his power and the recent event will not weaken his power unless the U.S. Congress imposes strong sanctions. MBS is still very popular among the young Saudi nationals (which account for more than 60 percent of the population) partly due to the social reforms (including more entertainment and letting women drive).”
Seznec is less convinced that MBS will not face any challenge to his power, but he stressed that in phone conversations he has had this week with people in kingdom, there wasn’t much concern shown. “The whole issue is not seen in Saudi Arabia as a major crisis. … People are not about to go out in the street and complain,” he said, though he added that the press is controlled in the country. “The king is very old and knows he has to establish a legacy, and it really is in shambles right now because of this. The U.S. and Europe relationships are in terrible shape, but when you think from a strategic standpoint, the U.S. needs support for the fight against Iran, so can’t just entirely start turning against them.”
The most important commitments for MBS to see through, but which have not been completed, are on a lengthy list of reforms that will be required for private business growth, Iradian said. The Saudi business climate ranking among emerging economies was 90th out of 190 nations, according to a World Bank assessment this year, a weakness which stems from lack of transparency, rule of law, too much red tape, and obstacles in enforcing contracts and resolving insolvency, Iradian said.
Recent statistical measures of the Saudi economic goals are mixed. Fuel subsidies have declined and electricity prices increased by about 45 percent this year, in keeping with plans to make the population less reliant on government subsidies. Government non-oil revenue as percentage of GDP increased to 10 percent in 2017, and should reach 12 percent in 2018, according to Iradian. But the unemployment rate increased in the past two years to around 13 percent as of the second quarter 2018, when the plan is to cut it in half, and despite increased hurdles on employment of foreign labor. Meanwhile, foreign investment is still minimal. The kingdom wants to increase FDI to 5.7 percent in 2030, but it decreased to 0.4 percent of GDP in 2017. And little progress has been made on increasing the contribution of small and medium-sized businesses to the economy.
Many of the companies that are the biggest public companies in Saudi Arabia today, and the ones which are the largest weightings in the stock market, are the older-guard companies in core industries, such as chemicals, materials, telecom and financial services.
“I do still have some positive views still because I think the big companies are well-managed. … There is a fire ring around the top companies,” Seznec said. “All the political stuff is really unsettling but the fundamental wealth of the kingdom is still from oil and still from downstream industries and that is very much still protected.”
Holden said when it comes time to consider making stock purchases to match an index inclusion event, most fund managers, even the ones who are less index-focused in their investment approach, at least buy the top five stocks. He said there are reasons why some emerging markets managers may shy away from Saudi Arabia. It is not as appealing a story as other emerging market narratives, where managers have been compelled by emerging consumer stories and the rise of a larger middle class population. The Saudi stock market is still primarily traditional companies in financials and basic materials and there is not much diversity in the Saudi stock market. “These stocks are semi-boring,” Holden said. “It is not a classic growth opportunity, and you have the ESG [environmental, social, governance] issues.”
But Holden said, “If you add in the index inclusion part of it, there are always a certain number of funds who pay close attention. The Fidelity and Schroders and Oppenheimers all have their eye on the index. Funds will realize they are massively underweight Saudi at some point.”
Robertson said just because more Saudi stock buying is on the horizon doesn’t mean it will ultimately reward investors. “Often because locals (wrongly) believe that a flood of foreign money will enter a market and drive up valuations, the market rises until the upgrade to EM [index], then falls as reality strikes (that overvalued markets are not actually extra special).”
Robertson said that since the Saudi market is 95 percent locally driven market, the local sentiment story may be particularly powerful. That is why he thinks the Khashoggi headlines will fade in relation to the index inclusion events, even if any stock appreciation from the Saudi market may not be sustainable. “I’d be really surprised if this story is still a market driver in a month’s time, and the EM upgrade is not happening until the second quarter 2019.”