Focus on frontier markets – Middle East equities face turbulent fund flows if benchmarks adjust

Much attention on frontier markets in the Middle East and North Africa recently has focused understandably on macro-political troubles, but index providers could also play a significant role in the direction of their markets in coming years, suggests analysis from BofA Merrill Lynch Global Research.

The bank’s analysts note Saudi Arabia, UAE and Qatar all stand in line to graduate to benchmark indices produced by MSCI, whereas Morocco and Egypt are at risk of falling from indices.

Movement into or out of indices can entail significant inflows or outflows – respectively – from funds fully or partially following the benchmark weightings.

Potential flows to some ‘promoted’ markets could amount to $10bn or more, BofA Merrill Lynch Global Research says.

Those vying for upgrades to be emerging markets include Saudi Arabia, and Qatar and the United Arab Emirates. On the other side, though, Morocco could fall from the GEM list to Frontier, and BofAML argues Egypt could suffer the same fate.

Overall, the bank’s analysts are overweight frontier markets of the Middle East and Africa (as well as Eastern Europe), that offer an “undemanding valuation entry point for…a fairly significant and still overwhelmingly under-owned long-term investment opportunity.

“At this early stage of the ownership cycle and with limited direct links to Europe, we expect that this less correlated asset class will work in all but the most bearish global environments for risk appetite and for oil.”

Saudi Arabia is the top pick of the report’s authors both for the short and medium term.

“The Saudi Tadawul [stock exchange] currently trades on a 12-month forward P/E of 10.6 times, which is a 13% premium to global emerging markets. This is near a historic low premium, and more than one standard deviation below an average 43%,” the authors note.

They add the Saudi market could join the Frontier universe and “quickly vie for a spot in GEM” is it provides foreigners direct stock access – though the reinstatement process could last until mid-2015.

But the rewards of index inclusion could be great – at least $1.25bn inflows from frontier funds, and $13bn from EM funds, if all 35 stocks in the nation’s domestic index enter both wider benchmarks, on BofAML’s reckoning.


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