Riyadh-Mubasher: Further adjustments in Saudi government's subsidies leading to eventual removal are in the pipeline, and market now expects this and the reaction should not be as harsh as the initial blow, Saudi Fransi Capital (SFC) said in a recent report.
The year kicked-off with a rocky start for Saudi equities, in light of recent developments – better to get it out of the way early on than face continued uncertainty.
"We believe the tremors should abate as most factors have been digested, however China may continue to create an overhang. We caution that dividend cuts have yet to be reflected on the market, expected around mid-year," SFC said.
The -16% sell-off in the Saudi market since the beginning of December resulted from a confluence of factors creating the perfect storm.
Downsized budget plus energy subsidy adjustments were compounded by sub-$33 oil. U.S. interest rate liftoff and stronger dollar raised questions if USD-SAR peg is sustainable and the impact of tightening monetary cycle in a weaker economic environment.
With borrowing costs ticking up, capex may be deferred. For those dependent on financing lifeline, rights issue may be on the cards. Geopolitical tensions further added discount to the market. However, the wildcard factor is the persistent health concerns on the Chinese economy marking a dismal start to 2016.
"Before writing-off the rest of the year, we parse transient factors from permanent ones. We believe geopolitical tensions should ease and oil may recover if high cost producers buckle," the research firm said.
However, gradual removal of subsidies will substantially change the cost structure for industrial users and consumption patterns of individuals. Corporate earnings may potentially contract 15-20% over the next three years shrinking net margin premium over EM peers (16% vs. 8%). Market expectations will fully adjust post-1Q16 results.
"We believe the market is now reflecting tighter state spending, higher borrowing costs and geopolitical tensions," said SFC.
At least, the guessing game on macro direction can be put to rest and focus can turn to portfolio positioning. Earnings hit has been quantified thanks to corporate announcements amounting to 5% of LTM net income.
Post-Q1-16 results, impact of subsidy adjustments will be fully realised and may in fact positively surprise on other cost adjustments. "What we see as not priced-in are dividend cuts, which can pressure the market lower around mid-year. If miraculously dividends are maintained, implying a yield of 4.4%, then investors have a reason to cheer," the research firm said.
Historically, TASI has commanded a substantial premium over MSCI Emerging Markets index, likely due to lower cost base and higher margins.
The premium has rapidly dissipated over the last six weeks, with TASI trading 10.4x P/E versus 10.7x for EM. "In our view this reflects a temporal normalisation of valuation multiples. Premium should return if net margins re-establish a long-term spread over EM peers," SFC said.
