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August 2019

Saudi Arabia: Potential and pitfalls

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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Key points

  • Investor interest in Saudi Arabia is on the rise amid solid stock market performance, easier market access, and Vision 2030 reform agenda.
  • Global exchange traded product (ETP) flows into Saudi Arabian equities have seen a meaningful pickup as the MSCI EM Index inclusion this year marked an important step.
  • However, the reign of Crown Prince Mohammad bin Salman is controversial and a number of key events on the horizon that could impact Saudi Arabia highlight both the opportunities and risks for investors. These risks include energy prices, geopolitical tensions in the Gulf, and successful implementation of the ambitious reform efforts.

Overview

Following an impressive 16% gain in 2018, Saudi Arabia’s equity market strength has continued this year, with the MSCI Saudi Arabia IMI 25/50 outperforming the MSCI Emerging Markets Index by five percentage points year to date.1 Saudi Arabia’s economy grew at a pace of 2.21% last year on strong oil sector growth and is projected by IMF to grow another 1.8% in 2019, with non-oil economy growing faster at 2.3%.2

While energy contributes the most to Saudi Arabia’s economy, the stock market is largely made up of two sectors—financials and materials—as the Saudi government privatized many industries. Financials shares have benefited from a rising interest rate environment as the central bank raised benchmark interest rates several times in the past 12 months, boosting net interest margin and return on equity expansion in the banking sector.

Figure 1: Saudi Arabia has outperformed both EM and FM benchmarks

Figure 1: Saudi Arabia has outperformed both EM and FM benchmarks

Source: Bloomberg, as of July 18, 2019.
Relative performance measures the ratio of the return of the MSCI Saudi Arabia IMI 25/50 Index against the MSCI Frontier Markets 100 Index and the MSCI Emerging Markets Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

Key trends

Steady inflows following MSCI's decision to include Saudi Arabia in the MSCI Emerging Markets Index help explain the near-term price momentum, but we are keeping an eye on three key trends:

Vision 2030: Saudi Arabia has outlined a major reform agenda to overhaul its economy. Adopted in 2016, the “Vision 2030” framework aims to reduce oil dependence, diversify the economy, improve public services, and increase the privatization of business activities. Among the dozens of national programs underway is the $72 billion National Transformation Plan (NTB), the goal of which is to modernize the economy, improve socio-economic conditions, and boost tourism.

Improved fiscal conditions: Data released by the Ministry of Finance alongside the 2019 budget suggest a deficit of 5.2% of GDP this year. The government had projected a deficit of 131 billion riyals, marginally lower than the 136 billion riyals of 2018. In addition, the current account surplus is likely to remain for the next five years and beyond, removing any fears around “twin deficits”.3

MSCI EM Index inclusion: After the announcement last year, MSCI started to include 32 securities from the MSCI Saudi Arabia Index in the MSCI Emerging Markets Index, representing a weight of approximately 2.7% of the index on a pro forma basis following a two-step inclusion process that began in May and ends in August 2019. The inclusion offers diversifying exposure to Saudi Arabia’s market. Prior to the inclusion, only 1% of the Saudi stock market was owned by foreign investors, compared to the 11% average of other emerging market countries.4

Key risks

Recent events have reminded foreign investors of the degree of uncertainty in the region.

The downing of a U.S. drone and a series of attacks on shipping vessels in the world’s key oil exporting region in recent months have the potential to affect oil infrastructures in Saudi Arabia, threatening the stability of the country’s economy. Relations between Iran and the U.S. have deteriorated significantly since President Donald Trump withdrew from the 2015 nuclear deal last year and imposed tougher sanctions on the country. While the U.S. has signaled strong support for Saudi Arabia and sent additional troops to the kingdom in preparation for escalated tensions with Iran, Saudi Arabia also has the burden to deal with additional turmoil in Yemen, caused by rivalry between Sunni-majority Saudi Arabia and Shia-majority Iran. Our BlackRock geopolitical risk indicator on Gulf tensions, which scans and analyzes broker reports, financial press and tweets for keywords related to the risk, spiked to more than five standard deviations above its historical average.

The other risk to Saudi equities is lower energy prices as the global economy slows down in a late cycle. However, the energy sector holds just a 0.84% weight in the MSCI Saudi Arabia IMI 25/50 Index given that the state-owned Aramco remains unlisted.5 While the IPO is currently on hold, Saudi Arabia’s energy minister has said the kingdom planned for the listing to proceed in 2020 or 2021, and it could create another positive catalyst for Saudi Arabia equities.

What flows are indicating

Global ETPs focused on Saudi Arabia have seen their assets under management (AUM) nearly doubled this year after gathering over $612 million year-to-date.6 If reform efforts continue, that is likely to lead to further flows, we believe, helped by Saudi Arabia’s position in the MSCI EM Index. If one applies the expected 2.6% weight to the roughly $1.7 trillion in global assets under management—$385 billion in index funds and $1.3 trillion in actively managed funds—tracking the MSCI EM Index implies a potential $10.0 billion in index fund flows and $33.8 billion in active fund flows ahead.7

Figure 2: U.S. listed ETP flows into Saudi Arabia focused exposures

Figure 2: U.S. listed ETP flows into Saudi Arabia focused exposures

Source: Markit, as of July 2019.

Conclusion

Saudi Arabia’s reform agenda, Vision 2030, could reshape the Saudi economy and financial markets. Saudi Arabia's MSCI EM Index inclusion, and potential for continued growth, means investors' portfolios are also rapidly being reshaped. While the initial MSCI inclusion opened the door for more foreign inflows into Saudi Arabia, investors are wise to approach the country with caution: Potential risks include western sanctions, Gulf tensions, and slowing growth leading to a decline in energy prices that could impact the health of Saudi Arabia’s overall economy.