August Bulletin – Jadwa Investment

August 10, 2010

Editor’s Note:

Today we are providing a snapshot of economic developments in the Gulf as reported in the Jadwa Monthly Bulletin for August. Topics covered in this month’s report include a review these issues: high inflation for the rest of 2010, lackluster second quarter stock market results, and climbing oil prices. We thank Jadwa Investment Chief Economist, Brad Bourland and head of Research Paul Gamble, for providing this insightful report and for sharing.

Click here for the full report (PDF)

August 2010 – Monthly Bulletin

Jadwa Investment

High inflation likely for the rest of 2010

Inflation hit a one year high of 5.5 percent in June as a result of higher food prices and the strengthening of domestic demand. The rise in inflation in the Kingdom is out of step with inflation trends elsewhere in the world and inflation is over four times higher than the average for the other five members of the GCC. With rental inflation likely to go up, Ramadan and unfavorable weather conditions in central and eastern Europe set to lift food prices and higher electricity tariffs, we have raised our forecast for average inflation to 5.2 percent in 2010 and 4.2 percent in 2011.

Inflation has rebounded from a two year low in October 2009. After bottoming at 3.5 percent, the inflation rate has risen in seven of the subsequent eight months. At 5.5 percent inflation is less than half of the peak of over 11 percent in July 2008, but it is very high on an historical basis. Since 1980, inflation has averaged just 1.2 percent, even allowing for the surge through 2007 and 2008.

The pickup in inflation is contrary to what is happening in most of the rest of the global economy. Out of 44 leading developed and emerging markets that Reuters produces comparative figures for, the bulk are declining and only one (Turkey) has an inflation rate currently above that in the Kingdom. Inflation is also well above that in other GCC members; the latest inflation rates for Bahrain, Kuwait, Oman, Qatar and the UAE average just 1.2 percent.

The divergence in the direction of inflation is because rising domestic demand is causing some supply bottlenecks in the Kingdom, while most other countries still have large spare production capacity. High government spending has pushed up the prices of raw materials (though these only indirectly affect the prices consumers pay) and rises in government pay, pensions and other benefits are stoking domestic demand. As the economy improves, a broader revival of consumer spending, illustrated by the rapid growth in point of sale transactions and cash withdrawals from ATMs, is also lifting demand for goods and allowing retailers to raise margins after a tough couple of years.

While strong domestic demand for housing is continuing to push up rents and keeping overall inflation high, rental inflation has fallen. Nonetheless, it is much higher than elsewhere in the GCC, which explains the difference in inflation rates. In other GCC countries, particularly the UAE and Qatar, rental inflation was driven by an influx of expatriates. As the economic downturn hit, many expatriates lost their jobs and left these countries at the same time as more accommodation came on stream, causing rents to plunge. In contrast, the demand for property in the Kingdom is being driven by domestic population dynamics and a reduction in the average household size.

Externally, the effect of higher international food prices earlier in the year continues to work through the Saudi economy, with food prices the component of inflation that has increased the most recently. Some, but by no means all, other commodity prices are up, notably precious metals. Nonetheless, several external factors are dampening inflation. For example, over the past year the riyal has strengthened against most of the currencies of the Kingdom’s main trading partners and shipping costs are well below where they were one year ago.

Food price inflation has climbed to 6.2 percent in June from 0.3 percent in October 2009. Food prices in the Kingdom are linked to global food prices. The chart on the left shows changes in food price inflation in Saudi Arabia generally lag changes in global food prices (as measured by the IMF food price index) by three to four months. However, global food price inflation has been falling since December and at their current level global food prices are below where they were in June of last year, yet local food prices have continued rising.

Other components of the cost of living index have been mixed. Since overall inflation bottomed in October 2009, inflation for home furnishings and ‘other expenses and services’ have gone up, while inflation for the other components of the cost of living index (clothing and footwear, medical care, transport and telecoms and education) has changed little. Total inflation excluding rents is at its highest level since February 2009.

In contrast, rental inflation has continued to fall. Rents remain the main source of inflation, as they have been since mid2007. Rental inflation averaged 0.6 percent between 1980 and 2006, compared to 12.9 percent since January 2007. However, rents have not been the cause of the recent rise in inflation. Rental inflation has eased in 22 of the past 23 months since it peaked at 19.8 percent in July 2008 and in June 2010 stood at 9.2 percent, the lowest for nearly three years.

Inflation is probably close to its peak, but we do not expect it to fall too much in the coming months. Ramadan will lift food prices. Since 2002 food prices have risen more than five times faster in the Gregorian month in which Ramadan starts than the average for the other 11 months of the year. In addition, wheat prices are up by nearly 50 percent over the past month owing to a heat wave and drought in central and Eastern Europe. Higher electricity prices will feed into inflation and the fall in rental inflation appears at an end for the moment.

While rental inflation has been falling in year on year terms, on a monthly basis it has not slowed. Rents have risen by an average of 0.9 percent per month over the first six months of this year. If they maintain this pace, year on year rental inflation will start to rise in July and will exceed 11 percent by the end of the year. We do not think that the pickup in rental inflation will be that sharp, as in recent years monthly rental inflation has moderated in the second half of the year. Over the past three years, monthly rental inflation averaged 1.3 percent in the first half of the year and 0.9 percent in the second half. In addition, more housing stock is gradually entering the market, with various public sector financed programs coming to fruition. Nonetheless, it seems likely that rental inflation will return to double digits later this year.

A further factor that is set to push up inflation is an increase in electricity tariffs introduced at the start of July. Government, commercial and industrial users are now paying on average around

9.6 percent more for electricity. The price was hiked to encourage greater efficiency in energy consumption; energy consumption is growing by around 8 percent per year and the government is investing a vast amount in new power generating capacity to try to meet this demand.

The price rise will not have a direct impact on inflation, as the price paid by consumers for electricity has not been changed. It will, however, raise costs of production for companies. Sabic has announced that the cost of steel production will go up by 7 percent because of higher electricity tariffs and prices of other metal products and manufactured articles will also be affected. In addition, retailers will pay more to power their facilities. The extent that commercial and industrial users pass on their higher operating costs will determine how much the tariff hike raises inflation for consumers.

Owing to the impact of these price pressures, we have raised our forecasts for inflation. We now expect inflation to average 5.2 percent in 2010. We have also lifted our forecast for inflation in 2011, though we still anticipate a decline, to 4.2 percent. The pickup in domestic demand and bank lending are expected to continue, but as the local private sector becomes more confident about the economic environment, it will invest to boost supply. Greater supply of property should allow rental inflation to resume its decline during the year.

External inflationary pressures will be subdued. Food price inflation is expected to moderate. Food prices are heavily influenced by weather conditions, making future trends difficult to predict. Those forecasts that are available for global food prices suggest stability in 2011; the World Bank projects a 3 percent fall, whereas the US Department of Agriculture predicts they will rise by around this amount (though these could be revised up owing to the current heat wave in parts of Europe). We see little inflationary pressure elsewhere in the global economy. Prices of other commodities will likely rise owing to the ongoing global economic recovery, but those of precious metals, which have a more direct impact on inflation in the Kingdom, should fall as risks to the recovery diminish. Little movement in the dollar is anticipated.

Even if inflation falls to our forecast level, it will remain high on a global basis. Last month the IMF lowered its prediction for inflation in advanced economies in 2011 to just 1.3 percent. While inflation in fast growing emerging economies such as Saudi Arabia would generally be higher than in advanced economies, price controls and an abundant supply of low wage expatriate workers in the Kingdom should hold down prices to a greater extent than elsewhere in the emerging world.

For the moment, we think that the government will accept the relatively high level of inflation in the Kingdom. Its main concern remains supporting the recovery of the private sector and we do not foresee it holding back the implementation of projects, particularly as the costs of the necessary skills and technology are generally well below where they were a few years ago. Furthermore, while bank lending growth remains sluggish, there is little likelihood of an adjustment to interest rates, which in inflation adjusted terms, are heavily negative.

Stock market watch

Second quarter results fail to inspire the TASI

Second quarter results of listed companies were generally lackluster. Net income was the highest since the third quarter of 2008 and up compared to the second quarter of 2009 and the first quarter of 2010, but for many of the larger companies earnings were slightly below consensus estimates. Investors seemed disappointed with the results; over the period in which they were released (between July 5 and July 21), the TASI fell by 0.6 percent and underperformed most global markets. Nonetheless, the results reinforce our view of a consistent pick up in the economy so far year.

Net income of all listed companies was up by 25 percent in year on year terms and by 11 percent on the first quarter of 2010. In both cases these rates are less than half of those for the first quarter. Earnings for 10 of the 15 sectors rose in year on year terms, with insurance, petrochemicals and media the best performers; hotels, real estate and telecoms recorded the largest declines. Recently, the TASI has had a strong relationship with quarterly earnings growth, but the chart to the left suggests that for the second quarter the TASI has underperformed given the earnings data.

As the largest sector, petrochemicals results greatly influence the direction of the market. Earnings more than tripled in the second quarter in year on year terms, but this failed to stimulate the market as they were down slightly on the first quarter of 2010. Year on year, the sector benefitted from the startup of major plants and higher product prices. The quarterly decline was due to slightly lower product prices and higher costs of feedstock and iron ore.

Bank earnings were also below expectations. Their net income was down by 9.4 percent compared to one year ago, though up slightly on the previous quarter. Banks were hit by the sluggish pace of new loan growth and higher provisions for bad debts. Operating income was down by 0.9 percent in year on year terms, while provisions for bad debts rose by SR2.4 billion in the second quarter, 27 percent higher than their increase in the corresponding quarter of 2009.

Earnings in the insurance sector showed the largest gains compared with the second quarter of 2009, rising by over 300 percent. This was the result of the improvement in the financial performance of many of the recently established insurance joint ventures and better results by Tawuniya. Insurance companies also benefitted from the rise in the local and global stock markets since the end of the second quarter of 2009. These gains also helped the multiinvestment sector record healthy growth in year on year terms. Media was the other leading performer. Gross income was up slightly, but earnings received a strong boost from operating income, signaling that much of the improvement was due to cost control efforts.

Telecoms earnings were mixed. Overall, earnings were down, with STC below expectations, but Mobily recorded healthy earnings growth and Zain, while still losing money, posted strong growth in gross income. The hotels sector was the worst performer in year on year terms, as the 2009 total was distorted by a onetime land sale. Despite growing sales in volume terms, total earnings of the cement companies also declined, as new competition and high production capacity across the industry drove down prices.

In brief: Stock market

The TASI has traded in a fairly tight range since the end of May.  Though it has moved slowly upwards over the past two weeks, the moves have been small and volumes are low. With second quarter results slightly below expectations and global markets fairly subdued, there has not been a catalyst for the market to go significantly higher. On a price to earnings ratio basis the market is now at its most attractive level for around a year and we think that, provided there are no disruptions in global markets, the TASI should rise from the final week of Ramadan and gain momentum over the remainder of the year.

Volumes have fallen sharply in July, with the number of transactions dropping to the lowest level since January 2005. In part this reflects a seasonal trend, as volumes generally drop during the summer when many investors are on holiday. It is also a sign of the structural decline in stock market transactions; the July total was less than half that of July 2009 and only 26 percent of the total in July 2008. With the TASI failing to make up much ground after two crashes in the past five years, retail investors remain cautious about returning to the market. As trading in August is affected by Ramadan, volumes could be even lower.

The apparent disillusionment of Saudi individual investors with the stock market is illustrated by the continued excess of their monthly share sales over their share purchases. During July, Saudi individual investors were net sellers of shares worth SR347 million. Over the first six months of the year net selling totaled SR2.6 billion. Since the start of 2008 Saudi individual investors have been net buyers in only one month. Over this 31 month period, their net sales have totaled

SR7.1 billion. Local corporations remain by far the largest net buyers, followed by mutual funds. Foreign investors via the swap agreement were net sellers for the second consecutive month in July.

There appear to be clear trading patterns around the month of Ramadan. In a report we issued in late July we highlighted that share prices tend to fall from the last week before Ramadan to the

end of the third week of Ramadan before rallying over the final week of Ramadan and the five weeks after Eid alFitr. The report also examined performance in the runup to Ramadan and it is notable that so far in 2010 performance is in line with that of previous years. Over the years from 2000 to 2009 the TASI tended to rise during the fifth, third and second week before Ramadan and fall in the fourth week. This year again, the TASI fell in the fourth week before Ramadan and rose in the fifth, third and second weeks.

In brief: Oil market

Oil prices (WTI) climbed over $80 per barrel for the first time since early May at the start of August. WTI is up by almost $10 per barrel (13 percent) since the start of July. Higher prices are largely the result of moves in financial markets. In particular, share prices have rallied and the US dollar has weakened over the past month, both of which tend to push up oil prices. The outlook for the fundamentals has been mixed, with the International Energy Agency revising up its forecast for global demand in 2010, though by just 70,000 barrels per day, and preliminary independent surveys suggesting that Opec oil production rose in July.

Oil stocks have remained well above their historical trend, though this does not seem to have had an adverse impact on prices. The International Energy Agency puts oil stocks held by commercial users in the OECD at the equivalent of 61 days of future demand at the end of May. This is in line with the figure for the end of the second quarter of 2009, but five days above the 2005 to 2009 average for this date. In the US, where more up to date information is available, oil stocks have risen in the past few weeks and are not far off their high for the year.

Saudi oil production has been very stable this year. Independent estimates put Saudi oil production at just over 8.2 million barrels per day in July, compared to an average for the first seven months of the year of 8.15 million barrels per day. We had anticipated production averaging 8.3 million barrels per day this year, (up 2.4 percent on the 2009 average) but in light of data for the first seven months of the year we have revised our projection down to 8.2 million barrels per day (up 1.2 percent on the 2009 average). As oil production is such a large part of the economy the revision has resulted in a slight downgrade to our forecast for real GDP growth for Saudi Arabia this year; to 3.9 percent from 4.2 percent.

A change to oil pricing policy introduced at the start of the year appears to have improved the ability of Aramco to set its pricing formulas. Saudi oil is priced against a benchmark. Until the end of last year, the benchmark for oil sales to North America was WTI. This was changed to the Argus Sour Crude Index at the start of this year. This measure was chosen as it is more representative of both market conditions and the blend of oil that Saudi Arabia exports to North America than WTI. The chart to the left shows the weighted average of the discount or premium to the benchmark set by Aramco for the pricing of Saudi oil exports to North America. From January, when the benchmark was changed, pricing has been far more stable than in previous years.

Click here for the full report (PDF)

For comments and queries please contact the authors:
Paul Gamble, Head of Research – pgamble@jadwa.com and Gasim Abdulkarim, Associate Director: Research – gabdulkarim@jadwa.com or: Brad Bourland, CFA, Chief Economist- jadwaresearch@jadwa.com
Head office:
Phone +966 1 2791111
Fax +966 1 2791571
P.O. Box 60677, Riyadh 11555
Kingdom of Saudi Arabia
http://www.jadwa.com

[Complete report with charts, graphs and tables at this link.]

About Jadwa Investment - Jadwa Investment is a Saudi Closed Joint Stock company operating under the supervision of the Saudi Arabian Capital Markets Authority (CMA). Under the CMA decision published on August 21, 2006, Jadwa was awarded a license to offer all types of investment services including dealing, managing, custody, arranging and advising. All investment services offered by Jadwa Investment are supervised by a Shariah Supervisory Board and are fully Shariah-compliant.

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