How will Middle East equities perform in 2006?

By any account 2005 was an amazing year for stock markets in the Middle East. Egypt came top with a 131% gain, while Saudi Arabia and the UAE both delivered more than 100%, Jordan was up 92%, Kuwait 78%, Qatar 70% and Bahrain a relative laggard, up 23%.

The question is really whether this kind of performance or even a less spectacular gain can be repeated in 2006. Will the profits growth continue to justify such high valuations? And will the oil price continue to justify the high levels of optimism about the economic outlook?

IPO slowdown

In the second half of 2005 there was a notable slowdown in the number of new share issues. Markets became too volatile for investment banks to risk the failure of an initial public offering in many cases.

This is going to have an impact on bank profits for 2005, as IPOs make the banks a lot of money, and therefore should impact on bank shares which comprise up to half of some indices. In any case serious questions about the sustainability of profits from many cyclical businesses should be asked.

The oil price has been strong in the first days of 2006, but it is not clear that we have seen the impact of high oil costs on the global economy yet. Veteran analyst George Soros is forecasting a US recession in 2007 due to high oil prices, higher interest rates and a housing market slowdown.

Once Middle East stock markets begin to so sense a whiff of a US recession they are likely to respond very sharply. It is very clear that a US recession is the one macroeconomic factor that can be guaranteed to lower oil prices from their present elevated levels; this does not mean that oil prices will crash, but they could well move significantly lower than current prices.

Risk vs gain

An investor in Middle East equities therefore has to weigh up the risks of staying in the market. Why risk three years of huge gains when the outlook is for far more limited returns? Why not cash out and look for somewhere else to try: local real estate or gold, for example?

It is always tempting after a good run to hold on for the last phase of the upturn, but at this point the risk relative to the likely return becomes higher and the risk may not be justified. Middle East stock markets also lack the legions of institutional investors that cushion the larger global markets against massive contractions in value.

In the past the regional equity markets have swung between bouts of irrational enthusiasm and manic depression with long and deep bear phases. It may be different this time but these are retail markets driven by the sentiments of the crowd, and late-cycle investments are notoriously tricky to manage successfully.