Middle East: bumpy road to a deal
Iran: tensions key to geopolitical risk premium
Our understanding from our virtual meetings is that both Iran and the US are likely to be incentivised to reach an agreement under a Biden presidency, but a comprehensive agreement is likely to take time. As such, any material return of Iranian oil to global markets is unlikely near-term. Iran's usable reserves could now be as low as US$9bn. Hence, its ability to maintain the status quo is uncertain. A key date could be June 2021 when Iran is scheduled to hold presidential elections. The leaning of the next Iranian president could provide a key signal about the Iranian regime intentions.
An interim agreement (similar to that of November 2013) to freeze the Iranian nuclear program and further US sanctions, alongside limited sanctions relief, could be possible in early 2021 to gain time and prevent escalation. Miscalculation and the possibility that Iran might provoke a crisis to create a sense of urgency in order to gain leverage ahead of any potential negotiations are risks.
Saudi Arabia: recalibration and consolidation
After a severe recession in 2020, we see a relatively shallow 2021 recovery dampened by low oil prices, crude oil production restraints within the OPEC+ deal and fiscal consolidation. The pre-budget statement indicates spending is set to drop over the 2021-23 period (to levels unchanged versus last year's pre-budget statement), but drivers remain unclear. The pre-budget statement also suggests a more conservative budgeted oil price assumption for the 2021-23 period versus last year's pre-budget assumption. This is because the broadly unchanged revenue targets likely stem from the lower assumed oil revenues, given the potentially higher non-oil revenues on the back of the measures introduced this year.
According to our speaker, a Biden administration's approach towards Saudi Arabia could be different from a Trump administration (but the views of US Congress are unlikely to change). Still, we do not expect financially significant US measures as the bilateral relationship possibly recalibrates.
Egypt: IMF program provides anchor
The IMF Stand-By Arrangement (SBA) program focuses on safeguarding Egypt's economic gains and providing an anchor to address the emerging imbalances until the COVID-19 shock subsides. A successor program, potentially unfunded, could be negotiated depending on developments in 2021.
Economic activity has remained resilient and is likely to have been in positive territory over 2020. A return of portfolio inflows is helping Central Bank of Egypt (CBE) forex reserves increase again. We expect the mid-point of the inflation target for 2021 to be brought down from the 4Q20 target of 9%. This could indicate room for further policy rate cuts, but real rates are likely to remain high versus peers. USD/EGP is likely to remain moderately flexible. The current baseline within the IMF program envisages primary surpluses of 1.4% and 0.5% of GDP in FY20 and FY21 respectively. This is likely achievable, and authorities have signalled they would bring back medium-term primary surpluses of 2% beyond that horizon to anchor debt dynamics.
Turkey: at a fork in the road
Turkey's economic outlook in 2021 likely will be shaped by the authorities' policy response as well as the global backdrop. Recent policymaker appointments raise the likelihood of orthodox tight monetary policy near-term, but it is unclear if this would be sustained or sufficient. A benign global backdrop could ease the adjustment. After three years of almost no growth, Turkey needs to find a way back to near potential growth. Given the high external financing needs, Turkey needs economic reforms to boost productivity and to take steps to strengthen the rule of law to increase investor confidence. The president's recent call for a reform agenda on the economy, democracy and the judiciary system shows an understanding of these needs, although we are yet to see the details.
The CBRT has increased the average funding cost by several hundred basis points since August and credit growth has slowed down considerably. More tightening, along with a return to orthodoxy, might be needed to restore CBRT credibility and stop dollarization. However, this comes at the expense of domestic demand when the number of Covid cases is increasing. Only slight measures have returned so far, such as restrictions on the movements of the elderly and a smoking ban in public outdoor spaces. However, an acceleration in number of cases and Covid-related deaths might put pressure on officials to take more stringent measures, causing the economy to slow further.
There is less room now for support if lockdown measures are implemented. The monetary stance will remain tight and there is less fiscal space, although public debt remains low compared with major EMs. Public debt to GDP increased to 39.2% in Q2 from 32.5% at year-end 2019. The budget deficit likely will be close to 5% in 2020. We expect growth to weaken in Q4 and 1H2021, and gain some momentum in 2H 2021. Overall, it is possible that 2020E will end with a mild contraction of -0.5%. Base effects and a return to normalcy will help growth reach 4% in 2021E.
Geopolitical risks remain
Our understanding from our virtual meetings is that a Biden administration would recalibrate the relationship and could come under Congressional pressure to impose CAATSA sanctions, but, given the importance of Turkey as a partner, its actions would likely partly influence US sanctions policy. Halkbank's trial due to start in March 2021 is a case of sanction enforcement rather than policy, according to our speakers.
EEMEA Financials Strategy: Year ahead 2021
UAE banks: Dubai banks provide most standout opportunities
2020 has been the perfect storm of pain
The UAE banks have suffered the effects of three pronged storm in 2020 including a weak economic backdrop (even prior to the pandemic), the impact of the global pandemic and geo political tensions. These factors have in turn suppressed loan growth, (just mid single digits in 2020), caused asset yields to fall sharply and introduced significant asset quality uncertainty, culminating in forward expectations falling rapidly (average 35% decrease in fwd P/E expectations for the UAE banks since end of 2019) and the banks sharply de-rating relative to their long term average valuations (the UAE banks trade at ac.13% below their 10 year average 12mth forward P/B ratio).
Expectations for 2021 remain tepid as risks persist
Given the persistence of the aforementioned risk factors, market expectations remain tepid with the IMF forecasting 2021 GDP growth of just 1.3% in the UAE (following a 6.6% contraction in 2020). Oil prices have little scope to recover sharply, especially in the 1H21as the market remains amply supplied. Economic uncertainties are also high given the pandemic continues to impact some of the UAE's key industries, most notably travel and tourism. On the banking side, while margin compression is expected to abate, there is little scope for expansion as Fed rates are set to remain near 0%. Loan growth is expected to reach mid to low single digits and provisioning to remain elevated at c.130bps on average (c.50-60bps above long term averages). As such, we (and consensus) expect aggregate banking revenues and net income to remain broadly flat YoY in 2021 (despite some consolidation in the sector).
Changes abound: 2021 providing reasons to be more optimistic
While the backdrop remains cautious we see a number of factors that provide material upside risks to earnings via a more optimistic economic outlook,(stronger loan growth and lower provisioning costs) including: (1) The recent announcement that 100% Foreign ownership of businesses will be permitted in the UAE (outside of strategic sectors). We believe this will pave the way for significant FDI, (2) 10 year visas and Retirement visas are now being issued, which we see combatting the persistent population decline which the UAE has suffered over the past few years (3) The changing of social laws to become more accommodative of foreign cultures. Such measures include allowing unmarried couples to cohabit and relaxing rules on the sale of alcohol. There have also been discussions (in the press) over potential grating of gambling licences (to casinos) (4) the announcement of diplomatic relations with Israel, which we see combatting Geo political risks in the region as well as spurring further economic activity\, and (5) The extension of the TESS loan deferral program to the end of 1H21 (from YE20), which we see reducing risks of a spike in asset quality deterioration.
Vaccine particularly pertinent for the UAE
The news that multiple, highly effective vaccines have been developed to protect against Covid 19 is particularly pertinent to the UAE. While the authorities have managed to control the pandemic relatively well (with one of the lowest covid-19 death rates globally), relatively important sectors such as travel (most notably the two airlines, Emirates and Etihad) , tourism and trade have been hit disproportionately. This is further accentuated by Dubai being the host of Expo 2020 (which was postponed 12 months to October 2021 due to the pandemic). We believe the vaccine provides a realistic chance that the travel & tourism sector (including attendance at the EXPO) and trade could rebound more strongly than currently anticipated
Risks revolve around geo politics and strength of oil price rebound
Key risks around our positive thesis on the Dubai based banks include the scope for an increase in regional geo political tensions (particularly given the forthcoming Iranian elections, which could spur the country to take a more hard line attitude towards relations with neighbouring GCC countries), a less pronounced recovery in oil demand, which could negatively impact oil prices and the UAE growth outlook.
ENBD and DIB preferred banks in MENA
At this juncture, we see a stronger opportunity in the Dubai based banks, Emirates NBD and DIB, given they are discounting a less optimistic outlook than their Abu Dhabi counterparts yet are set to benefit more from the upside risks we articulated above. They also stand to benefit more acutely from the economic upside coming from the potential success of the newly developed vaccines. Specifically, ENBD and DIB are both currently trading on 2021 P/E of 9.0x, a 21% discount to EEMEA peers while offering 2020 dividend yields of 3.7% and 4.5% respectively. We discuss these names in more detail below.
Pursuing a conservative path to build strong buffers
The current backdrop of Economic uncertainty has seen ENBD management pursuing a path of conservative but prudent provisioning. This policy has culminated in one of the best provisioned banks in the region, with stage-3 coverage of 90% and an NPL coverage ratio of 119%. We expect this relatively conservative approach to continue in 2021, with cost of risk to be elevated relative to norms. However, given the significant upside risks to the economic outlook presented by structural reforms and the potential success of the newly discovered vaccines, we believe this could lower the need for elevated provisioning in 2021. Each 10bps reduction in cost of risk would drive a c.6% increase in our 2021 EPS forecasts.
An improving global economic backdrop could also see an improvement in the Turkish macro, which we see as a another source of potential upside surprise for ENBD given more than 20%of its earnings are derived from its Turkish subsidiary, Deniz Bank.
ENBD trades on 2021 P/E of 9.0x and P/B of 0.9x, a respective 21% and 45%discount to EEMEA peers. This also makes it the cheapest bank we cover in the UAE. We believe such a valuation is unwarranted given: ENBD's strong growth potential, competitively advantaged position in the Emirate of Dubai, standout liquidity and capital positions, extremely healthy provisioning buffers against asset quality deterioration and the leading digital banking platform in the MENA region (which we see as key in a post Covid world).
Dubai Islamic bank
Discount to EEMEA unreflective of superior ROEs
We see DIB as a mispriced opportunity, with significant upside potential and multiple catalysts ahead. While the economic backdrop currently presents dsignficant earnings risks ahead, we believe these have been adequately reflected in the current share price, with the shares now trading at a 21% discount to peers on 2021 P/E and discounting a long term ROE of just 11.0% (vs. LT through cycle average of 17.2% and 2020-23E ave. of 14%). As such, we believe the shares fail to reflect a number of key positive factors including: (1) forthcoming increase in FOL to 40% (from 25%), which we see driving significant foreign capital inflows in to the name; (2) The significant merger synergies from its recent acquisition of Noor, which we see becoming more visible in 2021 (3) An attractive 2020 dividend yield of 4.5% with room to grow, and(4) its ability to take market share in the high growth Islamic banking market.
KSA banks: Recovery largely priced in. Focus on standout opportunities
2020 not such a bad year for the Saudi Banks
The Saudi banks, like others in the MENA region, have faced the perfect storm of falling rates (rates were cut 200bps between 3Q19 and 1Q20 by the Saudi Central bank in response to the pandemic)and a weak and increasingly uncertain economic outlook, with the Saudi economy forecast to shrink 5.6% by the IMF in 2020. Yet despite this, the Saudi banks have fared strongly, with system loan growth having reached 11% YTD (and 14% YoY at 3Q20) from a CAGR of just 3% over the preceding 3 years. This, in conjunction with government support measures (SAR50bn of interest free deposits, which helped bring Cost of funding down sharply) helped sector revenues grow 3% YTD. Furthermore, the banks were able to limit the fall in earnings to just 6% YTD, as cost control measures help offset a significant part of the 34% pickup in impairments. .
2021 gives some scope for optimism
We see numerous reasons to be optimistic on the KSA banks looking in to 2021 including: (1) The Saudi banks are entering 2021 from a position of strength, with tier one ratios above 17% on average, NPL coverage in excess of 140% and healthy liquidity measures., (2) the IMF sees Saudi posting the highest 2021 growth rate in the region, at 3.6% (vs. less than 2% for other GCC countries). (3) we see strong loan growt, underpinned by continued strong growth in the mortgage market (>30% YoY growth expected in 2021) and the awarding of major Government contracts associated with the log awaited mega projects We see loan growth reaching 9% in 2021, with upside risks (4) Margin decline is set to abate, with 4Q20 likely representing the bottom in net interest margins for the banks. The extension of Central bank support measures should also be supportive for margins given the cost of funding advantages provided, (5) Cost of risk is set to ease in to 2021 (particularly if the vaccine allows the Saudi economy to operate more freely); and (6) We see scope for material growth in non-interest income streams diversifying away from using balance sheet (given low interest rates)
Dividends likely to be announced in conjunction with FY20 results.
The uncertainties in the economic outlook and concerns over liquidity, capital and asset quality pushed the Saudi banks to refrain from paying a dividend in 1H20. With many of these concerns now having eased, the banks having greater confidence in the economic outlook (particularly given the potential for a global recovery underpinned by the roll out of the vaccine) and strong capital positions, we believe the Saudi banks will announce healthy dividends in conjunction with FY20 earnings,with an average yield of c. 4%.
Valuations now discounting much of the positive outlook.
The Saudi banks have posted a relatively strong performance in 2020 YTD, with the Tadawul banks index falling just 6% YTD. AS such, valuations are now relatively rich, with the Saudi banks trading at .almost 13x 2021earnigns, a c.15% premium to EEMEA peers. That is to say, we believe much of the positive outlook for the Saudi banks is already being discounted in the shares, leaving limited opportunities with significant upside.
Focus on names with stock specific growth drivers
With the central bank unlikely to hike rates for the foreseeable future and valuations now looking relatively full, our investment strategy for the Saudi banks remains to focus on banks with mispriced, stock specific growth stories (not reliant on the macro backdrop). Specifically, we highlight banks who are benefitting from growth in the lucrative mortgage market (where yields are significantly more attractive than corporate loan yields), can deliver significant cost savings (e.g. via merger synergies) and are able to deliver strong non-interest income growth via advisory businesses. IN this regard, we highlight Samba as our preferred name among the Saudi banks. We also see an attractive opportunity in Saudi British Bank (SABB)
Set to create significant value in a low margin world
Samba signed a binding merger agreement with NCB to create the undisputed national champion of banking in the KSA (aligning it with the Vision 2030 National Champion's strategy) and arguably the most competitively advantaged in the Kingdom. The deal harbors strong strategic rationale in our view, with the potential to create significant shareholder value via cost and revenue synergies. Our analysis suggests synergies could comfortably underpin EPS accretion of c.15% by 2023. We particularly see a profound opportunity for revenue synergies, which will likely surpass other transactions in the region. Specifically, with Samba operating an over capitalised balance sheet (CET1 of c.19%) and having a highly conservative approach to risk,; we believe there are considerable gains to be made by giving Samba's balance sheet access to NCB's distribution platform. We also see NCB potentially benefitting from the significant unrealised gains sitting in Samba's investment portfolio
Given the prevailing lower for longer interest rate environment, we believe the ability to create value via cost reductions and market share capture will become increasingly important, and a thus a potential source of rerating. With the shares now at 1.3x 2020 P/B, Samba trades at 22% discount to Saudi Peers and a 19% discount to EEMEA peers; which we believe does not reflect its growing competitive advantages and ability to deliver significant shareholder value creation.
Negative news behind us. Time to focus on value creation
SABB faced a difficult 2020, with the bank having to clean up its balance sheet following its merger with Alawwal bank in 2019. Specifically, the bank wrote off SAR7.4bn of merger related goodwill as well as increasing provisions to bolster its buffers. We also saw a key share overhang risk being removed as NatWest markets and Santander sold their remaining 5.6% stake in the bank.
Looking ahead, with these risks now addressed, we see momentum developing behind SABB's compelling equity story, That is to say, we believe SABB is reaching an inflection point, with the bank set to deliver more than 600bps improvement in RoTE by 2023 (vs.2019) Our expectations are underpinned by: (1) The delivery of significant merger synergies (cost and revenue), totalling over SAR1bn by 2022(2) a significant pick up in loan volumes as the bank's focus shifts away from integration to competition. We also see a shift in the bank's risk tolerance allowing it to compete more effectively and take market share (particularly in the mortgage market). (3)A normalisation in cost of risk by 2022 and (4) Asset liability management that will help offset some of the weakness in NIMs, including cost of funding management and asset yield augmentation. We expect these factors to be articulated in more detail, with detailed targets when SABB rolls out its 5 year strategic plan (likley in 1Q21).
With the shares on 2021 P/B of 0.9x, SABB trades at 44% discount to EEMEA peers and a 46% discount to the Saudi banks. WE believe this fails to reflect SABB's unique ability to generate RoTE growth and take market share in the Saudi banking market,
GEM Banks: 2021 Year Ahead: Here’s for a less volatile, more boring 2021 - Chats and graphics can be accessed using the link
Summary views and recommendations
We have a broadly MW recommendation on UAE bank's bonds (MW on senior, OW on AT1s). We expect these credits to remain defensive as they are tightly held by regional investors. However, spread compression looks limited in senior space as senior bonds and sukuk currently trade at Z-spread below 180bp (at the exception of Bank of Sharjah which 24s are indicated at Z+263bp) and offer limited spread cushions. We note that across all GCC banks' senior credits, the average spread is only 134bp. We believe sub-debt offers better value, especially when considering the strong capital ratios of UAE banks.
We are OW Emirates NBD perps (yielding 3.4% and 5.1% to their call dates) and FAB AT1, which we expect to be called next year (2.8% YTC). We are also OW ADCB 4.5% 23s, a rare subordinated bond from the region yielding 2.8%.
Sector strengths and opportunities
• Strong capital buffers. Capital ratios in the UAE are among the highest in EEMEA. The average CET1 stands at 13.4% while the average CAR stands at 16.6%. Leverage is low as well with equity to assets at 12.1% in average. The weakest ratios are seen at the very small Bank of Sharjah where CET1 and CAR ratios stand at 9.6% and 10.7%. In March, the UAECB allowed banks to tap up to 60% of their capital conservation buffer currently set at 2.5% of risk-weighted assets, while the four D-SIB banks were able to use up to 100% of their domestic systemically important bank buffer (D-SIB) which stands at 1.5% for FAB and ENBD and 0.5% from ADCB and DIB. These forbearance measures will hold till Dec. 2021.
• Sound liquidity. Liquidity in the banking system remains sound and stable. As loan growth remains subdued around 5.5%, the system L/D ratio has stabilized around 95% for the last 2-3 years. Also, like in other GCC countries, state deposits in the system are high at 19% of the total and provide some cheap funding for banks (though these are concentration in the largest banks). In addition, as part of the support measures to mitigate the impact from Covid-19, the UAE Central Bank (UAECB) launched a comprehensive AED100bn ($27bn) targeted stimulus package. Starting from March, UAE banks had access to up to AED50bn ($13.6bn) of liquidity via interest free collateralised loans. The remaining AED50bn has been provided by the easing of banks' regulatory capital requirements. While UAE banks are lobbying for an extension of the programme to 2021, the UAECB has still to decide.
• Strong state support. We have little doubt that the State will continue to support the major banks in the UAE. The UAE authorities provided support, in the form of additional capital and liquidity, to its banks in 2008/09. The banks' senior ratings continue to benefit from multi-notch uplifts for support. We do not expect this to change and see strong state backing as credit positive.
Weaknesses and challenges for the sector
• Asset quality pressure accelerated since 4Q19; coverage slips below 100%. While the UAE has experienced a low growth environment since late 2014, asset quality pressures have been muted until late 2019. However, pressure have accelerated since then driven by a moribund macro environment combined with the Covid-19 outbreak starting from March. As a result, non-performing loans increased by close to 60% y/y as of Sept. end across UAE banks, though this large increase was partly driven by high profile defaults such NMC Health. As of September end, the average NPL ratio stand at 5.8% (up 100bp y/y YTD) while Stage 2 loans represent another 7.9% of the loan book (flattish YTD). NPL total coverage has deteriorated materially to 78% at the end of September vs. 113% a year ago. Banks' management are guiding for more pressures to come in 2021 and for elevated cost of risks to be sustained next year.
• Concentration to real estate. Exposure to the construction and real-estate sectors is quite high across the banking system at about 20% but as high as 25-30% at some banks.
Main trends for 2021
• Consolidation & regional expansion. The consolidation of the UAE banking system is likely to continue as the market remains overbanked (49 conventional banks and 7 Islamic banks for 9.6mn inhabitants) though mergers will be more difficult going forward given the lack of common shareholders. Following the recent mergers of ADCB/UNB and DIB/Noor, the focus is likely to shift to the smaller banks such as ADIB, Mashreqbank and Commercial Bank of Dubai (CBD). Meanwhile, UAE banks continue to screen for organic and inorganic opportunities to expand in the key markets of Saudi Arabia and Egypt (by potentially buying Lebanese's subsidiaries in the latter).
• Margins likely to be under pressure. UAE banks' NIMs are under some pressure in the low rate environment given the structure of the liabilities (high share of CASA deposits), low yielding assets (treasuries and central bank deposits) and loan-to-deposit ratios below 100%.
EEMEA Energy: 2021: the year ahead – Growth and Value in EEMEA Energy – Chats and graphics can be accessed using the link
Aramco: still in a league of its own
Aramco was the best-performing oil company throughout the highly volatile 2020. Best-in-class fundamentals and limited liquidity were, in our opinion, some of the main drivers of its outperformance. Going into 2021, Aramco's enormous potential will still likely be constrained by the output restrictions of the OPEC+ deal and limited upside to oil prices. due to high inventories.
We also believe Aramco's leverage is bound to increase in the near term. The Saudi budget breakeven oil price and oil revenue dependency are driving Aramco to sustain its US$75bn dividend pledge to both the government and minority shareholders. On our estimates, with reduction of capex expenditures to US$30bln from the previously planned US$40bln in 2021, Aramco will require at least a US$52/bbl oil price to cover its dividend payments. Until then, Aramco will be forced to increase leverage or resort to asset disposals or capex cuts to maintain the overall dividend commitment.
Nevertheless, on a global scale, Aramco's leverage, even without a capex decrease or asset disposal remains fully manageable as the company can rely on debt financing until the OPEC+ agreement expires in the middle of 2022. At that stage, if the oil market tightens due to a drastic capex decrease, Aramco will be virtually the only oil company in the world that can deploy meaningful spare capacity at zero cost. On our estimates, the available Maximum Spare Capacity (MSC) will amount to an unprecedented 3 mn bbls or 30% of Aramco's production. Needless to say that Aramco's dividends and valuation metrics will be meaningfully different under 10mn or 11mn bpd of production.