Nick Hello, everybody, and welcome to the abrdn Emerging Markets Equity Podcast. I'm Nick Robinson from the EM Equity team.

In this podcast series, we explore the factors that underpin our thinking on emerging markets from key individuals to evolving trends. We seek to answer the five W's: the who, what, where, when, and why that are shaping investment opportunities in the region. Today, we're going to talk about the Middle East.

Just five years ago, the Middle East was a tiny slice of the emerging markets benchmark, less than 1%, so not really on the radar of most managers. Let's roll forward to today and that's completely changed. The region now comprises just shy of 8% of the benchmark, and its largest constituent, Saudi Arabia is for sixth largest EM country overall, at 4% of the benchmark. So that puts it ahead of legacy index heavyweights like South Africa and Mexico, Thailand, so it's become pretty critical.

Today, we're going to discuss this region, what's behind the rise of it and the opportunities and challenges investors faced when approaching it. So, joining me to discuss this is my colleague, Nina Petry. Nina has been with the firm for seven years and covers stocks in the consumer and real estate sector. She's also on the team that runs our fund that's aligned with the UN Sustainable Development Goals. And she's just returned from an investment trip to the Middle East, so she's extremely well placed to discuss the region. So Nina, how are you welcome to a podcast, how was the trip?

Nina: Yeah I'm good I'm recovering from a cold but definitely getting there now. The trip was really interesting actually, was one of the, one of the best investment trips that I've done mostly because visiting Riyadh right now, you really feel that there are things happening and we can talk about the reasons for that but that was quite exciting to experience.

Nick: Yeah, that's great. So it's a really interesting place, isn't it? The last time I went there was probably about five years ago, pre COVID. And I made the mistake of going during Ramadan, which was entirely my mistake, but it meant finding somewhere for lunch was challenging. But the upside was that actually, at the end of the day, once the sun had gone down, we had the most amazing meals, you can really make up for lost time.

Nina: It’s all a tradeoff, isn't it?

Nick: It is, so when I think about our history at abrdn of investing in in the Middle East, you know, going back 10 years or so, we had some exposure to Oman, Qatar and the UAE. But these were all relatively small investments in a, in a frontier market strategy. Whereas today, it's become a hugely important part of the core emerging markets benchmark. So yeah, I'm wondering if you talk a bit about what's been behind for huge rise of a region in the last five years.

Nina: I think the big change factor for the Middle East is really the evolution of capital markets in Saudi Arabia, which as you highlighted Nick is the, is the biggest constituent in the Middle East, with taking probably just over half of the region's overall weight in major indices. And some others like, like Kuwait, for example, joined the benchmark in recent years in 2020. So others have raised their profile but really think Saudi Arabia is the driving force behind this, this change in the, in the profile of the Middle East for foreign investors.

And to understand why that happens, I think we have to go back a little bit further to the rollout of Vision 2030 in 2016. So, this is a very ambitious transformation project that was launched by Saudi Arabia's Crown Prince Mohammed bin Salman, or MBS as he's known. His father, King Salman ascended to the throne in 2015 and the following year and MBS announced this very extensive reform agenda that is ultimately aimed at diversifying the kingdom's economy to be less reliant on oil. And the need to diversify was known for a long time, in part because the state benefits and the subsidies that many Saudis have grown used to, become unsustainable when oil revenues fall. But the succession line that was established in Saudi Arabia, since its founding, is one where the crown would move from brother to brother, between the sons of the founder. So, of the seven kings that the Kingdom has had, four started to reign when they were already over 60 years old. So at some point, that had to move on to the next generation. And now that King Salman, you know, brought his son MBS into a role where, you know, he has the potential to rule Saudi Arabia for a long time. Now, you kind of have someone who, who has the energy and the, and the time to implement these very difficult changes there. And this is a ruler, a potential ruler of Saudi Arabia, who is, who evidently prefers very rapid change, and often very autocratic means of achieving it. And that contrasts with the usual, more consensus driven approach that was taken within the royal family. In one of the big projects to come out of Vision 2030, coming back to the heart of your question, is the financial sector development programme, which looks to develop more sophisticated capital markets, that will have higher market cap, but also higher institutional investor participation, higher foreign investor participation, and all of that is to support this economic diversification effort. And they moved quite fast with this. So, the programme is launched in 2016. And by the end of 2019, they completed the listing of Saudi Arabia's national oil company, Saudi Aramco, which at the time it you know, $2 trillion was the world's largest traded company. And this was a big moment for the Kingdom of Saudi Arabia, and a big step in boosting its presence globally and in capital markets. Fast forward to now and last year alone, you had over 40 IPOs in the Middle East. And most of that is coming from Saudi Arabia and from the UAE. A large part, many of these IPOs would be privatisations of companies owned by the government or by government related entities. And I imagine we'll see more this year. Maybe not at the same pace, but probably there are more to come.

Nick: Yeah, I remember back in 2016, when Vision 2030 was first announced, so there was quite a lot of scepticism about it. But it sounds like these efforts to diversify away from oil are becoming relatively realistic would you say?

Nina: Yeah, being in Saudi Arabia and speaking with, with folks from government entities and from government linked entities, they have a number of development funds and all of that - it's very clear that the commitment is there. And Vision 2030 kind of underpins everything that the various entities say about what they're trying to achieve. So, the commitment is there, but I think it may be somewhat, somewhat paradoxically, what oil does is a big driver of how realistic these reforms will be. Right? Because the funding needs for Vision 2030 in Saudi Arabia are significant. The UAE recently announced that they want to invest $160 billion in renewable energy, but the funding for that has to come from somewhere. So weaker or a more volatile oil price, can lead to a more challenging fiscal dynamic, that might mean that they have to pare back some of their ambitions in some areas of the economy.

The fiscal breakeven level for the region is estimated to be between $50 and $75, depending on the country in the Gulf Cooperation Council. So they actually need you know, they need a bit more than that to maintain the reform momentum that we've seen so far. And usually, most of the estimates that I've seen, say that about $90 a barrel is where they have a comfortable level of funding to achieve their targets. So where we're at right now, maybe $85, $87ish, there's still a bit of a windfall gain that can go towards funding all these projects. But that's, I think, a main piece of the puzzle there. And the other one is the role of the sovereign wealth funds. So, in Saudi Arabia, that's the public investment fund, the PIF, those funds are behind massive projects in the region. And they are largely behind this diversification even of the of the capital markets of the stock markets, as they list some of their holdings.

Nick: I suppose another thing, and I really noticed this from my two trips that I've done to Saudi over the years, was the difference between about 10 years ago, when I first visited and about five years ago, in terms of bit of social and religious liberalisation, that occurred, you know, things like shopping malls becoming opened, and cinemas and the like, yeah, how has, how has that changed the investment opportunities set over the years in terms of what we can actually get exposure to the portfolios?

Nina: Yeah, these changes are quite huge. And they're huge in a couple of ways, actually. So what Saudi people will say, when you speak with them is that it was difficult to live in Saudi Arabia and know what you could do somewhere else. This is the feedback that I, that I heard from a few people there. So in 2016, you know, until 2016, you had the religious police, which is officially called the Committee for the Promotion of Virtue and Prevention of Vice. And they would kind of patrol public spaces enforcing gender segregation, enforcing rules on how women should dress, enforcing bans on stuff like music, right. And now, you had this 35-year ban on cinemas being lifted. And they want to roll out I think 300 cinemas across the country from this being completely banned, until not long ago. They do have more entertainment options, right, like concerts. And I think that that has two very major implications. One is just more people, especially because this is a very young population, more people sticking around and wanting to stay in Saudi Arabia, and more tourists go into the country, this is a main lever to diversify the economy, is bringing tourism and keeping some of the money that Saudis spend abroad in the country. So, you know, I would, I would point you, for example, to the POS data that the central bank publishes. And that shows that in 2016, the share of consumer spending that was going to restaurants and cafes was 5% of total. And now it's 15%, even though that total spending part has also increased quite significantly. So for a company operating in that segment, this is a really quite meaningful expansion of their, of their growth potential. Right. And this is true across a number of sectors that benefit from, from people doing more in Saudi Arabia and having more to do.

Nick: Yeah, and of course, I suppose one of the really interesting aspects of liberalisation is the fact that more women can now enter the workforce in Saudi which must be one of the biggest demographic shifts of any emerging market in recent years, in terms of the number of available workforce for employment. How's that been impacting the economy?

Nina: Yeah, that's also huge. And a lot of those highly publicised changes, right, like a big one that people talked about around the world was lifting the ban on women driving. And this and some other reforms are ultimately supporting that, that drive to bring women into the workforce. And the scale has been, the scale of that of that new labour poll is also is also worth highlighting. Five years ago, the female labour participation rate was under 20%, maybe around 17%, and now it's 37%. Right? So that's quite a huge increase in your labour pool. And actually, there were some government reports in the last couple years, saying that actually, just over half of Saudi university students in the country and abroad are women, even though women are a smaller portion of the population. So, in a country that struggles with productivity, expanding the pool of well-educated workers is quite a massive reform. And this is not just, this is not driven by public sector hiring it's, it's private sector led growth in the employment of women. And this is, again, a very important marker of progress towards their targets, right, because improving fiscal responsibility and reducing the scale of state benefits also requires ceding a bit of ground to the private sector. And this participation of women is, I think, really ties up a lot of these reforms very neatly.

Nick: When we think about ESG issues within the country, there’s an autocratic government, which has been involved in some well publicised issues over the last several years to put it mildly. But when we look down at the companies, do you get any sense that companies are beginning to look at ESG issues more seriously, I mean, I suppose you are involved in the running of our Sustainable Development Goals fund. So, do you think there’s any scope to add one of these companies at some point?

Nina: Yeah, so it's a bit of good news and bad news there. So, the bad news that might not actually be news, is that ESG considerations and integration are still in very early stages in Saudi Arabia. And I think this is to be expected to some extent, right, because as foreign investors, sometimes we struggle to, to find an investor relations contact at a company, you know, this is because, this is simply because of the level of maturity of their market. So, they are still very much early in their journey of understanding what do investors want to know? Right. And that's, in some cases, even just the financial information on the business. So, ESG, would be, I think, the next step there.

The good news is that the Saudi Exchange has engaged with us quite frequently on this. So I, myself have had three or four calls and meetings with them, as a client of the exchange, right, as a potential investor in companies listed on the exchange, where they were very keen to hear, what would we expect from a company, what do we want to see what kind of disclosure should they move towards, you know, guiding or even requiring in the future? So, there are very real efforts on the part of the exchange. But putting aside the macro level controversies with Saudi Arabia, which are of course, you know, very, very serious issues. at the company level, this is still quite early stage. And I can think of one there's one company that I can think of off the top of my head that has quite an informative and helpful sustainability reports. But only one comes to mind.

Nick: Okay, so, so early days, but I suppose being optimistic, you would imagine that Saudi may follow a path to other similar emerging markets, whereby as more and more investors are demanding this information and this behaviour, companies start to take it more seriously. And I suppose having the exchange involved also has good precedent in emerging markets in that, we've seen a very similar situation in Brazil where the local exchange Bovespa, very much led efforts to enforce disclosure, and things like accounting standards on companies. So, I suppose some positive angles there.

I guess one, one thing that's occurred with the region in general of late is, that we've seen that Russia has now left a benchmark, and that was a place where lots of managers used to get exposure to commodities, specifically oil, I suppose with Russia having left now, has that changed the outlook for the region as an investment destination?

Nina: Yes, I think it has. So there are two main drivers, I would say, of Saudi performance relative to broader EM. And that's oil on the one hand, and the US dollar, because these currencies are pegged to the dollar. And Russia's invasion of the Ukraine had a ripple effect that was positive for both of those variables. So, you had that, you know, boost to the region. But, also moving forward, you know, as you as you kind of alluded to Nick, Russia, when it was in the benchmark and seen as investable, it was a cleaner way to get exposure to an oil economy. And that's partially because of the depth of the market and the maturity of that market. And for a bit of context, you know, how early Saudi Arabia for example, is in its journey, the UAE is a bit more advanced, right. But Saudi didn't have an electronic means of opening an investment account until 2018, when this financial sector development programme that I mentioned was already underway. So it's quite early, right, but now that Russia is no longer in global EM benchmarks, the role that this region can play for an investor isn't as easy to replicate through another market. And I think it's quite important that wherever investment will flow in the next year, in the next two years, investors got an opportunity to go through a bit of an education process in the last few years, that will make it easier to invest in the region in the future, right? So, investors like ourselves, now know more about the Middle East know more about the companies that are available there and kind of went through that process of okay let's learn about this and know what's around so that as and when we feel that it's a good investment opportunity, we're ready to invest I think that's an important change.

Nick: Yes, yeah, I agree, really fascinating insights there Nina, so thanks so much. And certainly, you've illustrated well, some of the potential opportunities in the region, particularly Saudi, but also the challenges that we face in terms of approaching a market that is very early in its journey towards becoming more mainstream.

So that feels like a good place to draw this podcast to a close. So with that, I'd like to thank you, Nina. Thanks very much.

Nina: Thank you

Nick: And thanks to everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for the next episode and tune in.