Saudi Arabia's MSCI Boost Is Dragging Emerging-Market Stocks

(Bloomberg) -- Saudi Arabian stocks are benefiting from their inclusion in the emerging-market universe. But emerging-market stocks are suffering because of the Saudi presence.

The kingdom’s May 29 addition to MSCI Inc.’s indexes, a decision in the works for over two years, has sent Riyadh stocks into a bull market and brought record fund inflows. But the euphoria masks the fact that the earnings outlook for Saudi companies is deteriorating faster than for peers and can barely justify the country’s record valuations.

This blind-alley racing has crashed the case for emerging-market stocks as a whole. With the addition of Saudi companies’ poorer estimates, the average profit forecast for the MSCI equity benchmark plummeted on May 29. While that looks ugly on its own, it also makes the gauge’s valuation pricier given that the projections are the denominator in the price-estimated earnings ratio.

In other words, any value buyer looking at emerging-market-wide exposure would have been put off by the sudden surge in its cost.

Even though Saudi Arabia accounts for only 1.5% of the emerging-market universe for now, with a second batch of inclusion slated for August, a majority of the stocks included in the May 29 re-balancing were Saudi. That makes the plunge in estimates mainly a Saudi affair.

The impact is even more stark for the Europe, Middle East and Africa region, where Saudi Arabia enjoys a 9.1% weighting. Before the nation’s upgrade, analysts had raised earnings projections for the region’s companies by 3.3% this year. That turned into a 1.9% drop after the inclusion. Forecasts for the kingdom are down 7.7% in dollar terms.

JPMorgan Chase & Co. underscored the worsening fundamentals in Saudi Arabia this week as analysts Naresh Bilandani and Saanil A Jain downgraded some of the country’s biggest lenders to underweight and said the risk-reward equation for Saudi banking stocks looked unattractive. Banks account for 47% of the Tadawul All Share Index, which fell 0.7% in Riyadh on Wednesday.

“We are yet to see a material pickup in credit growth near-term that could offer an EPS surprise and justify the greater-than 50% valuation premium that Saudi banks are trading on versus the rest of” the central and eastern Europe, Middle East and Africa region, the analysts wrote.

Inflows into exchange-traded funds accelerated this year as the MSCI upgrade approached, and have continued since May 28. However, short traders are betting a more realistic assessment of the earnings potential of Saudi companies will take over soon. They have boosted bearish bets against the iShares MSCI Saudi Arabia ETF above 10% of outstanding shares for the first time since its inception.

To contact the reporters on this story: Filipe Pacheco in Dubai at fpacheco4@bloomberg.net;Srinivasan Sivabalan in London at ssivabalan@bloomberg.net

To contact the editors responsible for this story: Dana El Baltaji at delbaltaji@bloomberg.net, Robert Brand, Justin Carrigan

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