Saudi Tadawul to attract $5bn in second phase of MSCI upgrade, IIF says

Inclusion of Saudi Arabia's biggest stocks into MSCI's Emerging Markets index took place after markets closed on Tuesday

Visitors look at stock price information displayed on a digital screen inside the Saudi Stock Exchange. Bloomberg

Saudi Arabia is expected to attract an additional $5 billion (Dh18.36bn) in equity inflows as the Arab world’s largest bourse completes the second phase of its inclusion into the MSCI emerging markets index, the Institute of International Finance (IIF) said.

Investor appetite for Saudi equities spiked in August while during first eight months of this year, foreign equity inflows to the kingdom surpassed those of India and China - a "remarkable" development given that Saudi Arabia's economy is just a fraction of the size of the two other countries, the IIF said.

"In the absence of major domestic and external shocks and further deterioration in EM [emerging market] investment sentiment, Saudi Arabia can count on additional equity inflows from active investors whose portfolios are benchmarked to the MSCI EM index," Garbis Iradian, IIF's chief economist for Mena, said in a report on Saudi equities.

Saudi Arabia's Tadawul stock exchange gained 5.9 per cent during the year to Tuesday, according to Kamco Investment Company, which was the last day before the second round of inclusion took place. By midday on Wednesday, the Tadawul All-Share Index slipped 1.1 per cent.

The kingdom has attracted $18bn in foreign portfolio equity inflows so far this year, as foreign investors have significantly increased their exposure to Saudi equities ahead of the MSCI upgrade.

Early positioning by foreign investors to include Saudi stocks in their portfolios has been relatively slow since the MSCI inclusion announcement last year as factors such as concerns about policy uncertainty and high valuations for Saudi-listed companies kept some on the sidelines.

However, it seems investors have shrugged off such concerns this year and inflows to Saudi Arabia would have been even higher had it not been for global trade conflicts and concerns regarding the escalation of regional tensions, Mr Iradian said.

Indeed, the strong inflows to Saudi Arabia this year are in sharp contrast to other EMs. The IIF said that after a positive performance in the first quarter of this year, renewed trade tensions sparked a sharp decline in equity flows to most EMs.

The kingdom received more than $4.5bn in foreign equity inflows in May and $2bn in the first three weeks of August, becoming the top equity investment destination among EMs, according to the report.

"We expect Saudi Arabia to continue reaping the benefits of the capital markets reform and the inclusion in global indices," Mr Iradian said.

The IIF expects portfolio investments will be the main driver of foreign inflows to Saudi Arabia this year.

"Despite the recent weaker performance of Saudi Arabia’s largest sectors – banking and energy – the rationale for investors’ interest in Saudi Arabia’s stocks can be explained by portfolio re-allocation benefits," the IIF said.

With the local currency pegged to the US dollar and backed by large foreign reserves, exposure to Saudi market represents a natural currency hedge for investors, the institute said.

Equity markets usually rally after upgrade announcements by index providers but retract after the inclusion becomes effective, a pattern seen for other countries whose markets were promoted to MSCI emerging market status.

While Saudi Arabia has shown a similar increase after the announcement, "there is a reason to think that a major correction will not necessarily occur, unless global oil prices fall to well below $55 per barrel", Mr Iradian said.

This is because foreign equity inflows remained high after the first phase of the upgrade and the Saudi market is bigger and more liquid compared to other markets in the region that joined the MSCI EM index recently. Additionally, many diversified portfolios are unlikely to ignore Saudi Arabia as an EM investment destination.