Where is the Correlation?
It is well known that oil revenues - and by default oil prices - are what drive GCC economies, despite efforts by individual GCC states to diversify their economies. Hydrocarbon GDP continues to dominate the economic structure, and consequently, periods of high oil prices and high economic growth, have fed into the stock market through increased liquidity and petrodollars. However, this relationship seems to be breaking, with oil price no longer driving stock market performance. From 2005 to date, crude oil and the S&P GCC Index have had a correlation of only 12%, a relatively low figure. Since 2008, crude oil price increased by 19% while S&P’s GCC index fell by 46%. So why is this correlation diverging and is it likely to return?
Figure 1: Oil Price and S&P GCC Composite Index
Source: Reuters Eikon
Reason #1: The Oil Price-Economy-Stock Market link broken thanks to Banks
Bank lending has always been the conduit through which petrodollars have made their way into the stock market. The oil revenues feed into the citizens’ coffers through wages and social allowances, which are then placed with banks and are subsequently lent out. Roughly 10% of loan portfolios are for the purpose of stock market investing. In the past (especially 2005-2008) bank lending was growing at a frantic pace of 33% a year while in the subsequent period that average fell to a muted 5%.
Lending has considerably slowed over the last few years as GCC banks have exercised greater prudence and heightened risk aversion in the face of highly leveraged corporates and individual retail clients. Banks have been unwilling to lend as they have worked towards shoring up capital, increasing provisions and coverage of non-performing loans in addition to maintaining existing credit lines. On the other handmany retail investors have been deleveraging and therefore cannot procure the means to fund their activities in the stock market.
Reason #2: Increased Government Spending
Encouraged by the strong oil price and oil revenues and coupled with the need to shore up infrastructure on the back of demographic changes, GCC governments are investing heavily in infrastructure and other social projects, to the extent that this is crowding out a weak private sector, which is mostly represented in the stock market. Also, some of the big family houses that are direct beneficiaries of this government spending are not represented in the stock market, leading to the lack of transmission mechanism between oil price and stock market performance.
Reason # 3: Fear Factor
The aftermath of 2008 global financial crisis has left deep wounds on the psyche of many corporates, high net worth individuals and retail investors. Many regional investors had substantial investments abroad and faced losses due to this. This has caused risk aversion and a fear factor that prohibits them from taking risk. In the past, the smooth transmission mechanism between oil revenues and stock market created the needed Feel Good Factor (FGF) that enabled investors to take risk and infuse confidence. The fear factor is doing exactly the opposite thing, leading to a disconnect between oil price and stock market. The fear factor is also exacerbated by the political developments in the form of “Arab Spring”
Reason #4: A “dependent” monetary policy
Most of the GCC governments peg their currency to the USD, forcing them to mirror US monetary policy even though the economic settings are not as nearly synchronized as it should be for the peg to function logically. This causes needless friction in terms of inflation and other side effects. For eg., even though the GCC region is growing well economically, thanks to high oil price, it has to have a loose monetary policy in line with US. However, this does not result in increased borrowing due to risk aversion both on the part of lenders and borrowers. In normal times, such low interest rates should encourage borrowers to borrow and seek higher yields in the stock market.
Reason #5: Increasing global connect
The GCC region is today more interconnected with the outside world than before, thanks to increasing trade. This means that events outside the region will have an increasing impact on the local economy. Lack of growth in inter-trade among GCC countries also forces this situation.
Why is the correlation important?
The GCC region is oil dependent and will continue to be oil dependent for the foreseeable future. Economic progress need not translate instantly into stock market riches as we have seen with many countries including China. However, it has to eventually catch up and reflect especially in predominantly one-product economies like those in the GCC. Hence, sooner or later, oil wealth should resonate in stock market success aided by regulatory reforms, institutional participation and bank strength. Also, oil price strength on account of improving global demand may enable return of confidence while oil price strength on account of supply fears may hinder confidence. While continued bank distress may delay the transmission process for the moment, correlation is bound to come back - at least in the medium term if not short-term. This is a good thing and good for the region’s economic growth.