The investment industry likes to contend with geographic complexity by inventing unifying principles. This is why jargon like G7 and BRIC earns slots in our lexicon, along with over-arching concepts such as “developed world” and “emerging markets.”

In this spirit, we think global investors should consider adding to their market framework the concept of “Islamic Triangle.” We define this space as stretching from Casablanca, to Istanbul, to Muscat. Investment specialists refer to this area as MENA (Middle East North Africa). Historic local terminology applies the labels Mashreq and Maghreb. Nineteenth-century imperialists called it the Near East; politically correct internationalists now call it West Asia. Less informed Americans these days may call it “over there.”

We view the zone as awash in investment opportunity, regardless of the emotional perceptions it may invoke. Our rationale combines the region’s unique relationship to US monetary policy, with strategic attributes and at-hand features, in an equation that yields a compelling allocation story. Any investor who considers the major emerging markets, such as China or India, should further consider the Islamic Triangle in the mix of opportunities.

 

Impact of US Rate Policy

Our case for more aggressive exposure to the Islamic Triangle rests fundamentally on the likely impact of a prolonged period of low US interest rates. Nearly all of the region’s nations have effectively outsourced monetary policy to the Federal Reserve, by linking their currencies to the US dollar. Low interest rates in the US will reflate these economies faster than the developed world because they lack the structural problems that plague the major economies. While the timing is hard to predict, the opportunity cost may be well worth the wait.

Of the 20 countries in our Islamic Triangle universe, about half peg their currency to the US dollar. None link to the euro, although the Maghreb countries use a composite that is heavily influenced by EU exchange-rate movements. The only country in our universe with an independently floating currency is Turkey. (See Table 1 for further details.)

 

The chart presents our view by comparing the Fed Funds Rate and a GCC-wide Shariah-compliant index over the past decade. (We use the Islamic index to demonstrate the resilience of our case, because this index excludes the conventional bank stocks one would expect to have a tight correlation with interest-rate policy.) Equity-market activity essentially falls into four periods, each reflecting a set of external circumstances:

 

• Engagement: before 2002. In the context of lingering fallout from the Asian currency crisis, global investors may have paid scant attention to any emerging-market allocations. Financial-market reform in many Middle East countries was limited in scope.

• Liquidity: 2002-2006. Regional markets saw impressive gains from buoyant oil prices and unfolding “cultural demonstration,” as residents shifted investment focus internally post-9/11. Loose US monetary policy formed the foundation for these gains, especially as liberalization took hold in some markets.

• Volatility: 2006-2009. Interest-rate increases took their toll on valuation readings, leading to a sharp decline in asset prices. The heavy presence of retail investors in some markets may have exacerbated volatility. Still, the region may have been on the verge of a stock-price recovery, were it not for the spread of the credit crisis.

• Stagnation: since 2009. The global backdrop has kept investors out of Islamic Triangle markets in general, reinforced by turbulence in local rebalancing processes. More constructively, the sideways market may have established a stock-price floor that is ready to support an upward trajectory once sentiment improves.

This link between US monetary policy and investment gains in the Middle East has been seen before and will likely be seen again, although the upside may be less dramatic. The Islamic Triangle extends beyond the GCC, of course, but Saudi Arabia is still the largest market in the region. More buoyant activity in the Kingdom will have attendant cross-border investment implications for markets as dispersed as Morocco and Turkey.

 

On-Ramps for Upturn

Granted, the potential for US low-interest-rate policy exporting inflation to the developing world may raise longer term issues, as well as reviving debate within the Islamic Triangle about the merits of the US dollar currency peg. But nearer term, we see a strong likelihood of regional markets sustaining outperformance, not unlike to we saw in the 2002-2006 period.

In this context, the most important question may be what will trigger a change in sentiment to bring investors meaningfully back into Islamic Triangle markets. We see two catalysts:

 

• Rebalancing of Local Economies. The excesses of the past cycle are in the final stages of being wrenched from the system. Timely examples include the downgrading of Bahrain’s credit rating, and Dubai World’s concession to creditor demands by announcing asset sales. To eventual investor effect, such acts of capitulation are filling the news flow.

• Strengthening Activity in Europe. As Germany’s economic recovery gains momentum, it will have a positive impact on North African and Eastern Mediterranean economies, helping to compensate for lingering weakness in the US. Europe is the major trading partner for Turkey, Morocco, and Egypt.

One specific indicator generating positive signals is private-sector loan growth. Having bottomed-out in 2009 and early 2010, lending by commercial banks is beginning to see signs of recovery. Egypt, in particular, seems to be leading the region because of strong asset quality, supported by the rationalization within the banking sector over recent years.

Oil is a special case. Further strength in hard commodity prices will also support sentiment, given pockets of exposure in parts of the Islamic Triangle. Jordan and Morocco aggressively export phosphates. Saudi Arabia and Sudan are both established gold producers, albeit limited in scope. Egypt has been reforming its extractive industries’ policies and procedures.

 

Long-Term Confidence in the Story

As most of the world’s major economies continue slogging through recession, the tactical case for the Islamic Triangle is convincing. The strategic case for exposure to the region also deserves consideration. Exposure to oil makes the obvious case. Two others are less clear:

 

• Demographics. If young people are the drivers of economic development, then the Islamic Triangle has an impressive future. Youth (age 15-24) as a share of working-age population in the Islamic Triangle is about 30%, twice the proportion in the developed world (based on data from the International Labor Organization).

 

 

The benefits of social inclusion and productive potential begin to drift away, however, when one considers the unemployment problem in this age group. The Middle East and North Africa have some of the highest youth unemployment rates in the world, at 23%-to-24%.

Exacerbated by the global recession, this problem demands intra- and extra-regional attention. Fiscal taps will open wide as governments aim to attract new industries, develop educational initiatives, and expand public works programs. It is the positive rate-of-change in unemployment trends that will lend strong support to the story.

 

• Islamic Finance. We believe that when global financial-market history is written about the past decade, the growth of Islamic finance will be a dominant theme. Based on principles of sharing risk and avoiding speculation—in addition to a core tenet prohibiting interest (“making money from money”)—the industry’s growth has helped the Middle East’s service economy grow and prosper.

 

AAOIFI, the Bahrain-based Accounting & Auditing Organization for Islamic Finance Institutions, claims more than 200 member firms worldwide, but few have cross-border footprints. This may explain why the industry is poorly understood within conventional circles. Outside Muslim-dominated geographies, Britain has likely made the largest strides in advancing the Islamic banking industry.

Obviously there are nuances to these points in each of the region’s economies. For instance, King Abdullah’s economic development strategy in Saudi Arabia is heavily premised on accelerating advanced education. Witness the overnight development of Riyadh Women’s University, now being built along the Airport Road and set to be the largest such institution in the world. On a more sober note, the political backdrop in some countries has inhibited local development of the Shariah-compliant financial services sector.

 

Regional Feature: High Dividend Yield

The Islamic Triangle is chock-full of compelling features for the global investor. We think one of the most important at this time is the region’s high dividend yield, atypical of emerging markets. Such impressive relative value is unsustainable as stock prices rise, but it helps support the at-hand buying decision.

The average dividend yield across these markets is 5.7%, according to our colleagues at London-based MENA Capital. This contrasts impressively to figures seen elsewhere around the world. As the long-term US bond yield moves toward 2%, a high dividend yield is compelling.

Investors should be duly cautious, of course, in buying stocks as a substitute for income-based assets such as bonds or real estate. In the extreme, dividend streams can dry up unexpectedly (e.g., BP in the wake of the Gulf of Mexico disaster). But having made the point, we note that dividend payouts tend to be relatively stable, in part to help corporate management mitigate stock-price volatility.

Our short list of features can easily be extended. Market technicians may be drawn to the low correlations with the major market indices, supporting a case for diversification, while economists will appreciate the impact of relatively high per capita income, especially in the GCC markets. Fundamental analysts will value the under-researched nature of most of the equities in the region.

Opportunity Lies in Imperfection

For a New York or Hong Kong investor monitoring multiple portfolio positions across a range of asset classes, the Islamic Triangle may not be a top priority, but perhaps should be. At just over $1 trillion, the Islamic Triangle’s total market capitalization is just a bit less than Brazil’s or India’s. Among major markets, it compares with Australia or Switzerland. Relative to GDP—a sign of an equity market’s importance to a local economy—the number is nearly 60%, relatively low, but indicative of the structural potential over time. (The relationship in Malaysia and Taiwan is roughly 90%.)

These capitalization-based comparisons are tabulated from an aggregate figure for what is a highly fractionalized region. This is not a single, highly liquid market with deep trading volumes in well-researched stocks. Instead, one faces a cacophony of technical, fundamental, and strategic themes that may be best understood by a specialist investment team. The poor representation of Islamic Triangle markets in the major benchmark indices reinforces this requirement for dedicated oversight, managing the situation for its absolute-return potential.

We acknowledge some bias in our view, given that our own business focuses on this part of the world. Yet, as Brazil, Russia, India, and China inspire notions of a “power shift” to the developing world, we think the Islamic Triangle deserves consideration for a “portfolio shift” to a more prominent position among investment holdings.

 

Table 1: Classification of Exchange Rate Regimes and Monetary Policy Framework

Exchange Rate Arrangement	Monetary Policy Framework
	Exchange Rate Anchor			Monetary Aggregate Target	Inflation Targeting Framework	Other*
	Dollar	Euro	Composite
Currency Board	Djibouti
Other Conventional Fixed Peg Arrangement	Bahrain Jordan Lebanon Oman Qatar Saudi UAE Yemen		Kuwait Libya Morocco Tunisia
Pegged Exchange Rate Within Bands			Syria
Crawling Peg	Iraq		Iran
Managed Float (No Pre-Determined Path)			Algeria	Sudan		Egypt
Independent Float					Turkey

*Includes countries that have no explicitly stated nominal anchor, but rather monitor various indicators in conducting monetary policy.
Source: International Monetary Fund, 2008.

Table 2: Islamic Triangle Regional Profile

	(A) Market Cap (US$ Billions)	(B) GDP (US$ Billions)	(A) / (B)	Number of Stocks	Dividend Yield
Saudi	323	370	87%	127	4.6%
Turkey	249	615	40%	315	7.6%
UAE	82	230	36%	103	6.2%
Kuwait	99	111	89%	189	5.6%
Qatar	86	84	102%	43	6.1%
Egypt	58	188	31%	94	6.1%
Morocco	69	91	76%	73	5.2%
Jordan	27	23	117%	191	5.7%
Bahrain	17	20	85%	44	8.0%
Oman	17	53	32%	134	4.8%
Lebanon	12	34	35%	10	6.1%
Tunisia	12	40	30%	50	2.7%
Total	1,051	1,859	57%	1,373	5.7%*

*Column total for Dividend Yield is the simple average of markets listed.
Data as of July 2010. Note: Market capitalization data represents the total equity market; GDP based on current exchange rates.
Source: MENA Capital (London).

(c) Codexa Capital

www.codexacapital.com