Dubai debt - should equity markets be concerned?
Ted Scott, Director, UK Strategy at F&C Investments on the implications for equity markets: The news that Dubai has announced delays on the repayment of part of its debt has sent shockwaves through risk asset markets. Geographically, Dubai is insignificant being a city State and a small dot on the map. Its amount of outstanding debt is large at an estimated $60bn, but still modest in the context of the vast sums that have been written off relating to the US housing market and commercial loans in various developed economies. So is the market's sharp fall an overreaction?
What has happened?
The United Arab Emirates comprises seven semi-autonomous states of which Dubai is one. Dubai, as is well known, has over the last several years embarked on a massive construction spree that led to a boom in real estate prices followed by a subsequent collapse as the global credit crunch took hold. Unlike its neighbour, Abu Dhabi, Dubai was not rich in oil and therefore relied on borrowing to finance its projects. The objective of the construction boom was to build an economy that was not dependent on a depleting resource, oil, and create a financial and tourist centre that could generate its own growth.
The size of the borrowing quickly escalated to around $60bn and for some time its scale of leverage has been of some concern. However, the perception was that the debt was effectively underwritten by Abu Dhabi where the elder brother of the ruler of Dubai was, it was believed, prepared to help finance the infrastructure spend in Dubai. For this reason, the perception was that the Dubai's debt was regarded as sovereign risk status. The key point is that the perception of that risk has dramatically changed when Dubai asked for a debt standstill at Dubai World, the government's flagship construction company. The debt in question was only $3.5bn of the total, relating to a bond that was due in December but the news meant that the parameters of risk of Dubai's financing had significantly shifted.
The read across to other countries
It is important to distinguish between semi-sovereign and sovereign debt status. The move by the Dubai authorities has meant that its debt is now regarded as semi-sovereign and has been reflected in a large widening of the credit default swaps (CDS) for the debt of about 200 basis points. (The CDS is effectively a form of insurance for holding the debt).
Financial markets had known for a long time about the size of the Dubai debt but had been relaxed because of the perception that it had de-facto sovereign status. As a consequence of the effective downgrade it has impacted other countries that could possibly have similar problems financing their debt to Dubai. Yesterday, CDS spreads rose sharply on several countries with big financing deficits, including Russia, Turkey, Ireland and Greece. Overnight, the market has become concerned about quasi-sovereign risk countries and one only has to remember what happened to Iceland at the height of the current financial crisis to appreciate that the risks are real and default is possible.
Countries that have large financial liabilities, especially emerging economies, are regarded as especially vulnerable and hence the move in spreads yesterday. For the European Union it underlines the disparity between the financially prudent north, with Germany at the helm, and the profligate south. Italy and Greece are seen as particularly risky in this respect and CDSs for Greece soared on the news. It is estimated that EU country deficits have tripled from 2.3% to 6.9% in the last year and a half and will rise to 7.5% in 2010. Greece's financial deficit has ballooned from 7.7% to 13% in 2009. It has been felt that, rather like the UAE, the EU would underwrite the financing requirements of the heavily indebted nations such as Greece. But the situation in Dubai has concentrated minds on the risks involved. Greece cannot opt out of the EU because its currency would collapse and the cost of servicing its debt would rocket, so effectively the richer countries in the EU are guaranteeing the strained balance sheets of the poorer nations. For the time being!
What it means for markets
On a day when Wall Street was closed and the LSE ceased trading for several hours, equity markets across Europe fell sharply. The more developed markets, including the UK, generally lost about 3% of their value and also opened sharply lower this morning although they have rallied slightly. Other markets fell more, with Greece dropping by about 8%.
Financial stocks bore the brunt of the fall reflecting their exposure to Dubai. European banks have made huge loans to the emirate and the UK banks are particularly exposed. HSBC has the most exposure but as a percentage of tangible equity Standard Chartered is more vulnerable (at about 47%).
Although the markets collapsed on the news, on its own, it was an overreaction to the problems of Dubai. However, 2 points should be made that mean that equities were right to be marked down aggressively and could fall more in the short term.
Firstly, we still have not had a significant correction since the bull market started in March. We have had 2 periods of consolidation in June and in the last 6 weeks or so, but the market has remained firmly in a solid up-trend and is still about 9% over-bought on a 30 week moving average. Within the markets, the stocks with higher risk appetite and beta had strongly outperformed and these included financials, especially banks. Banks were already discounting a sharp recovery in earnings not just in 2010 but also 2011 and, therefore, from a valuation perspective, were overdue a pull back.
Secondly, the news on Dubai has come as a salutary reminder that the risks in asset markets are still high and reflect the enormous structural imbalances as a result of the global credit crunch that remain with us. In the case of public deficits, the imbalances have significantly increased in size, including the UK and US. We have been saying for a while that the path of economic recovery is going to be fragile and uncertain and would probably result in muted growth of GDP in 2010-11. However, recently, equities and some other asset classes (e.g. commodities and real estate) had risen to a level reflecting a level of complacency regarding the inherent risks.
The Dubai debt story is a welcome reality check for equities and, while shares still represent a preferred asset class, within the market there remains better value in good quality defensive and growth companies. Despite their recent outperformance this should continue while the market consolidates and corrects and most of these companies have relatively limited direct or indirect exposure to of semi-sovereign states and their contagion.