A Western Alternative to the West

I must thank Agora Financial for inviting me to the Investment Symposium for the fifth time in a row. I am very sorry to see it come to the end of the road. But do trust it will make a comeback someday… like an old rock star whose retirement is announced but never happens.

[ahem]

However, today there’s another spectacular comeback story I’d like to share with you: the recovery of Dubai.

It was only three years ago, in 2010, that I stood at the Investment Symposium with the Dubai economy in tatters and investors’ dreams in shreds. I showed cartoons of heavily indebted Arabs begging for money. It was not so far from the truth.

Dubai real estate prices had fallen 60% from the peak. The stock market was a disaster area. Government debts had ballooned to $115 billion, according to the IMF. Then Abu Dhabi stepped in with $20 billion to stop Dubai from going bust. It was the start of a spectacular recovery. Without being too modest, this is exactly what I told Symposium attendees would happen in my first speech in Vancouver. I don’t think anybody believed me then, nor when I repeated the tale a year later!

Now, I admit that investors in Dubai needed patience. Even in 2011, stocks dropped another 20% before hitting rock bottom. The recovery started only last year, with shares up 20%. But the rally this year has been truly spectacular at 63% on the Dubai Financial Market. That’s against a falling trend in other emerging markets. The market has also massively outperformed the S&P 500. Indeed, it ranks among the best stock market performances in the world this year. It’s trounced the S&P 500. But it is still 75% off its re-based 2006 all-time high.

House prices have also recovered very strongly, though we are still a little shy of the peak valuations of 2008. The villa units tipped by the ArabianMoney newsletter in April last year have gained 50% in value. For rental increases, Dubai is ranked No. 1 in the world this year. Total real estate transactions in the first half were up 60% on H1 last year.

How has this happened? Essentially, the high-growth economy of the UAE has recovered from double-whammy recession of a credit bust and real estate crash by getting back to basics, hugely assisted by a boom in oil revenues and an influx of cash as a safe haven in the Arab Spring. It has been a combination of all three, so let’s examine them in turn.

First, the UAE economy has unique systemic strengths that have long given it way above-average GDP growth. The population is 80% expatriate. There is zero taxation: none whatsoever at the personal level and no IRS. The quid pro quo is that the government has no health, education or social costs for all these residents, though it has to fund infrastructure development out of its own pocket. Foreign companies operate in a zero tax environment from free zones and many choose Dubai as a friendly city in an unfriendly region. The wise and visionary rulers of the UAE are 100% responsible for this economic model and stand out as a success story in a region with many more failures.

In truth, the government is very dominant in the local economy behind its many trading names, although thousands of multinationals also choose to make Dubai their home. This is the region’s most open, liberal and efficient city. The Dubai government has made massive investments in its airline and airports, hotels and tourism and, of course, the free zones themselves like Jebel Ali.

Dubai’s Emirates airline is a world-beater, with a fleet of 35 A380 superjumbos and another 55 on order. Three years ago, there were only 16 in service. Dubai airport is one of the fastest growing in the world, and will overtake London Heathrow as the busiest in the world next year. Dubai’s luxury hotels are the envy of the travel industry. The new Marriott Marquis is the tallest free-standing hotel in the world. Then there is Dubai’s dominance as a trading hub for the region and its growing services and financial sectors.

Thus, as the global economy picked up after the 2008-09 crisis, Dubai was well positioned to profit from the rise in trade and the return of high oil prices. Dubai is not a big oil exporter, but neighboring Abu Dhabi, the capital of the UAE, certainly is, and the past couple of years have been the best ever for total oil revenues because high oil prices have persisted and not peaked out, as so often happened in the past. When you have a country with an oil surplus of $50 billion a year, debts of $115 billion or $142 billion, according to the latest IMF estimate for Dubai, pale into insignificance.

Of course, it is actually much better than that in the UAE. With, say, $4 trillion of oil in the ground and as much as $1 trillion estimated to be held in bonds and stocks by the Abu Dhabi Investment Authority, the UAE is a net creditor nation. That is to say the UAE is owed far more money than it has in total debts. If you contrast that with the heavy net debts of the USA, EU, U.K. and Japan, then you can understand my conviction about the strength of the local economy going forward. The Dubai debt crisis of late 2009 was not an illusion, but a bit of a large red herring, nonetheless. It would not be allowed to happen again.

Finally, even the protests, revolutions and civil wars of the Arab Spring over the past two years have actually benefited the UAE very significantly. We have had no social unrest, apart from a plot by the Muslim Brotherhood that was foiled at an early stage, and everybody involved was arrested, tried and convicted by the due process of law.

For this reason, the UAE has become a safe haven from the Arab Spring for rich Arabs and their families. Nobody with the means is going to leave their loved ones in an unstable and dangerous place, even if they continue doing business there. The super-rich might go to London or Paris, but Dubai is a cheaper home and the business opportunities are better. The culture is also closer, and often shockingly Western for these newer expatriates.

Still, they have been very good for house prices. Dubai was left with a very large inventory after its real estate crash in 2009 — estimates ranged from 50,000-100,000 units, and the takeup has been astonishing over the past couple of years. Not even the most optimistic estate agent would have predicted what has happened. But then how could you possibly have predicted the Arab Spring and the exodus of residents from Libya, Egypt, Syria and Bahrain and their demand for homes in Dubai?

There was also a spillover effect on tourism, particularly in Dubai. Even Turkey has become unsafe this summer, adding to the long list of countries now not suitable for tourists and carrying official travel warnings. Dubai has been the major beneficiary, with its expanding inventory of hotels kept close to the bursting point. Perhaps the Arab Spring was perversely the ‘bit of luck factor’ that turned a modest recovery in the UAE into a kind of new boom.

We are still not back to the heady days of the mid-2000s, however. Construction activity is back, but not at those levels. Real estate companies are selling off-plan apartments again, but the numbers of units are much lower. Still, important road improvements and the new Dubai tram system are being completed now. And it is amazing how many of the towers left half-built in the crash have now been finished off.

So what next? Will this recovery continue, and how can foreign investors sitting here today profit from this revival? Hopefully, it’s clear that this recovery is way ahead of anything seen so far in the USA and that a simple projection forward of current trends established a much better outlook. The UAE is, after all, a much smaller economy with very particular strengths. I have never found another place like it in my long career, and have been fortunate enough to find it profitable for my own business activities. Modest talent can bring great reward in the UAE. You’re not always up against the best in the world as in the USA.

High oil revenues and prices should continue into the future, although some sort of short-term blip downward is always possible in a future global economic crisis. However, the UAE is possibly the lowest-cost oil producer in the world, so it has the best competitive position and the highest profits from oil. ArabianMoney thinks money printing by global central banks will continue to support higher energy prices for many years to come. Hence, it is perfectly possible that the UAE could be in an economic boom when the rest of the world is languishing in a depression.

At the same time, the Dubai government’s investment in its airline and airports (and the second is up and running) is very timely. The legacy carriers of the world pay their staff way too much and have massive pension liabilities. Without this hole in their bottom line, Gulf airlines are able to afford new planes and routes, and are going to drive more and more of the old carriers out of business. The business model is correct, and economics will do the rest.

In addition, the Abu Dhabi government is following a very similar investment-led development plan, further boosting GDP growth prospects. Its Etihad Airways is growing rapidly; luxury hotels are popping up like rabbits; and key infrastructure is being built, like the $20 billion that is being spent on four nuclear power stations. However, it has overbuilt new real estate that was sold at Dubai peak prices, so the upside for property is more limited.

Rising real estate prices are both a benefit and a tax on an economy. As in the mid-2000s, surging accommodation rental costs are inflationary. Then again, rising house prices attract external investment and fuel up local consumption. Besides, Dubai real estate is still very cheap by comparison with most international hub cities. There is a pricing gap to close, and in the meantime, there is considerable wealth and prosperity to be created. Yes, there will be a bubble again, but how long will it take to get there and how much higher will prices go in the interim?

UAE stock markets are being driven higher by retail, rather than institutional, investors, and this is both a weakness and an opportunity. This summer, the Dubai and Abu Dhabi bourses finally won an upgrade from frontier to emerging market status in the MSCI index. That’s important because some emerging-market funds will now have to invest in the UAE. Institutional investors have yet to discover the market.

Look at the valuation metrics for the Dubai Financial Market courtesy of my old friends at Daman Investments, an excellent local broker if you need one. We also recommend the National Bank of Abu Dhabi’s brokerage arm NBAD Securities, which will establish offshore accounts for U.S. citizens without them visiting the UAE.

UAE stocks look cheap on price-earnings, price-to-book and return on equity. There is still value there. The market’s come up like a rocket this year, but is still 70% short of its all-time peak in 2006. It is only 18 months since it hit rock bottom. It runs on a seven-year cycle. Ergo, we have 5.5 more years to go in this bull market.

Most people are mature enough investors to know nothing goes up in a straight line. You would have had to be patient from 2010, when I first spoke of a recovery at the Vancouver Investment Symposium, but the recovery has gone better than I predicted then, and when nobody thought it possibly could. So why not anticipate outperformance now?

Regards,

Peter Cooper
for The Daily Reckoning

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