Wednesday, December 10, 2008

"Deflation, Dubai, and GCC Growth Revisited"

There is a somewhat cautiously optimistic report out today saying that the temporary sting in the UAE property market is likely to be short lived. First, I would like to say that I hope this report is right, and I want to commend the authors for providing us with something potentially uplifting in the midst of all this gloom and doom. However, I do have to question exactly what it is they are basing this view on beyond mere wishful thinking.

The three major trends of the last 24 months have not only slowed and changed course but they have utterly imploded.

They are:
1) Dubai’s booming Real Estate Story
2) The GCC’s booming Oil Story
3) The overall boom in emerging financial markets

All three of these interconnected broad investment themes have slowed, reversed direction, and then proceeded to fall off a cliff in a matter of four months. The real estate story in Dubai was for the most part a function of themes two and three as the Emirate managed to leverage the surrounding wealth in the region and boom in emerging market real estate investing to fund its aggressive development. However, investors are not stupid, and foreign flows don’t find their way into a region whose major revenue source declines 73% in 5 months. The health of the real estate market in the UAE, if health is measured by a consistently upward sloping price graph (I would tend to disagree with the view of price as a determining factor but I’ll save that for another blog), is directly tied to the price of crude. This is a harsh reality that people in this region still have a hard time accepting. While I will concede the progress has been made with respect to diversifying the economies of the oil producing GCC nations, the reality is that they have for the most part barely scratched the surface. 2008’s record surpluses will turn into current account deficits at current crude prices. All things being equal, when you factor in the accumulated wealth during the oil boom this is not exactly a disaster, as the GCC should be better off than most other emerging economies. Problem is all things are not equal. The region has massive infrastructure plans that were predicated on a sustained oil driven liquidity boom. The marginal liquidity coming in was quickly being soaked up by future long-term investments. This means that liquidity at the margin needed to stay positive to sustain the increasingly ambitious plans of regional developers. Why? Well, simply put your ability to finance future growth plans through external capital inflows becomes seriously impaired when creditors and investors believe that your revenue growth has peaked. In most cases, you can dodge an economic shock if this scenario plays itself out gradually. However, if your major revenue source and liquidity provider collapses in a matter of months you will most likely find yourself in difficult situation. For Dubai, and several other GCC nations, the situation is exacerbated by the fact that they were operating a two pronged economic growth strategy. Not only were they borrowing against the future to fund massive and rapid current infrastructure projects, (I.E. building a long lived asset like a global city in a matter of five years with significant short-term funding) but they were also using accumulated wealth and borrowing against their future anticipated wealth to fund external acquisitions to complement their strategic vision and diversify their economies.(Think Sovereign stakes in pretty much every global financial company you can name, stakes in the likes of MGM, land mark real estate in N.Y. or London, football clubs in Europe, home builders in California, semi conductor makers, automobile companies, and ports) Thus, a global financial collapse coupled with a oil price implosion is going to pose a considerable challenge for the region, as both prongs of the economic development plan take a hit. Growth plans will need to be reined in, businesses re-sized and difficult decisions will have to be made with respect to foreign asset allocation.

I didn’t think oil would reach $147 and I also never thought it would hit $60 in a few months let alone the $40 it is at today. However, I am not going to plan my investment strategy under the assumption that the price of crude will rebound 100% in the next 4 months, and I assume the powers at be won’t be doing the same. Oil is an enigma and I have given up trying to come up with a fair price for it. All I know is that the world definitely relies on it, it has been at the heart of every major conflict over the last 100 years, and the West has always gone to great lengths to control it. Therefore, I won’t rule anything out with respect to the recent crazy price swings. But at the same time, I think one needs to be realistic about what impact a depressed oil price of even 6 months is likely to have on this region.

In my humble opinion, the real estate market will most likely follow the equity markets and oil market with respect to its correction. This is the most probable outcome. Many people will argue to the contrary, but I have hard time believing that this will be the case. If Emaar shares can fall 80% and crude can decline 70% then I see no reason to believe that very leveraged residential property won’t meet the same fate. History has proven that the belief that any one investment can be “unique” or “safe” is a complete and total fallacy that holds up only until conventional wisdom provides evidence to the contrary.

Keynes once stated that an

“investment becomes reasonably ‘safe’ for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are "fixed" for the community are thus made "liquid" for the individual.”

When the convention is broken in a matter of months an investment is no longer perceived to be reasonably safe, as the investor has just witnessed a period in which he did not have sufficient time to revise his judgment and alter his investment. This is the problem with bubbles, and right now, we are getting a nasty dose of the illiquidity that comes with a breakdown in conventional wisdom.

1 comment:

Brad Zurich said...

There is a slow down for sure but that doesn't mean its one way traffic all the all. There will be some new businesses and deals around so that will boost sentiment. But the larger picture is dim. Oil is what UAE depends on and its fallen over $100 from its peak. This will certainly be hurting their economy.
The real estate boom in Dubai too will be hurt.