Peter J. Cooper’s Weblog

US investment banking giant Goldman Sachs has established a $300 million proprietary fund to invest the bank’s own money in the Middle East. It is called Goldman Sachs Middle East Investments, and the bank’s partners will also be able to invest personally in the new fund.

The move is a remarkable about turn in the flow of investment from major Western institutions this year, which has been mainly in the reverse direction with emerging market funds pulling out of the region. Not for nothing is Goldman Sachs the reigning king of Wall Street, and its new fund demonstrates typical market prescience and a grasp on fundamental economic realities as well as classical diversification into non-correlated assets.

According to a report in The Daily Telegraph, ‘the focus for the fund is wide-ranging, but it is thought likely to major in financial institutions as well as energy assets.’ Nobody has seen the business plan for the new investment fund. But it is an interesting exercise to consider its rationale, if only to analyse what is behind the thinking of the world’s most important investment bank in deciding to invest in the Middle East at this time.

Surely its logic has to come down to three things. First, the oil price is down from its $147 high of earlier this year but not exactly a disaster at around $113 a barrel. In the early 2000s the OPEC price band stood at $22-28 a barrel, and even if prices fell back to $70 that would still represent a tripling of oil revenues.

Besides Goldman Sachs is on the record as believing oil prices will spike to $150 to $200 over the next couple of years. Less than a year ago that $150 target was laughed at and yet it was almost reached a couple of months ago. Who is to say that oil prices will not stay high and for longer than some forecasters now assume?

In the mid to late 1970s, for example, the global economy was in dire straits with crashing stock markets, depressed real estate and yet commodity prices remained resolutely strong, albeit very volatile. The Middle East flourished in its greatest ever oil boom.

Perhaps the same thing is going to happen again, and Goldman Sachs clearly wants to be in on the act. Secondly, I am sure that Goldman’s analysts have taken careful note of the investment boom in the region. The $1.3 trillion worth of projects in the GCC exceeds present investment plans in China.

This is a huge forward order book that will keep economies moving for three, five, even ten years ahead. A good parallel to draw here is with Hong Kong in the early 90s. Its $25 billion airport infrastructure programme kept the city booming during a period of global recession, which actually helped to keep its construction costs down.

Only when the cranes came down and the Union Jack ceased to fly over Hong Kong in 1997 did the city experience a major economic recession. The Gulf States and principally the cities of Dubai, Doha and Abu Dhabi are surely only in the early stages of their major growth phases, with so many projects either under construction or still in the planning stage.

Thirdly, I suppose Goldman Sachs has spotted a trading opportunity. With the emerging market funds on the retreat from the Middle East stock prices have fallen to levels not seen for five years in terms of price to earnings.

But at the same time profits are still heading upwards for regional financial institutions, and even the somewhat maligned property companies do have very substantial cash flows and the prospect of very much higher profits to come in many cases. Indeed, this is probably the point of the annual calendar when local stocks represent a great buy as autumn traditionally brings a revival of local investor interest, most likely after Ramadan this year.

No other part of the world is benefiting from the energy price explosion to the extent of the Middle East, and you can probably justify investment here just from the point of view of diversification. It makes excellent sense not to have all your investment eggs in one basket and to keep money in one place that is booming helps to counter a downturn in other markets.

However, the big unanswered question is whether the Gulf States will in fact prove to be negatively correlated to global markets, particularly their bourses. My feeling is that Wall Street remains wildly overvalued for what is coming: a double dip recession with a surge in bankruptcies, unemployment and further falls in real estate prices.

At some point in the near future this reality is going to catch up with the Street. Will investment houses then sell everything they have, including Gulf stocks? Some may well have to do so but others will be looking for non-correlated asset classes. They will not have much choice.

Real estate is in crisis. Bonds are threatened by inflation. Cash pays very low interest rates. Global stocks will be in turmoil. So that leaves precious metals and the Middle East.

Goldman Sachs and its partners may well think prudential diversification and an eye to the domestic investment plans of local governments more than justifies its decision to create Goldman Sachs Middle East Investments. And as we know from a recent survey of the expansion plans of global financial institutions Goldman is not alone, as Dubai is the number one choice for growth over the next three years.