Last Wednesday, as Americans prepared for their Thanksgiving Day celebrations, Dubai’s flagship government-owned holding company, Dubai World, announced that Dubai will seek a standstill agreement on all of Dubai World’s debt until at least May 30, 2010.  Dubai is one of seven emirates that make up the United Arab Emirates (UAE), which has a federal government and a central bank. The wealthiest emirate by far is Abu Dhabi, due to its oil revenues.  Dubai lacks oil but has pursued an aggressive growth program to develop trade, tourism, and transport, a la Singapore.  The program has been fueled by debt and characterized at times by flamboyant excesses. Note that Dubai’s GDP accounts for only 2% of the GDP of the UAE.  Investors were not totally surprised that Dubai World would encounter problems, but felt assured that the UAE would stand behind Dubai. Such support was not immediately evident as events unfolded last week.

On Thursday, this bombshell roiled global markets outside the US (closed for the holiday) and continued to unsettle markets on Friday. The US stock market joined the global sell-off, with the Dow-Jones Industrial Average losing 154.48 points (-1.5%). Oil dropped to $76.05 a barrel and the yield on 10-year US Treasuries ended the week at 3.202%. These reactions were more moderate than some anticipated, following the more pronounced declines outside the US on Thursday, which saw a 3.2% decline in the pan-European FTSE Eurotop 300 and a similar decline in the FTSE 100 in London. Since UK banks were believed to be among the most active in Dubai, financial stocks dropped 5.3% in London, with Barclay’s shares declining 8%.  Clearly markets were shocked by the news and uncertain about exposures and likely outcomes, in view of the lack of transparency about restructuring plans and the position of the UAE authorities.

By Friday the global sell-off was losing steam as global investors appeared to come to the view that the problem was containable. The amount of debt involved, $60 billion, is relatively small and it seemed rather likely that Abu Dhabi would extend help to Dubai in an effort to limit the damage done to the financial standing of the United Arab Emirates. Over the weekend the UAE central bank indicated that it would “stand behind” local banks by setting up an emergency liquidity facility for UAE banks, including local subsidiaries of foreign banks, in a move designed to shore up confidence in the banking system. The move was welcomed, but many questions remain as to what, if any, further moves the UAE and Abu Dhabi may decide to make. Of immediate concern is a sukuk, or Islamic bond, of Dubai World’s real estate unit, Nakheel World, on which a payment of $4 billion is due on December. It was announced on Monday, November 30, that “constructive” initial talks with banks on a restructuring of $26 billion of Dubai World’s debt (including the $6 billion of Islamic bonds sold by Nakheel World) have commenced. 

While Dubai and Abu Dhabi shares tumbled Monday, their first trading day since the announcement last Wednesday, global markets appear to have moved on as the problem became viewed as more of a regional issue with only limited potential for contagion.

It is revealing to look at the way global markets have reacted.  The initial sharp global reaction, despite the relatively small amount of debt involved, reflects a continuing sense of investor unease about the rapid run-up in risk assets this year, fueled by massive liquidity provision by the central banks and the continued presence of other substantial credit risks in the global economy.  This event was a reminder that not all credit risks will be bailed out. The lack of transparency magnified the reaction. 

On the other hand, the speed with which markets outside of the Gulf limited the contagion and turned their attention to other market developments is an encouraging indication of market resilience.  The cyclical bull market in global risk assets still has legs but has entered a more difficult stage in which differentiation between assets will become particularly important. Debtor countries will likely face a more difficult time.

While the Dubai problem did not lead to a major correction in global markets, it served to remind investors of the growing risk of such a correction, which may be triggered by an event few have anticipated.  One protection against such a risk is choosing investments wisely, avoiding weak credit risks.   Another protection that we also recommend highly is a strategy of broad diversification across countries, industries, and asset classes.  The current availability of almost 800 exchange-traded funds on the US market makes such diversification available at low cost. By the end of the third quarter of this year the availability of ETFs by type was US Equity: 334, International Equity: 157, Global Equity: 60, Fixed Income: 72, Commodity: 20, Currency: 20, and Leveraged/Inverse: 126, according to Morgan Stanley.

At Cumberland we have been using ETFs in our actively managed equity portfolios since 2000.  In 2006 we launched our Global Multi-Asset Class portfolio, crafted exclusively of ETFs covering the asset classes of US and international equities, US and international fixed-income, commodities, currencies, and real estate. A new brochure explaining this investment style is now available on the Cumberland website at http://www.cumber.com/content/styles/GMAC%20093009.pdf .