Frontier Markets: The next emerging story?

Call of the frontier

EMs have evolved in terms of their size, pace of growth and importance to the global economy. Greater political stability, improvements in infrastructure, financial deepening and a rapid expansion in trade have driven dramatic changes in the fabric of EM countries. As EMs have matured and become less risky places, the expected excess returns from investing in them have almost certainly converged downward.

Replicating the higher returns of the EM group of the past may require investors to look to new geographies. Despite some challenges, this brings us to the FMs. As we argue in the following pages, FMs offer many of the features that made yesterday’s EMs successful in the past.

Following the same path

Economic growth—Accelerating at same pace as EMs in the past

There is almost universal acceptance that emerging economies have taken over as the engine of world growth. In recent times, though, economic growth has slowed in some EMs, and this has caused a narrowing of the EM growth premium over developed markets. Indeed, if you strip out growth in China and India, growth rates look poor in comparison with years gone by. By contrast, economic growth in FMs has largely accelerated, driven by some of the factors we discuss in more detail below. Encouragingly, many of these positive drivers are set to remain enduring themes. Figure 1 reflects the similarities between EM and FM growth.

Figure 1: Following the EM economic growth path

As of 31 Aug 2013

* EM includes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

**FM includes: Argentina, Bahrain, Bangladesh, Bosnia-Herzegovina, Botswana, Bulgaria, Croatia, Estonia, Ghana, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Trinidad and Tobago, Tunisia, UAE, Ukraine, Vietnam and Zimbabwe.

Sources: HSBC and World Bank.

Demographics—A working population

Economic growth is additionally underpinned by a young population in most frontier countries at a time when the developed world and some parts of the EM world (e.g., China) are aging rapidly. Currently, around 60% of Africa’s population and 50% of the Middle East’s population are under 24 years old. Africa will have the world’s largest working population by 2040 (Figure 2).

Figure 2: Consumer—Comparable with the BRIC countries

As of 31 Dec 2012

1Percent of population under the age of 24.

2Size of workforce (15–64) by 2040 in USDbn.

3Size of population earning above $2,700 p.a.

Sources: World Bank, CGIDD and Boston Consulting Group Analysis.

UN World Population Prospects 2012 Revision.

Productivity and wages—Competitive advantage coming to the fore

Currently, the output of workers in FMs is considerably less—in terms of gross domestic product (GDP) output per employed adult—than in EMs or in the developed world. In principle, becoming more productive should be easier in FMs, where workers are less productive to start with and the capital stock is lower; in other words, there is more “low hanging fruit.”

Commensurate with this lower productivity are lower wages. Although standardized data on wage rates is difficult to come by, it is clear that wages are lower than their EM counterparts. With many EMs moving up the value chain, wages have risen accordingly, no more so than in China where they have experienced around 15% year-over-year wage growth for a number of years now. By contrast, wages have remained low and wage growth has been slower, especially in places such as Vietnam and Sri Lanka. This has increasingly seen companies based in FMs beginning to win orders from western companies where once those orders were being given to China and other EM countries.

Natural resources—Commodity wealth attracts investment and growth

The majority of the world’s natural resources are found outside the developed economies. Although many of these are found in parts of the EM world (especially Brazil, Chile, Russia and South Africa), many FMs have substantial commodity reserves. Leading among these are Iraq, Kazakhstan, Mongolia, Nigeria, Ukraine and Venezuela. While an ample commodity endowment is not always a guarantee of economic success, it is the case that, if managed correctly, commodity wealth can lend significant support to a country’s economic growth.

While oil is the most abundant commodity in FMs, iron ore, uranium, bauxite and coal are also relatively important. Iraq, Nigeria, Kazakhstan and Venezuela all have the potential to raise production in the future. Currently, Ukraine has the world’s highest iron ore reserves. Kazakhstan and, to a lesser degree, Venezuela also have notable reserves. Bauxite (refined into alumina and smelted into aluminum metal) is abundant in Vietnam and present in Kazakhstan and Venezuela.

Urbanization and infrastructure—Building BRICs of growth

As with the BRIC countries before them, urbanization and infrastructure are themes that will help support long-term investment. Infrastructure is very much the backbone of an economy and helps to provide the framework for both economic growth and modernization. At its simplest, infrastructure spending is deemed necessary to reduce or avoid bottlenecks—for example, in transportation—which would otherwise occur as a consequence of rapid growth or urbanization. More generally, economists have long recognized that the provision of “public goods,” such as clean water, sanitation, education and health services, can have positive effects on productivity throughout an economy. Additionally, the globalization of trade has also magnified the importance of infrastructure with respect to economic growth and development.

Why focus so largely on infrastructure? Well, it has been proven that investment in a country’s infrastructure can yield large economic gains. Building roads or railways immediately boosts output and jobs, but it also helps to spur future growth. The World Bank estimates that a 1% increase in a country’s infrastructure stock is associated with a 1% increase in the level of GDP. Infrastructure investment in both the EMs and FMs has, in the past, been largely neglected, to the detriment of their economies. Governments have now realized, however, that infrastructure is one of the keys to a strong and sustainable growth cycle. This realization has caused a marked increase in investment in recent years, with currently over half of the world’s infrastructure investment now taking place in these regions.

Deepening financial markets: Investor appetite is strong, but there remain hurdles to clear

While the economic backdrop is important to the financial market outlook, there are other important considerations for investors (liquidity, valuations, regulation, the competitive environment and corporate governance).

Equity markets in FMs are small, but they are unlikely to remain that way forever. As mentioned, a key reason to pay more attention to the FMs now is that there is every reason to expect them to follow the same path charted by EMs over the past couple of decades. This path has brought growth in the breadth and depth of the financial markets, leading to greater liquidity and easier access for international investors.

Liquidity, however, can still be a barrier for public investment. Liquidity remains much lower than in emerging and developed markets, and for some institutional investors, there are still very few companies of sufficient size and liquidity outside the main markets. For example, Uganda, Zambia and Mauritius have very good and well-run companies but currently, due to the lack of liquidity, are not attractive investment destinations.

Going forward, the process of improvement will involve a number of steps: fewer restrictions on foreign investments, more liquid equity and foreign exchange markets, a solid legal and operational framework for investing, better custodial and settlement arrangements, greater disclosure from companies and more analyst coverage. All of these factors should help play a role in broadening the investor base and lowering the cost of capital for equity market investing.

Market capitalization—Room for catch-up

Encouragingly, though, there is real room for catch-up in terms of capitalization. Today, FMs represent just over 1% of world market capitalization1 and, as a share of their own GDP, have ample room to catch up with both their developed and EM counterparts (Figure 3). (There is a small caveat to this. By including only MSCI-listed stocks, and given that MSCI tends to exclude stocks that are not listed on its local index, for markets where a significant number of stocks are listed on foreign markets—Kazakhstan and Ukraine, for example, where some large stocks are listed in London, Toronto and Warsaw—the figure is understated.) Nevertheless, none of these adjustments would push the overall FM ratio above 5%, implying that there is still a great scope for the deepening of these equity markets in line with the sizes of their economies.

However, the fact that equity markets will get larger does not necessarily mean investors will benefit. More market capitalization can be achieved either through an increase in share prices or from the issuance of new shares (of either new or existing companies). A portion of the increase in the capitalization of Ems over the past decade has come from new issuance rather than equity market performance (with China a particularly striking example). Nevertheless, most EM investors have done well even in an environment of heavy stock issuance, and we see no reason why the same pattern would not apply to FMs.

Figure 3: Total market capitalization at similar levels as emerging markets in mid-90s

As of 31 Aug 2013

* EM includes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

** FM includes: Argentina, Bahrain, Bangladesh, Bosnia-Herzegovina, Botswana, Bulgaria, Croatia, Estonia, Ghana, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Trinidad and Tobago, Tunisia, UAE, Ukraine, Vietnam and Zimbabwe. Data are based on total market cap of all listed companies as calculated by World Bank. Market capitalization data are not free-float adjusted.

Sources: HSBC and World Bank.

FRONTIER MARKETS SHINE BRIGHT WITHIN THE EMERGING MARKET UNIVERSE

As many are aware, EMs have suffered poor performance over the last couple of years as a deceleration of economic growth and aggregate weakness in EM corporate earnings has caused sentiment to weaken. There also remain concerns over the implications of tapering upon the EM world. In short, the growth thesis of the emerging world has come under intensifying scrutiny causing underperformance. However, we do not believe that the long-term case for EM investing is broken, but it is currently going through a meaningful period of change. We maintain a belief that many EM stocks retain sensitivity toward a recovery in global growth, and given this, we remain optimistic on a bottom-up basis that earnings growth will recover and this will be rewarded by markets.

In contrast to the poor performance, however, from EM stocks, FMs have performed strongly (Figure 6). In fact, FMs have actually outperformed global and regional EMs in three of the last five years. The main reasons for this have been that economic growth has remained robust in most parts of the frontier world, especially Africa and the Middle East. Investors have also recognized that robust domestic economic growth can be translated into strong earnings growth at a company level. There are a number of companies within the frontier space that are currently delivering 20% per annum earnings growth, and they are predicted to deliver this for a number of years going forward. This is a very compelling story.

Figure 6: Frontier markets have performed strongly in a tough environment

As of 31 Mar 2014

*Annualized returns to 31 Mar 2014.

Sources: MSCI and Factset.

Looking for diversification within a risk framework?

One of the challenges for investors in recent years has been the rising correlation among asset classes that has reduced diversification. Even rising correlations among the more mature EMs have required investors to look farther afield for diversification opportunities. Of course, while the financial crisis emphasized how strongly the world becomes correlated when we encounter a protracted slowdown, and a subsequent bear market, FMs do continue to harbor greater diversification benefits compared with their emerging counterparts. As Figure 7 illustrates, not only have FMs tended to have much lower correlations to world equities than their more mature EM brethren, but they also provide additional diversification within the EM space itself.

Figure 7: Frontier markets offer real diversification benefits

As of 31 Dec 2013

*Barclays Global Aggregate Bond Index.

Sources: Zephyr Style Adviser and T. Rowe Price.

There are a number of reasons for this low correlation. FMs remain quite local in character, driven by their own internal economic and political dynamics. Foreign investors also tend to play a less important role in these markets. Moreover, the small number of securities in many of these markets means company-specific factors play a far more important role.

More surprisingly, frontier countries appear to be less volatile than other emerging equity markets when analysing the standard deviation of indices (Figure 8). This largely reflects lower liquidity and lower efficiency within the frontier space. Admittedly, individual FMs can have high volatility. However, when amalgamated together into an index or portfolio, volatility is dramatically reduced, primarily due to the very low correlation between individual countries.

Figure 8: Volatility is lower compared with other emerging markets

As of 31 Dec 2013

*Barclays Global Aggregate Bond Index.

Sources: Zephyr Style Adviser and T. Rowe Price.

VALUATIONS AND THE SEARCH FOR HIGHER RISK-ADJUSTED RETURNS

Due to their nature, it is more difficult to evaluate valuation metrics compared with other asset classes. Investors are hampered by a lack of reliable consensus earnings forecasts for most markets, while even historical valuation data can prove difficult to retrieve. Since January 2008, MSCI has calculated trailing price/earnings (P/E), price/book, dividend yield and return on equity data for each market; however, these multiples, while useful, can give a distorted view given that (1) most country indices have only a handful of stocks and are thus heavily affected by company-specific anomalies and (2) earnings visibility is generally low in these markets. It is clear, however, from the MSCI data now available that FMs still remain attractive, even despite recent outperformance. The region’s trailing P/E was 14.0x as of March 2014 (Figure 9).

Figure 9: Valuation metrics have become more attractive

As of 31 Mar 2014

Source: MSCI and Factset.

APPROACHING INVESTMENT IN THIS DISTINCTIVE AREA

Against this positive backdrop, however, investors still have to remember that FMs carry higher individual risk. These are markets that are at the beginning of their evolution, and this brings with it its own inherent challenges. A key consideration for investors is the difficulty of generalizing across a widely dispersed set of economies facing very different levels of development, economic conditions and structural constraints. FMs are not homogeneous. There is considerable variation in political stability, economic performance, openness to foreign investors, corporate governance practices and exposure to exchange rate risk.

A FOCUS ON FUNDAMENTAL BOTTOM-UP RESEARCH IS CRUCIAL

FMs also operate in a much less efficient space in terms of analytical coverage. This lack of broad research coverage can often lead to price anomalies. Within each region, there can be quite polarized underlying returns. As such, there is a pressing need for active management.

1 1.3% of total market cap as at January 31, 2014 as measured by MSCI (free float adjusted)

2 Sources: Demirguc-Kunt and Klapper (2012) and World Bank (2011).

3 Sources: Safaricom and Central Bank of Kenya.