Frontier Markets: Liquidity and IPOs

Oliver Bell - Portfolio Manager, Frontier Markets Equity and Middle East and Africa Equity Strategies

So most people assume this is the risky part of the investment spectrum. The reality is that if you look at the last 5 years, this has been the highest returning region for the least volatile region. Since 2012 we have seen significant outperformance.

As you can see from the left-hand side, frontier markets as a whole have provided some very good outperformance. Especially when you compare to that pale blue line of emerging markets.

So what's changed? What's driving investor interest into this asset class? And I'm just going to take a few minutes to look at the bigger picture. The single biggest change is the lack of conflict. So if you go back to the 1990s, 50 of these countries had some form of conflict.

Today despite the fact of what you see on television, what you read in the newspapers, the actual countries, the number of countries that are truly conflicted, have some form of war, is probably about five. With this peace actually we have seen an increasing amount of democracy.

So again if you look at the orange line, in aggregate the frontier markets are as democratic, if you like, as the emerging markets were back in the mid 1990s. With democracy is coming accountability. What accountability brings is better macro economic management. But also look at inflation. They brought inflation down to under 10% in aggregate.

So this is very significant change. What this has done has attracted investment. So all this investment and stability is clearly providing quite a strong platform for growth, as you can see from the charts on the left-hand side.

For two decades, the pale blue of emerging markets have exhibited superior economic growth. But as that moderates and further forms are needed to sustain that, you can see the orange bars of frontier markets should now start to overtake in terms of economic outperformance.

I’m going to turn now to some of the nearer-term issues. Clearly, China slowing down could have an impact, because there are many countries that export into China. There are actually very few countries that have a very high percentage of their exports that go to China within the emerging markets. So again, we think they should be fairly resilient to a Chinese slowdown. Contracting global liquidity – so if the US does start raising rates, how does that impact this asset class? Well, historically, it’s those countries that have large current account deficits that get impacted most, because they have to fund that somehow.

In aggregate, it’s about 20% of the investment universe. Whilst it will have an impact on these countries, with the asset class in total, it perhaps is not so important. I think uniquely the Gulf Corporation Council, so those countries in the Middle East which have pegged currencies, could uniquely benefit from the rising US interest rates. Argentina and Nigeria – both of them have fairly important upcoming elections in 2015. In Argentina, one of the reasons the markets have been fairly sanguine about the recent default is because they’re looking through to the October elections next year. It’s an extraordinarily cheap market if you measure the market cap to GDP and given that this was one of the wealthiest countries globally only 100 years ago, you can see how its demise, in terms of market cap to GDP, has been compared to its neighbours in Latin America. And in Nigeria, the electioneering starts a year ahead of time – the reality is we expect the election to pass off fairly smoothly, and that the reforms that the current government have been embarking upon will continue, and actually we’ll see this giant of a country slowly emerge as a very powerful force within Africa.

Ebola is quite an emotive subject; we read about Brazilians cancelling trips to Namibia even though where they’re sitting in Rio de Janeiro is closer to the ebola breakout than Namibia is - we shouldn’t necessarily write off the entire continent. So as I summarise the asset class of frontier markets – the price to book basis – just under 2 times – is not really reflective of the significantly higher return on equities that you can expect. And I think as I draw your attention to the right hand chart – the earnings growth we’re seeing, and the earnings growth that’s expected in the coming years is clearly underpriced by the market. And if we’re right about the cocktail of ingredients for these set of countries, reminiscent of emerging markets of the late 90s, then we have a very exciting decade ahead of us.

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