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Frontier Markets the PATH to TRANSFORMATION

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Frontier Markets the PATH to TRANSFORMATION PRICE Frontier Markets PERSPECTIVE® August 2017 THE PATH TO TRANSFORMATION In-depth analysis and insights to inform your decision-making. EXECUTIVE SUMMARY ■ The cocktail of economic and political ingredients across many frontier markets is reminiscent of emerging markets of the late ’90s, suggesting that a long period of positive growth can ensue. ■ Peace, improving politics, and a focus on economic management are attracting the investment necessary to help unlock frontier countries’ potential. Oliver Bell ■ With better economic backdrops comes capacity for well-run companies to Portfolio Manager, potentially achieve higher levels of earnings growth. Frontier Markets Equity Strategy ■ Over the past five years, frontier markets have provided better risk-adjusted returns than many other equity groups, including both developed and emerging markets. ■ While volatility is to be expected, low correlations between frontier and global markets and extremely low intramarket correlations are strong arguments for an allocation to frontier markets. THE PATH TO TRANSFORMATION— between and in frontier markets (e.g., PEACE, POLITICS, INVESTMENT, Sri Lanka’s civil war and conflict in AND GROWTH the Niger Delta). That number has When T. Rowe Price launched the significantly reduced as of today, and Frontier Markets Equity Strategy in June the ending of these major conflicts 2014, we noted that many characteristics has provided a foundation for political of the frontier countries were reminiscent improvements. In many of the frontier of the emerging markets of the late ’90s— countries, we have seen an embracing state of democracy, levels of investment, of the democratic process and several demographics, rising urbanization, examples of peaceful handovers to nominal GDP levels, GDP per capita, and political oppositions (e.g., Nigeria, very low market capitalization (Figure 1, Argentina, Sri Lanka, and Georgia). page 2). As we see improvements in Notably, Pakistan’s government these political and economic indicators, served its first full term without a coup we should expect frontier markets to in almost 70 years. The democratic grow significantly in terms of market process encourages governments to representation. focus on economic improvements with the motivation of getting reelected and Starting with peace: Looking back has led to completion of IMF programs, FOR INVESTMENT PROFESSIONALS ONLY. to the mid-90s, there were close to capital market liberalizations, and NOT FOR FURTHER DISTRIBUTION. 50 separate major conflicts going on policies to attract investment. Vietnam is one such case, where FIGURE 1: Frontier Markets’ Growth Potential Is Similar to levels of foreign direct investment (FDI) That of Emerging Markets in the Late ‘90s have been rising year-on-year, with its Nominal GDP (USD Trillions) booming electronics market attracting As of December 31, 2016 40 the lion’s share of inflows as the country Emerging Markets* Frontier Markets (lagged by 20 years)** becomes a global manufacturing hub 35 (Figure 2, page 3). Meanwhile, Argentina 30 is playing catch-up as Mauricio Macri’s administration continues to enact 25 market-friendly reform, which has won 20 praise and renewed the confidence of 15 international investors. 10 National GDP (USDNational TN) Many frontier countries also have debt and 5 inflation under control. The combination 0 is a powerful driver for growth, with 1980 1985 1990 1995 2000 2005 2010 2015 2020 frontier markets consisting of some of the Source: HSBC fastest-growing economies globally. The group as a whole is expected to outpace Total Market Cap (USD Trillions) emerging markets and significantly As of December 31, 2016 outpace developed markets in terms of 20 GDP growth throughout the rest of this Emerging Markets* Frontier Markets (lagged by 20 years)** decade and likely beyond. 16 Our belief is that this favorable economic 12 backdrop will translate into robust earnings growth for well-managed companies, in 8 turn leading to better investment returns. We saw this in the last decade with the emerging markets equity asset class 4 where country investment returns were Capitalization (USD TN) Market 0 highly correlated to nominal GDP growth. 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 We have identified many companies Source: HSBC that have the ability to generate positive and potentially sustainable double-digit earnings growth for many years to come. these asset classes (Figure 3, page 3). supply chains and are therefore less In fact, our bottom-up fundamental Efficient frontier analysis easily confirms impacted by global cycles. Even though research shows that there are some the benefit of including an allocation to frontier’s correlation with global stocks companies with visible earnings growth the asset class. Of course, we should still has increased over the last couple of that could potentially reach 100% over expect some volatility from frontier, markets years, it still remains very low at 0.44 three years. but in a portfolio context, one of their key (Figure 4, page 3). In the period in 2012 attributes is a very low level of correlation when correlations were higher, the UAE FRONTIER MARKETS IN A between other markets, and therefore, and Qatar were significant parts of the PORTFOLIO CONTEXT other asset classes, so, adding frontier frontier asset class (since then reclassified Over the past five years, frontier markets market exposure to portfolios provides to emerging market), and there was much significantly outperformed emerging significant diversification benefits. higher participation from non-dedicated markets and most developed market investors, a situation that tends to Frontier economies are at an earlier stage regions on a risk-adjusted basis, while increase correlations as flows become of development and, in most cases, exhibiting lower standard deviation than more driven by global markets. are not tied into global manufacturing * Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, South Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, United Arab Emirates ** Argentina, Bahrain, Bangladesh, Bosnia and Herzegovina, Botswana, Bulgaria, Croatia, Estonia, Ghana, Jamaica, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Morocco, Nigeria, Oman, Pakistan, Romania, Serbia, Slovenia, Sri Lanka, Trinidad and Tobago, Tunisia, Ukraine, Vietnam, Zimbabwe, Saudi Arabia 2 According to our research, the FIGURE 2: Countries Like Vietnam Are Attracting Huge Levels of FDI current level of this “crossover” or FDI inflows (USD millions, rolling 4Q) as of December 31, 2016 non-dedicated investment in frontier 20,000 markets is extremely low, leaving Argentina Sri Lanka Pakistan Vietnam Kenya Nigeria Romania us more comforted that the asset class should not be affected by their 15,000 outflows (particularly the situation of non-dedicated investors cutting their 10,000 “riskiest” or off-benchmark positions during tough times). Looking at the top US$ (Millions) 15 emerging market portfolios, only 5,000 seven of them have any frontier market exposure, and typically, that consists 0 of just one or two stock holdings 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 (Figure 5, page 4). That leads us to advise that if you are seeking exposure Sources: World Bank and Haver Analytics you need a dedicated frontier portfolio to access the opportunity in these markets. Gaining exposure to a couple FIGURE 3: Frontier Markets Provided Attractive Risk-Adjusted Returns of holdings via your emerging market As of June 30, 2017 manager is not enough. 15.0 MSCI World MSCI EAFE MSCI Japan Another attractive feature of frontier 11.5 MSCI Europe markets is the heterogeneity of individual MSCI EM Asia frontier countries, making correlations 8.0 MSCI Frontier MSCI Emerging Markets between the countries themselves 4.5 extremely low. Frontier markets are effectively “dancing to their own tune” 1.0 MSCI EMEA with intercorrelations of, on average, 0.05 for the top 10 frontier markets -2.5 MSCI Latam versus 0.45 for the top 10 emerging -6.0 markets, resulting in much lower than in USD (% p.a.) Return 5-Year Annualized 10 13 16 19 22 25 expected correlations and volatility. Standard Deviation 5 Year (% p.a.) Sources: FactSet and MSCI One area where there is correlation with global trends is in the oil and commodity space. While the sector FIGURE 4: Frontier Markets if You Are Looking for Diversity allocation is low (energy and materials As of June 16, 2017 represent 12.3% of the MSCI Frontier Markets Index1), several of the large 1.0 index countries are net oil exporters and oil can represent a significant 0.8 portion of fiscal revenues and impact overall economic health. The large 0.6 oil exporters, are Kuwait, Oman, Kazakhstan, and Nigeria, along with 0.4 Correlation non-index Saudi Arabia. There are also several countries largely dependent 0.2 on at least one other commodity, MSCI Frontier MSCI Emerging Markets MSCI Europe S&P 500 although typically, these tend to be the 0.0 smaller African nations (e.g., Zambia’s 2009 2010 2011 2012 2013 2014 2015 2016 2017 dependency on copper). Sources: FactSet and MSCI 1As of June, 30 2017 3 Frontier markets as a whole have FIGURE 5: Largest Emerging Market Portfolios by Regional Exposure therefore not been immune to the As of June 30, 2017 downward shift in oil and other Developed Markets Emerging Markets Frontier Markets commodities. However, many of the 100 frontier countries have adjusted to the new oil price reality by tweaking 80 budgets and currencies and are now, in many cases, much better positioned 60 to weather future volatility. Some economies, such as Saudi Arabia’s, are Percent 40 also taking initiatives to diversify away from oil and commodity dependence 20 by channeling investment across different sectors. 0 NOW COULD BE THE TIME TO INVEST Portfolio 1Portfolio 2Portfolio 3Portfolio 4Portfolio 5Portfolio 6Portfolio 7Portfolio 8Portfolio 9 IN FRONTIER Portfolio 10Portfolio 11Portfolio 12Portfolio 13Portfolio 14Portfolio 15 Now could potentially be a particularly Source: T.
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