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Frontier Markets: Weighing the Risks

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Frontier Markets: Weighing the Risks July 2015 Frontier Markets: Weighing the Risks By Nathan J. Rowader, Senior Portfolio Manager A growing number of Why would investors even think about investing in fledging, so-called frontier economies half a world away? The quick answer is that some of the investors are looking to best-performing stock markets in the world can be found in places like capitalize on the next wave Bangladesh, Kenya and Argentina. Even in a year that challenged many of global development emerging economies, stock markets in these countries generated returns of 52%, 24% and 19%, respectively, in 2014.1 Although past performance does through an investment in not guarantee future results, investors in search of portfolio growth and frontier markets. diversification are taking note. Not so long ago, even the larger emerging markets (EMs) were considered exotic. But over the past two decades they have become a familiar Highlights investment story. Now a growing number of investors are looking to many frontier markets (FMs) as the next wave of global development. Despite The favorable demographics and strong growth volatility associated with interest rate concerns, political strife and currency potential of these early-state, frontier market moves, the MSCI Frontier Markets Index gained 19.26% between the end of economies provide ample opportunities. 2012 and March 31, 2015, compared to a -7.64% decline for the MSCI To fully understand the risk profile of the asset Emerging Markets Index over the same period (Figure 1). class, investors need to look past common assumptions and misconceptions. Frontier markets offer growth potential and low correlations within markets and with other asset classes, along with relatively attractive valuations. Given the volatility of individual markets, investors may want to consider strategies that provide diversified exposure across frontier nations. www.forwardinvesting.com FIGURE 1 Growth of $10,000 Comparison of Monthly Returns, December 31, 2012 to December 31, 2014 $15,000 $14,000 $13,000 $12,000 $11,000 $10,000 $9,000 $8,000 12/2012 03/2013 06/2013 09/2013 12/2013 03/2014 06/2014 09/2014 12/2014 03/2015 MSCI Frontier Markets MSCI Emerging Markets Sources: Bloomberg and MSCI Past performance does not guarantee future results. Frontier markets In essence, many frontier nations are the the 2014-17 period estimate that FMs’ gross are among the emerging markets of tomorrow. The 24 markets domestic product (GDP) will expand at a in the MSCI Frontier Markets Index today median CAGR of 3.5%, more than the 2.8% rate fastest-growing 2 represent a similar share of world market cap forecast for the U.S. economies in the that EMs did 25 years ago. Twenty-five years In assessing the opportunities, analysts point to world. In essence, from now—who knows? One thing is clear: the favorable demographics and strong growth they are the frontier markets are among the fastest-growing potential of these early-stage economies, along economies in the world. Over the five years emerging markets with their low valuations relative to developed from 2008 to 2013, the median compound nations (Figure 2). Indeed, the stock market value of tomorrow. annual growth rate (CAGR) among frontier of frontier nations is equivalent to a median market economies was 3.2%, far outstripping 23.4% of GDP, while the corresponding figure is the U.S. rate of less than 1.2%. And while the 47.8% for emerging markets and 68.8% for the U.S. economy has picked up steam, forecasts for developed world.3 Frontier Markets This listing represents countries in the MSCI Frontier Markets Index as of May 2015. Investors should note that index composition changes as countries grow. For example, in May 2014, MSCI reclassified Qatar and the United Arab Emirates as emerging markets. Americas Europe & CIS Africa Middle East Asia Argentina Bulgaria Kenya Bahrain Bangladesh Croatia Mauritius Jordan Pakistan Estonia Morocco Kuwait Sri Lanka Kazakhstan Nigeria Lebanon Vietnam Lithuania Tunisia Oman Romania Serbia Slovenia Ukraine 2 Frontier Markets: Weighing the Risks www.forwardinvesting.com Investors who look But the question looms: what about the risks? Investors are right to be cautious; frontier past common Spreading sectarian clashes in the Middle East, markets are no exception to the principle that economic woes in Argentina, election violence excess returns come with additional risks. But to assumptions and in Kenya—such troubles understandably give fully understand the risk profile of this nascent misconceptions about investors pause. It’s important to remember asset class, investors need to look past common frontier markets may that FM nations lack the level of political assumptions and misconceptions. Those who do stability, financial infrastructure, and legal and may discover some facts surprisingly different discover some regulatory framework that characterize more from what they might expect. What follows is a surprising facts. developed markets. Language and cultural brief survey of key investment considerations and barriers, physical distance and less abundant risks for those venturing into the FMs, as well as information all factor into the aura of risk our views on how investment strategies can be surrounding frontier markets. designed to help mitigate risks. FIGURE 2 Growth Potential at a Relatively Low Price Comparison of Price-Earnings Ratios and Dividend Yields, as of December 31, 2014 20 18.70 16.63 15 12.55 11.47 10 P/E Ratio 5 0 United Foreign Emerging Frontier States Developed Markets Markets 4.19% 4 3.36% 3 2.77% 2 1.91% Dividend Yield 1 0 United Foreign Emerging Frontier States Developed Markets Markets Sources: Bloomberg and MSCI Past performance does not guarantee future results. www.forwardinvesting.com Frontier Markets: Weighing the Risks 3 Political and Sovereign Risks Frontier market stocks When investing in countries where civil and At the same time, frontier stock markets are are often dominated political unrest can be common, there can be a often dominated by domestically oriented risk of market disruption. For example, an sectors, such as banks, telecommunications and by companies that are eruption of massive protests in Ukraine drove its consumer companies that are driven more by driven more by the stock market down 3.5% between November 21 the local economy than by global macro trends. local economy than by and December 17, 2013, but made almost no As a result, between January 1, 2009, and ripple in other FMs. In fact, during that period the December 31, 2013, the average intercountry global macro trends. broader frontier index was up 1.7% and Ukraine’s correlation among MSCI Frontier Markets Index nearest frontier neighbor, Romania, saw its nations was 0.36 as compared with 0.63 for market rise by 1.3%.5 countries in the MSCI Emerging Markets Index and 0.76 for the MSCI EAFE Index.6 That’s because frontier markets have had an unusually low correlation to each other. Spanning Our takeaway is that, given the diversity of the Americas, Europe, Africa, the Middle East and frontier markets and the low correlations Asia, these far-flung economies have little in among them, gaining exposure via a strategy common beyond being in a similarly early stage that invests across a broad cross section of FMs of development. A major development might roil can potentially help dampen the risk in any the economy in Nigeria or Argentina, but will have one country. little or no effect in Estonia, Kuwait or Vietnam. Volatility Individually, frontier markets can be quite volatile. volatile than EMs. Morningstar points out that But because they are so diverse and relatively EM equities have been considered a “risk-on” uncorrelated, as a group they have actually been asset class and that during “risk-off” periods, less volatile than the MSCI Emerging Markets investors have left in droves. “Given the Index or the S&P 500 Index in recent years relatively low foreign investor penetration in (Figure 3). This low group volatility reinforces our frontier-markets stocks and bonds, [the frontier belief that a broadly diversified approach to markets] asset class has not been as susceptible frontier market investing is critical. to this hot money-driven volatility,” Morningstar concludes.7 A recent Morningstar analysis cites other reasons why frontier markets have been less FIGURE 3 As a Group, FMs’ Volatility Has Been Relatively Low Comparison of Annual Volatility, as of December 31, 2014 Annual Volatility MSCI Frontier Markets MSCI Emerging Markets 2003 9.43 13.59 2004 7.73 15.21 2005 16.01 11.99 2006 14.85 18.21 2007 7.99 20.60 2008 24.13 41.02 2009 20.48 26.45 2010 9.63 18.11 2011 10.74 22.41 2012 5.78 14.47 2013 7.28 13.30 2014 10.65 11.24 Average 12.06 18.88 Source: MSCI 4 Frontier Markets: Weighing the Risks www.forwardinvesting.com FIGURE 4 Less Developed Nations Enjoy Lower Debt-to-GDP Ratios Mean Public Debt as a Percentage of GDP, 2014 Estimated Developed 75.7 Markets Emerging 41.7 Markets Frontier 48.2 Markets 0 10 20 30 40 50 60 70 80 Percent of GDP Source: CIA World Factbook, 2015 Fiscal Stability and Corruption At a time when many developed nations are Transparency International’s 2014 Corruption grappling with serious fiscal challenges, one Perceptions Index, the United Arab Emirates is might assume that frontier markets are in even ranked 25th, Estonia is ranked 26th and worse straits. In fact, the reverse is probably true. Botswana is ranked 31st on the list of least Having learned their lessons from earlier defaults, corrupt countries. These are all ahead of larger crashes and bailouts, many frontier nations have developed markets like Portugal (33rd) and Spain generally tightened up their fiscal policies and, as (37th).
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