Frontier Markets: The New Emerging Markets
Schroder Investment Management
By Allan Conway, Edward Evans
June 12, 2012
In this paper, we summarise the attractive investment case for frontier markets both over the long term but also for an investment today.
Frontier markets provide access to some of the most dynamic and fastest-growing economies in the world, supported by strong secular growth drivers. The investment opportunities are similarly benign as market liberalisation is accelerating and valuations look attractive in absolute terms and versus the developed and emerging world. Moreover, in a global macro environment dominated by uncertainties, frontier markets’ relatively low correlation with developed (and emerging) markets offers investors significant potential diversification benefits. We summarise below the attractive investment case for frontier markets both over the long term but also for an investment today.
What are frontier markets?
The definition of a frontier market is somewhat judgemental. Characteristics of a frontier market typically include a low/middle income country and a relatively under-developed capital market compared to their more developed global emerging markets (GEMs) peers.
Frontiers markets, as defined by the MSCI Frontier Markets index, comprise 26 markets spanning Asia, Eastern Europe, Africa, Latin America and the Middle East (which accounts for approximately 60% of the universe). However, the contrast in characteristics between frontier markets is significant, from the very wealthy Middle Eastern economies to the less developed, but rapidly growing, African states.
The universe can be broadly divided by the principal growth drivers for each economy; the Middle East is using oil revenues to diversify away from its reliance on oil; African growth is being driven by China’s increasing influence on the continent, building infrastructure and power networks and helping to unlock Africa’s natural resource potential. Frontier Asia is benefiting from newly-industrialising export manufacturing centres, together with low labour costs, and growth in Frontier Europe is dominated by commodity-driven economies.
There is no overlap between the MSCI Emerging Markets and MSCI Frontiers Markets indices although, as nations develop, markets can be promoted from the frontiers to emerging markets indices and vice versa. For example, Argentina was demoted from the MSCI Emerging Markets to the MSCI Frontiers index in 2009 and the UAE and Qatar may well be promoted to the MSCI Emerging Markets in the not too distant future. Thus, in many ways it is possible to view frontier markets as the GEMs of tomorrow.
The evolution of an investable asset class
Frontier markets are being increasingly recognized as a separate asset class and this has been reflected by the launch of the MSCI Frontier Markets index in November 2007. Furthermore, investors are increasingly looking to establish a strategic allocation to GEMs, rather than using them tactically, which should lead to an increased focus on the frontier
A combination of systematic index coverage following the launch of the MSCI Frontier Markets index, increased investor interest and accelerating market liberalisation, has led to the launch of frontier markets funds able to offer investors diversified exposure to these less developed markets, but significantly also with daily liquidity, which was not possible in the past.
Although frontier markets are less liquid than GEMs, they are still investable. For example, assuming 25% of average daily volume bought each day under normal market conditions, we would expect to be able to invest $100 million in the most liquid 70% of the MSCI Frontier Markets index in just two days.
There are foreign ownership limits in several frontier markets but in the vast majority of cases an investment via the local stock exchange is possible. Furthermore, several frontier companies are either listed on developed market exchanges, such as the London Stock Exchange, or are available via Depository Receipts (DRs).
Why invest in frontier markets?
The frontier markets provide access to some of the most dynamic and fastest growing economies in the world:
· Secular growth drivers
Frontier economies are at the early stage of development and are expected to grow faster than emerging and developed economies. This is significant from an investment perspective, since economic expansion acts as a key driver of long-term market returns.
· Frontier nominal GDP is around USD 3 trillion, approximately 4.2% of global GDP*.
· Frontier economic growth has been strong in recent years and is expected to be around 6% p.a. over the near term, similar to that of GEMs and significantly faster than global developed growth.
· Frontier markets have a combined population of approximately 842 million1, almost 60% below 30 years of age.2
· Labour costs are extremely attractive and Vietnam and Bangladesh are the new low-cost producers of Asia; for example, labour costs per hour in Bangladesh are approximately a tenth of the costs in China, which are almost a tenth of the costs in the US, as highlighted in the chart below.
· Natural resources are abundant; frontier markets contain around 41% of the world’s proven oil reserves and nearly 26% of the world’s gas reserves.
· Strong fundamentals
It used to be the case that investing in emerging and frontier markets was more risky than investing in developed stock markets. However, over the last ten years, the situation has changed dramatically and we would argue that today, given the very poor fundamentals in the developed world, the emerging and frontier countries are in fact less risky.
Frontier economies are typically strong:
· The fiscal balance for frontier economies is forecast to be in aggregate 0% (that is, in balance).
· Public debt levels are typically low (<50% of GDP). Private sector debt is also typically benign.
· The contrast with the debt-ladened developed world is conspicuous, as highlighted in the chart below.
· The current account picture is generally improving in frontier markets and FX reserves are strong at 35% of GDP (for GEMs, 19% of GDP)3. This reduces frontier economies’ reliance on others to balance their economies.
· Many frontier markets rank better than the BRICs (and Italy) on both the Corruption Perceptions Index and the World Bank Ease of Doing Business Survey.
· Attractive investment opportunities
1.) Stock markets are underdeveloped relative to their economies
Frontier stock markets are massively under-developed relative to their economies. While frontier markets represent only 0.4%4 of global equity market capitalisation, frontier markets account for a much greater share of world economic output of about 4.4%5.
Following the example of GEMs, as developing economies mature the equitisation of their companies will increase.This should lead to strong absolute stock market returns and accordingly this gap should narrow.
2.) Diversification benefits
One of the key attractions for an investment in frontiers is the potential significant diversification benefits, not least in the current global macro environment dominated by uncertainties.
Frontier markets tend towards low correlation with the MSCI World and the S&P GSCI indices. Intra-market correlations are also low among frontier market countries owing to the more locally-driven nature of their economies.
3.) Lagging stock market performance has led to attractive valuations
Despite frontier economies continuing to deliver strong economic growth and frontier companies generating strong earnings growth, frontier markets are still 46% off their 2008 highs and are lagging GEMs.
Consequently the MSCI Frontier index is now trading at a trailing 12-month P/E discount to not only the MSCI World index, but also to the MSCI Emerging Markets index (see charts below). We believe the underperformance provides investors with a strong opportunity to benefit from these overlooked markets.
Moreover, frontier markets have a higher dividend yield (around 5% on average) than GEMs; once again an attractive attribute in times of elevated global market uncertainty.
4.) Frontier markets are generally under-owned
Few international investors have exposure to frontier stock markets ($11bn in frontier markets compared to $691bn in GEMs6) and these markets are generally under-owned which provides first-mover advantage.
· How can investors access frontier markets?
The above rationale for an investment in frontier markets is attracting increasing amounts of foreign investor interest. However, there are few funds which offer exposure to these markets, not least with daily dealing, and few fund managers have the resources to successfully launch a frontier fund.
If you have any questions on frontier markets or would like further information, please contact your usual Schroders representative.
1: IMF, World Bank, data as of September 2011.
2: UN World Population Prospects database
3: EIU, Country Data. Data as at February 2012
4: FactSet. MSCI FM and MSCI AC World. Data to 30th April 2012.
5:IMF DataMapper. Based on 2012 Nominal GDP forecasts. Data as at April 2012
6: Source: CITI Investment Research and Analysis, EPFR. Data as at March 2012
The views and opinions contained herein are those of Schroders’ Emerging Markets Equities team, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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