Frontier markets: a good time to take the long view

This year frontier economies will once again register some of the highest growth rates in the world. Moreover, sub-Saharan Africa, a region with a large number of frontier economies, will grow in excess of 5 per cent per year in real terms between now and 2020. This provides a solid economic foundation for investors in frontier markets, a major attraction compared to developed markets, where returns increasingly rest on QE and other short-term stimulus measures.

Think of frontier economies as the emerging markets of 20 years ago. They tend to have young populations, rapid household formation, basic access to infrastructure, healthcare and education, and low but rising wages. Frontier economies are more exposed to commodity price and weather shocks, have smaller pension systems and some rely on external concessionary financing, though this is changing rapidly. They are more vulnerable to shocks, but offer higher potential returns. 

The 80 odd frontier economies make up a combined Gross National Income of about $5tn (€4.4tn). In addition, countries that have yet to establish stock exchanges count a further $3tn. Index representation is poor. The MSCI Frontier Markets equity index covers only 25 countries, $164bn of market cap for less than 400 companies out of a total market listing more than 1,000 companies with a market size of $1.2tn (source: Ashmore, Bloomberg). There is still no fixed income index.

The most important driver of frontier markets is consumption, based on the rise of the middle class. Improving healthcare, better access to basic services, increased education and even increasing wages, should see the population of working age in frontier economies rise faster than anywhere else over the next 20-30 years, according to the United Nations’ population forecasts.    

Frontier markets are volatile, but offer stronger longer-term returns. Despite strong annualised returns of 13.1 per cent over the last three years frontier market PEs are still a modest 11.3x. The MSCI Frontier Markets index is still 45 per cent lower than before the US Subprime Crisis in 2008/2009. Correlations tend to be lower than for other emerging markets. Fixed income opportunities are also becoming more widespread and better recognised. The number of African countries represented in the JP Morgan EMBI index – a benchmark index of sovereign dollar bond issuers – is now in the teens and should rise further in the coming years. Investors can also pursue opportunities in local currency corporate or sovereign debt. Opportunities are often short-lived; once they appear they tend to quickly be exploited quickly in illiquid market conditions. For example, the recent peaceful transition of power in Nigeria and prospects of better governance currently makes this market particularly interesting.

It is critical to understand company fundamentals and the general operating environment. Political risk, corruption and illiquidity are risks at the top of many investors’ minds. The good news is that political risk has declined sharply over the past 25 years. There are now ten times more functioning democracies in Africa than at the end of the Cold War. Out of 76 Frontier Markets recently examined by the World Bank, some 51 per cent had improved their global corruption rankings compared to 2002. Besides, it is possible to find well-functioning ‘clean’ companies able to add consistent shareholder value over time even in low-scoring markets. Illiquidity makes for potentially costly trading, but a long-term approach and building relationships with local liquidity providers goes a long way to towards resolving this problem. 

Jan Dehn is head of research at Ashmore