Opening up frontier markets

Mark Mobius, Executive Chairman, Templeton Emerging Markets Group

Frontier markets offer attractive growth and can diversify investors’ portfolios 

Frontier markets are geographically and economically diverse. The list includes Nigeria, Kenya, Saudi Arabia, Kazakhstan, Bangladesh, Vietnam, the UAE, Qatar, Egypt, Ukraine, Romania, Argentina and more. Their potential for economic growth and development remains considerable, especially if the trend toward the implementation of political and economic reforms remains on course. 

The relatively low correlation of frontier markets to global markets provides investors with an opportunity to diversify portfolios. Frontier markets have historically had low correlation with developed and emerging markets, as well as with other frontier markets, due in part to differences in the underlying industries and growth drivers in each country.

Nigeria and Vietnam are two frontier markets where we are currently finding attractive investment opportunities.

Nigeria is Africa’s largest economy and a major consumer market. It boasts one of the fastest-growing economies in the world, with GDP growth rates above 6 per cent every year since 2003. 

Despite recent challenges including the weakening price of oil, the major source of income for the government, we continue to pursue long-term investments in Nigeria. We are particularly interested in opportunities in consumer products as well in financial services. Nigeria exports more than 100 different non-oil commodities as well as a wide variety of finished or semi-finished manufactured products.  

The country benefits from a diverse range of potential growth drivers — for example, the Nigerian movie industry, “Nollywood,” generates nearly $600m ($537m) a year and employs more than 1m people.  

While a lower oil-price could prove a short-term test, the biggest long-term challenge for Nigeria is to foster government leadership that will be intent on economic development and utilising the country’s resources to develop infrastructure. We are hopeful Nigeria’s new leadership will pave the way forward toward a brighter future.

In Vietnam, a construction boom has been underway. In 2010, Vietnam got its first skyscraper, the Bitexco Financial Tower in Ho Chi Minh City. An even taller building is currently under construction in the city. 

The middle class has been growing in Vietnam and people have been trading in bicycles for motorcycles, scooters and cars. Vietnam’s first subway system has been under construction with the help of investment from Japan, France and China. Vietnam’s people have been eager to have access to new technology, with growth in mobile phone subscription rates topping India and the US during 2002 to 2012.

While there has been progress, the war was so traumatic and the people remain sensitive about foreign dominance, hindering acceptance of foreign investment. The Vietnamese seem to be gradually overcoming these reservations because of the developments they see in China, and we have recently seen more movement in allowing greater foreign investment. Vietnam has had a fast-growing economy, and we have found good companies there.

While frontier markets offer investors an attractive investment opportunity, one should not forget challenges exist. Some perceive the frontier market growth premium is available only at the cost of heightened risk caused by factors such as political instability, low shareholder protection and corruption. 

We contend the risks inherent in most frontier markets are more salient but similar to political, country- and stock-specific risks in any other market. The real difference is a lower degree of understanding and research from the global investment community. Research-oriented and detailed investment models allow investors a great deal of insight to better manage this information “gap”.  

Heinz Ruettimann, Strategy Research Analyst Emerging Markets, Julius Baer

Analysis must be done on a country by country basis as many of these economies have little in common

We differentiate between two sets of frontier markets. The first set is according to MSCI classification, introduced in 2007. The second includes countries with potential to become an MSCI frontier market. One could call them pre-frontier. 

The first set is a very heterogeneous group comprising Nigeria, Vietnam, Kenya and Bangladesh, as well as Kuwait and Bahrain. The second group is less heterogeneous and include countries such as Laos, Mongolia, Myanmar and Iran. 

Hence, the individual analysis is very country-specific and, depending on data availability, also very time-consuming. What most MSCI frontier as well as pre-frontier markets have in common is they start from a low base. 

The investment rationale and potential lie in the shift from an agriculture-based economy to a manufacturing and services based model. Such a shift boosts productivity, income levels and eventually GDP growth numbers. Once the broader investment community discovers the potential of the economy, the equity market will see a rapid re-rating. 

That said, selecting the wrong market may result in significant losses. On our radar screen are frontier or pre-frontier markets with high GDP growth rates, favourable demographics, cheap labour, low debt levels and only limited integration with global markets. Investing into a frontier market will provide good portfolio diversification. Risks that deserve special attention are fiscal, monetary and balance-of-payment imbalances, insufficient regulatory frameworks, unstable politics and differing currency regimes. 

Capital markets are also typically small and illiquid, so a frontier market investment must be long-term. 

A frontier market we like is Vietnam, which has gone through two balance-of-payment crises. Its economy turned around in 2012 and is now in its third year of economic expansion with triggers in place for continued performance. These include successful restructuring of the banking sector and state-owned enterprises. A far more distant trigger is the Vietnamese State Security Commission working towards fulfilling MSCI criteria to be upgraded to emerging market status. 

A pre-frontier market we favour is Myanmar. After decades of isolation, the government, established in 2011, is slowly opening up the economy. 

The country has a population of 62m, an abundant low cost labour force and is of strategic interest to China. In January, a new 2,400km oil pipeline between the sea port of Kyaukpyu and Kunming in China was opened. A parallel railway line is now being discussed. Hence, Chinese investments will continue to flow in. 

Myanmar’s financial sector is still at an early development stage. There are around 80 publicly held companies but only two are listed on the Myanmar Securities Exchange Centre. The next step for Myanmar’s capital markets will be this October when the Yagon Stock Exchange will open, trading a handful of listed stocks.   

Kevin Daly, Senior Investment Manager, Emerging Market Debt at Aberdeen Asset Management

Frontier market bonds have provided compelling returns over the past decade, making up for liquidity risk

For a number of years frontier markets were regarded as one dimensional, with growth driven by an abundance of commodity resources. 

Importantly, growth has been achieved without overheating. Inflation has been relatively well contained, exchange rates have generally stabilised while public sector and external debt levels have roughly halved. 

Today, that growth is supported by the ‘demographic dividend’ – the labour force is growing faster than the population dependent upon it –combined with infrastructure investment. In turn, this is boosting business activity.

When it comes to investing in frontier markets, the value of bonds extends far beyond just providing exposure to the wider growth story. Frontier market bonds can offer investors higher, long-term returns compared to mainstream emerging market bonds while also exhibiting less volatility compared to other risk assets. 

Frontier market bonds have exhibited compelling risk-adjusted returns over the past decade, providing ample compensation for the liquidity risk. Although correlations can fluctuate over time, historically frontier market bonds have had a negative correlation to US Treasuries. In periods of stress, correlations between frontier market bonds and US Treasuries have increased but remain low compared to other asset classes, and are also lower than mainstream emerging market bonds.

One of the principal countries to consider is Nigeria, with a more liquid local currency denominated bond market than some frontier market peers and a rich commodity base. The country suffered at the hands of the taper tantrum in late 2013 and the oil-price drop the following year. However, Nigeria is a prime example of a country with low debt levels that offers attractive yields on local currency and hard currency bonds.

 The oil price collapse came at a time when Nigeria was achieving real progress towards rebalancing its economy away from volatile petro dollars. Government reforms in recent years were starting to bear fruit. More electricity is being generated; initiatives to increase mortgage lending could succeed and an outbreak of Ebola was quickly dealt with. Inflation is rising again but has come down from 13 per cent in 2010.

While economic activity in the north east all but came to a halt late last year, Lagos continued to thrive. The entrepreneurial zeal of the city was tangible to the millions being drawn in from across the country and is home to most of the country’s millionaires. 

It is one of the fastest growing cities with flourishing telecoms, banking and services sectors. It is the centre of a small but growing urban elite and middle class. Growth of the middle class will probably temper if the oil price stays low for any amount of time but financial consultancy McKinsey forecasts it to grow to 27 per cent of the population by 2020.

That is not to say there is no room for improvement. Like all frontier and emerging markets, political and liquidity risk exist and country infrastructure requires work. However, even with these in mind there are reasons to feel positive. The election of Muhammadu Buhari, a former general from the north who has a fierce track record against corruption, could be the boost the country needs to eradicate terrorist group Boko Haram, while also addressing latent concerns about corruption and structural reform to the oil and gas sectors.