Frontier Markets Outdo Emerging Investment

Emerging Markets, ADB editions, May 2014

Frontier markets are now recognised as a sustainable asset class that is outperforming emerging markets, and several Asian nations are among the best positioned – but not the ones investors may have expected.

A new benchmark report by Renaissance Capital notes that the 35 countries it considers frontier have a combined population of 1 billion, nearly $2 trillion of equity market capitalization and daily turnover of $3.8 billion. The frontier equity bloc – which now has $22 billion of fund assets invested in it – has outperformed emerging market indices for the last two years, and the MSCI Frontier Index is now trading at a 12-month forward P/E premium to the MSCI EM Index.

Renaissance has devised a complex model combining national macro conclusions with screens around valuation, growth, liquidity and analyst opinion, and has concluded the best opportunities lie in Nigeria and Kazakhstan. While Nigeria has attracted significant debt and equity fund flows from international investors, and is considered Africa’s market darling, the appearance of Kazakhstan is more striking: the country’s stock market performance has been disappointing, standing at roughly the same level today as in early 2012.

“Kazakhstan is surprising its demographics,” Charles Robertson at Renaissance tells Emerging Markets. “It looks better than most of the former Soviet Union and has a lot of young people coming through. It’s got good public finances and external accounts and is also quite cheap, because it falls between two stools: Asian investors tend not to include Central Asia in their remit, and for emerging Europe investors it’s a trek to get there.”

Two other Asian frontier markets score well in the study’s methodology. Both Pakistan and Bangladesh are in a strong demographic position, with large populations within which a high proportion are entering the working age group. Pakistan also has room for private sector debt growth and has a high trailing dividend yield and return on equity, while Bangladesh has enjoyed one of the highest levels of GDP growth in the frontier world (around 6% on average from 2011 to 2013), has impressive forecast EPS growth to match and is in a strong current account position.

The two other Asian nations considered frontier, Sri Lanka and Vietnam, fare less well. Robertson says “regime change is inevitable, from autocracy to democracy, further down the line in Vietnam” among other places, and that transition tends to have at least a short-term negative impact on market performance. “Also Vietnam has used the Chinese model of taking large amounts of deposits, putting them through the state banking system and fuelling investment through high levels of debt. Vietnam’s level of private debt needs to be watched carefully.” Vietnam is also the most sensitive frontier market to exports, Renaissance concludes, as well as having relatively high public sector debt.

Sri Lanka scores poorly in terms of demographics, with a relatively small part of the population due to enter the working age group.

Renaissance is not alone in seeing the opportunity in frontier. Tomás Guerrero, a researcher at Spain’s Center for Global Economy and Geopolitics, calls frontier markets “a set of heterogenous countries that, up to a decade ago, were characterised by their instability, limited access and low liquidity” but now represent “a real alternative to developing economies” for investors. The fund manager Investec is one example of an institution targeting the frontier space.

But despite the strong performance of frontier markets in recent years, Robertson believes their outperformance of emerging markets may be over for the moment. “We’re not promising further outperformance. We’re saying: on a three to five year horizon, this is not an asset class that we think is here today, gone tomorrow.”