Following two decades of strong economic growth and infrastructure improvements, emerging markets have now become a mainstream asset class with a key role in investors’ portfolios. While leading countries such as China, India, Brazil and Russia (Bric) continue to be appealing, the attention has started to shift to so-called frontier markets. Often referred to as the emerging markets of the future, these smaller, fast growing markets offer attractive long-term prospects, but they are relatively new capital markets at an early stage of development, illiquid, with low levels of foreign ownership and still under-researched.
Frontier markets are driven by similar factors that drive emerging markets growth, such as positive demographics and growing infrastructure spending, says Andrea Nannini, senior portfolio manager of the frontier emerging markets and Mena equities at HSCB Global Asset Management. They are often rich in commodities, and the domestic consumption theme, dominant in countries such as China and India, is also significant in markets such as Nigeria, Egypt and Lebanon.
“In frontier markets you are investing in trends similar to those in emerging markets, but at a much earlier stage of the cycle, as if investing in the Brics maybe 10-15 years ago,” says Mr Nannini. “The opportunities in the longer term are bigger, because you are starting at an earlier point of development, but the flip side is that you have bigger risks too.”
These are mainly event risks, such as political, regulatory or market specific risks, although, says Mr Nannini, these can be managed in a well diversified portfolio, having exposure to many different markets.
It is counterintuitive, but in fact the volatility and correlation between frontier markets is lower than in emerging markets on the longer term. Individual frontier countries can be volatile, but as the correlation between each other is quite low and often negative, as they are all mainly driven by local factors, rather than global factors, the volatility of the whole group tends to be smaller. On the contrary, there is a growing tendency for larger developing markets to move in sync with each other, which increases their volatility, says Mr Nannini. However, in big market shocks, such as in 2008, frontier markets tend to suffer most, because they are less liquid, and price corrections are exacerbated by the lack of liquidity. For example in the last five months of 2008, frontier markets fell on average between 50 to 60 per cent.
Issues of their own
In 2009, while emerging markets had a very strong recovery with 60-70 per cent returns, frontier markets did not participate in the rally, growing by 11 per cent on average. This was because they were facing issues of their own, including Dubai’s debt problems and the Nigerian banking crisis.
“Today, frontier markets are still trading roughly 40 or 50 per cent lower than their pre-crisis levels in 2008, whereas emerging markets are pretty much back at the peak levels. We think there is potential for frontier market markets to continue their recovery,” says Mr Nannini.
In developing capital markets, foreign investments can really have a large impact on market performance. But in 2009, the big foreign inflows went back to emerging markets mainly, which generated stellar returns. “Frontier markets are small, still relatively new and little understood, and when the market starts recovering, usually the largest markets, such as Brics, and the largest stocks do best at first. As people feel the value is maturing, which is probably where we are now, the focus starts shifting towards mid or small caps, and the more exotic stories like frontier markets,” says Mr Nannini.
The United Arab Emirates and Nigeria present particular value today. Mena stockmarkets are still suffering in the aftermath of the Dubai debt crisis, even though the restructuring of the Dubai World, the investment company that manages and supervises a portfolio of businesses and projects for the Dubai government, was agreed in September, and the Dubai government has successfully completed its first debt issue since the crisis. This is a sure sign that the capital markets are opening up, but the stock market has not yet priced this in.
“The markets in Dubai and Abu Dhabi are by far the cheapest in the world,” he says. UAE are the largest overweight in Mr Nannini’s Mena fund, while in his new frontier market fund, the largest country overweight is Nigeria, which still appears to be trading at an attractive valuation level in the wake of the banking crisis, he states.
Nigeria is a fast growing economy, maintaining GDP growth of around 5 per cent throughout the crisis. Repercussions from the banking crisis meant that the market produced negative returns in 2009, and although it has been one of the best performing markets so far in 2010, it is still below 2008 levels.
