Emerging markets or frontier markets?

The emerging market sell-off earlier this year put the future of investing in these regions under renewed scrutiny. A number of opinions were put forward about how investors should be viewing their emerging market exposure.

One of the more interesting ones came from British financial columnist, Matthew Lynn. Based on his observation that frontier markets had continued to perform even as emerging markets were taking strain, he suggested that what investors had always been looking for in emerging markets, was no longer to be found there, but should be sought in even less mainstream places. (Read the full article in WSJ’s MarketWatch here).

He argued that many emerging markets were actually no longer “emerging” in any meaningful sense. Many of them had actually matured and were running into the same growth problems as many of their developed counterparts.

The growth story was therefore not to be found in emerging markets as much as frontier markets. They, he said, represent the real developing world

Before going any further, perhaps it’s important to be clear about the distinctions here: emerging markets are generally considered to be those with fairly robust financial and capital markets and good levels of liquidity, but which have not obtained the income levels of developed regions like those in North America, Western Europe, and the wealthier countries of the Asia Pacific. These are countries like Brazil, Mexico, Turkey, Poland, Russia, Taiwan, India, Indonesia, China, and of course, South Africa.

Frontier markets are those that show lower incomes, smaller market capitalisations and lower liquidity, but are still investable – in other words, it’s not impossible to get money in, and one can reasonably liquidate a position later. They also exhibit the potential to grow and become more liquid over time. Examples would be Kazakhstan, Bulgaria, Kenya, Nigeria, Kuwait, Qatar, Bangladesh and Pakistan.

To support his thesis, Lynn pointed out that the MSCI Frontier Index had posted a strong gain in 2013, while the MSCI Emerging Markets Index was slightly down. And we can even extend his figures further … for the year to the end of February, the MSCI Emerging Markets Index was down 7.96%. Over three years, it was also in the red, losing an annualised 4.31%.

In contrast, the MSCI Frontier Markets Index has been up 17.76% for the last twelve months. Over the last three years, it has gained at an annualised rate of 3.36%. Even more impressively, the MSCI Frontier Markets Africa Index was up 11.37% per year.

These figures indicate that, over the last few years, there has been a marked differentiation in the way in which frontier markets and emerging markets have performed. Equity investors have unquestionably done better in the former.

There is just one small caveat: after both frontier markets and emerging markets fell sharply in 2007/2008, emerging markets have actually recovered better. Their growth has slowed in the last few years at the same time as frontier markets have caught up, but they are nevertheless closer to their pre-recession highs.

Still, the question whether frontier markets now present the better opportunity for equity investors, is an interesting one. For South African investors in particular, looking at frontier markets mostly means looking at stock exchanges in other parts of Africa.

Nema Ramkhelawan-Bana, of RMB Global Research, says that the main appeal of these markets is a fairly simple one: “When you are looking at equity markets, your return is linked to growth,” she says. “And you are still getting good levels of growth in frontier markets because they are coming off a low base.”

For senior equity analyst at Sanlam Investment Management, Addington Jerahuni, this is the key appeal of investing in African equities. The strong GDP growth that we continue to see from many countries on the continent presents opportunity for a number of reasons. “Strong GDP growth underpins a strong possibility of corporate earnings growth and an increase in per capita income,” he says. “An emerging middle class also means more consumption. So what people are able to afford is changing and that speaks to volume growth for many companies.

“More and more people are also starting to get bank accounts in many African countries,” he adds. “And because credit penetration is also still very low, giving more people access to credit will push these economies further.”

It goes without saying that there is also immense opportunity for achieving scale on the continent. Nigeria, for instance, has a population of 165 million – more than three times that of South Africa.

“So in a country like that, you also have a volume growth story,” Jerahuni says. “And that’s big for businesses like breweries and fast moving consumer goods. Not only is there a huge potential for sales growth through volume, but there is also an opportunity to sell higher margin premium brands as consumers’ income increases.”

These factors feed into how investors all over the world are seeing these markets.

“I think that more people have bought into the long-term story that is the investment proposition for frontier markets,” argues Claire Rentzke, head of manager research at 27Four Investment Managers. “The money that has flowed back into the market post-2008 is more sticky and possibly less speculative.

“With the markets being less liquid, it is also harder for speculators to get out of the market quickly without impacting performance significantly, which they all realised in 2008. The frontier market economies are also looking more favourable in terms of reform and their improving fundamentals.”

Rentzke also suggests that many of the emerging market economies are finding it more difficult to sustain high growth rates as their economies change, and this is leading more investors to investigate the potential of frontier markets.

“China is still considered an emerging economy but you could easily argue that they are more developed than some of the developed economies,” she says. “Also, emerging markets have almost progressed onto the next phase in their development with lower growth rates possibly making them less attractive again, especially as growth in developed markets picks up.

“As an example South Africa’s growth is likely to be less than the USA’s growth over the year, so investors aren’t willing to take on additional risks that aren’t rewarded. Frontier markets still offer the prospect of much higher growth especially as the markets develop.”

Of course, all of this good news comes with a great deal of risk. These are complex markets in which to do business, and investors need to be circumspect about how they enter them.

“I think investors are missing out on potential returns in Africa,” says Johann Erasmus at Standard Bank. “But because in general they haven’t got the experience in terms of what to do or how to invest in these particular businesses as well as distinguishing the good from the bad it becomes a risky place. And it is advisable to invest through channels or managers that have got on the ground experience.”

Celeste Fauconnier, from RMB Global Markets, also adds the caveat that African economies remain very sensitive to external factors.

“I think in Africa we are still a far cry from the diversification that has developed in emerging markets,” she says. “Africa is still very slow in that respect, so any kind of commodity price slump or other external factor that affects our main trading partners will affect our growth rates.”

She adds that the equity markets themselves also lack the level of sophistication one finds in emerging markets. “The two main equity markets outside of South Africa are Nigeria and Kenya, and they are both still dominated by a single sector – banking in the case of Nigeria and telecommunications in Kenya,” she says. “The JSE is far more diversified. So there are also dangers in terms of being over-exposed to what is happening to specific sectors in a specific country. Investing in emerging markets is much safer in that respect.”

So these markets are not to be approached without proper consideration of how much risk one is willing to take on and, essentially, one’s time horizon. Taking a view that is too short-term can significantly increase one’s risk.

How South African investors access these markets and how much they should be exposed to them, will be the subject of another article.

Author: Patrick Cairns | 05 March 2014 23:32

Read the article on Moneyweb.co.za here.