In the ninth century AD, Ahmad al-Ya’qubi, perhaps the first historian of world culture in medieval Islam, wrote: “Whoever wants to go to China must cross seven seas, each one with its own colour and wind and fish and breeze, completely unlike the sea that lies beside it”.
These trade routes to the East served primarily to transfer raw materials, foodstuffs, and luxury goods and were the main arteries of contact (and conduits for the spread of Islam) between the various ancient empires of the Old World.
In the same way as the demand for silk and other luxury goods facilitated the Silk and Spice Routes, (stock) traders these days are navigating a different route in search of ‘alpha’ opportunities across the frontier world.
Investor interest in global frontier markets – those 60+ countries with a domestic stock exchange that are pre-emerging or ‘verging on emerging’ – is surging due to the ‘7Cs’ that characterised the asset class, namely:
1. Comprehensive universe
Global frontier markets provide investors with access to a comprehensive and diversified universe of highly inefficient pre-emerging markets. At HSBC, this includes both benchmark and non-benchmark opportunities and, in total, amounts to over 3,000 companies across 60+ countries, representing 26.5% of the world’s population and a 13.8% share of the world’s total GDP based on purchasing power parity.
2. Change
Just like their emerging market counterparts 20 to 30 years ago, we expect frontier markets to benefit from positive change (or relative improvements) driven by reductions in institutional voids. In particular, any reduction in these voids will support productivity growth which, in turn, should result in a degree of convergence with emerging markets. Given the starting point of these markets – with high institutional voids and low productivity – even modest improvements can generate significant productivity gains and return-on-equity for investors. Indeed, we believe this convergence presents a compelling opportunity for forward-looking investors.
3. Consumers
Frontier markets are notable for their large, young, fast-growing, and rapidly urbanising base of consumers. With positive change driving productivity growth (through better technology and improved skills) and growing GDP per capita, this enables a populous middle class with rising disposable incomes to consume and become an economic force.
4. Commodity wealth
Many frontier countries are naturally endowed with commodities and have been supported by the rise in commodity prices over recent years. This has generated strong government credit positions and allows governments to diversify their economies away from commodity production by investing in both hard infrastructure (e.g. roads, bridges, airports, seaports) and soft infrastructure (e.g. education, healthcare and other essential services) that will drive productivity growth over time.
5. Correlations
Global frontier markets have historically been amongst the least correlated to other equity classes, and lowly correlated with commodities. Frontier markets offer additional diversification as they have tended to have low correlations with each other (in other words, they exhibit low cross-country correlations). These low correlations occur because each market is driven by many different and often localised factors. Overall, these low correlations surprisingly result in lower volatility for the asset class and, while it may sound counterintuitive, the volatility of global frontier markets has in fact been consistently lower than emerging and developed markets over the last five years.
6. Cash returns
Investing in global frontier markets can potentially provide investors with superior cash returns in the form of dividends, as evidenced by the dividend yields being consistently higher in frontier markets than both developed and emerging markets over the last five years. This has been due to the fact that while the stock exchanges of frontier market countries may be relatively young, the companies themselves are not as they are typically well established, formerly government or family controlled businesses that are highly cash generative.
7. Cheap valuations
At present, the valuation opportunity looks attractive, with frontier markets trading on cheap valuations both in absolute terms and relative to global emerging markets and developed markets, but with higher levels of return-on-equity.
Forward thinkers
Collectively, these ‘7Cs’ could potentially drive superior investment returns to emerging and developed markets through high dividends, capital gains, and currency appreciation for those early adopters of the global frontier markets asset class.
For those forward-thinking investors willing to start building a dedicated allocation to global frontier markets now as a natural extension of their incumbent global emerging market allocation, not only could they immediately benefit from an improved risk/return profile within their emerging market portfolios but could also profit significantly from increasing flows into the asset class as these markets become a more popular investment destination for the conventional investor community.
