Could frontier markets be the ‘next big thing’? Performance in calendar 2022 might suggest not, with a US dollar decline of 26.1% for the MSCI Frontier Markets index, compared with falls of 20.1% for the MSCI Emerging Markets index and 18.4% for the MSCI All Country World index.
The risk-off environment that largely characterised equity markets last year could hardly be expected to favour an asset class whose very name means ‘out there’. However, to quote from a frontier markets report published by emerging markets boutique Ashmore, “if the idea of investing in markets that have historically produced strong long-term US dollar returns (higher than emerging markets) with lower correlation to global markets and less volatility sounds attractive, then read on”.
Ashmore describes frontier markets as “a diverse and global universe that is undergoing periods of structural change and economic reform”. But while the economies may be reforming and changing, this does not mean they are small or insignificant. Indonesia is classified as a frontier market, yet on a purchasing power parity basis it has the seventh highest GDP in the world (for context, the UK ranks 10th). Poland’s economy is larger than Australia’s, and Saudi Arabia’s is bigger than Spain’s.
On a per capita basis, tiny but oil-rich Qatar and the United Arab Emirates have a higher GDP than the US. Estonia is richer than Spain, and Kazakhstan outranks global tech powerhouse Taiwan. However, the comparison between Kazakhstan and Taiwan can serve to highlight an important point about frontier markets as an asset class: while economically these are not backwaters, their capital markets are in many cases relatively underdeveloped. The market capitalisation of the Kazakhstan stock market is around $48bn (£38.5bn), whereas Taiwan’s is $1.6trn (£1.28bn). Chipmaker Taiwan Semiconductor Manufacturing alone ($431bn) is around 10 times larger than Kazakhstan’s entire market.
While frontier stock markets may be largely unappreciated by overseas investors, they often enjoy enthusiastic local support. This can help dampen market volatility in times of stress – for example, at the height of the pandemic in 2020 when foreign investors retrenched from Vietnam, domestic retail investors poured billions into the stock market, completely replacing the lost capital. (It has since returned – Vietnam’s market capitalisation today is almost twice its mid-2020 level, although it has fallen over 25% from its March 2022 all-time high of around $250bn).
However, Ashmore points to a tendency towards short termism from domestic frontier markets investors, who may be overly focused on the latest corporate results and thus fail to spot longer-term structural drivers. This, the fund manager says, can provide opportunities for overseas professional investors with a longer horizon.
The options for UK investors interested in an allocation to frontier markets are relatively limited: fewer than 20 open-ended funds (most if not all of which are in Ucits/Sicav rather than domestic Oeic structures), and a handful of investment trusts. Open-ended funds from well-known managers include those run by Ashmore, Schroders and Templeton. Of the closed-end funds, all with the exception of BlackRock Frontiers (BRFI) are focused on a single market (Vietnam) or region (the Gulf states or emerging Europe, Middle East and Africa).
BRFI co-manager Emily Fletcher wrote last month on the reasons to be optimistic for frontier markets in 2023. These include continued high energy prices (beneficial for exporters, not just in the Middle East but also South East Asian countries such as Indonesia); China’s post-Covid reopening – boosting tourism particularly in Thailand and Vietnam; the relatively muted level of inflation in some (not all) markets; and generally low valuations versus global indices, offering opportunities for long-term investors.
While she also cautioned on the potential impacts of geopolitics and a higher cost of capital, she noted that tensions such as between China and the US can be positive for some countries (Vietnam is benefitting from the trend of ‘friendshoring’, with US companies increasingly diversifying manufacturing bases away from China), and that central banks in many frontier markets have leeway to cut rather than raise interest rates.
Frontier markets may be ‘inefficient’ owing to a lack of overseas awareness and analyst coverage, but such knowledge gaps can play into the hands of specialist fund managers and their underlying investors. Having noted last week that emerging markets may be the play to make as the dollar softens and China reopens, frontier markets – which are after all the emerging markets of tomorrow – may be even more so on a longer-term basis.