It took time, but investors are getting comfortable with holding emerging market equities and debt in their portfolios. After years of being panicked by huge swings in volatility, investors have come to understand that what happens in South Africa has little impact on the fundamentals in Indonesia, for example.
Yet behind them are the frontier markets, which are the next economic region for developed market investors to get to grips with.
They have less developed capital markets, are believed to carry too much inherent risk and are considered too illiquid, but growth in some of these economies is predicted to be some of the largest globally.
This, along with structural improvements, makes it timely to speak to one frontier equity manager about how he navigates risk and picks stocks in countries with little independent analysis.
Five years of peace and prosperity in frontier markets
Oliver Bell, portfolio manager of the T. Rowe Price Frontier Markets Equity Strategy.
When we launched our frontier markets equity strategy five years ago, we noted this universe bore a striking resemblance to the emerging markets of the late 1990s.
We observed structural drivers across these economies, as well as country-specific drivers, with many of these countries moving along the path of peace, improved politics, investment and growth. On the structural side, the peace dividend was by far the most important.
In the 1990s, almost 50 of these countries were at war or in some sort of conflict. Since then, there has only been a handful of battles within frontier nations in recent years, with the spreading base of peace enabling the start of real economic growth and investment. We have been encouraged by the peaceful transitions of power to democratically-elected governments in recent years, such as Pakistan and Nigeria. At T. Rowe Price, we have always understood frontier was not a homogenous asset class and many markets at different times could carry higher individual risk. Over the past five years, we have seen considerable variations in political stability, economic performance, foreign investor access, corporate governance practices and exchange rate risk.
Encouragingly, active management has shown to be pivotal when navigating this universe. We continue to believe there is long-term alpha to be captured in these markets, which is not being accessed by broader global or emerging market investors. Below, we highlight the four markets most impactful for alpha generation since the inception of our strategy and the prospects for these outposts over the coming years.
We have generated more alpha from Vietnam than in any other market over the past five years. While we have long been overweight the country, this was very much a contrarian position five years ago. Back in 2014, not many external investors were interested in Vietnam, but it all changed about two or three years ago when the government relaxed foreign ownership limits and significant investment flowed into the country.
Fast forward to now, Vietnam’s GDP growth this year is expected to be one of the highest in the world at 6.5% – which appears to be sustainable¹. Vietnam is fast becoming a hotspot for multi-national companies wanting low-cost manufacturing, especially for businesses seeking to divert supply chains away from China.
It is not difficult to see why. Wage costs average below US$250 a month, while Vietnam boasts a strong network of free trade deals and a strategic geographical location². As an ever-increasing number of global companies look outside of China, we see Vietnam benefitting from associated job creation, wage growth and increased demand for housing. Our current holdings are well positioned to benefit, extending across the banking, IT, consumer and real estate sectors.
The tide started to turn for Argentina in 2015, when Mauricio Macri’s market-friendly administration took over the country. An ambitious reform agenda was a step in the right direction, but memories of the country’s 2001 default came back to haunt us in 2018 – when a combination of climbing inflation, rates and debt impacted liquidity.
Despite some turmoil, stock selection in Argentina has been a bright spot. When fixed income colleagues warned us of increasing risk around the peso in late 2017, this prompted us to trim domestically-focused companies in favour of more geographically diversified global stocks with US dollar earnings. Our holdings in a fintech-oriented trading platform and a digital services business helped us mitigate some of the stock market’s 50% plunge.
Argentina’s path looks much more uncertain going forward, with President Macri suffering a resounding loss in recent primary elections, leaving his chances of winning October’s presidential election slim. With ex- President Christina Kirchner as his running mate, leading candidate Alberto Fernandez is an uncertain prospect and markets are likely to remain volatile with concerns of a return to populist policies.
Nigeria returned to the investible map last year, after recovering from a two-year recession. This downturn was primarily driven by the central bank’s reluctance to allow the naira currency to reflect its worsening economic conditions. We spent the large part of five years underweight the Nigerian market, which has been beneficial. Oil price stability has been key to kick-starting Nigeria’s return to growth, experienced alongside improving data coming from the consumer. We played this cyclical recovery through Nigeria’s banks. In 2017, banks were trading at valuations implying most institutions were poised to go bust and this proved to be too pessimistic.
However, while the top-down environment looks better today, fragilities remain. This particularly surrounds the currency, which has yet to converge to one official exchange rate. While hopeful, we are also uncertain if President Muhammadu Buhari’s second term will provide the necessary focus on economic progress. As a result, we dialed down our position sizes.
Bangladesh is a country undergoing monumental change. Over the past decade, GDP per capita almost doubled to more than US$1,500, foreign direct investment (FDI) trebled and exports compounded in the high teens. In addition, adult literacy rates rose from 47% to 73% and power generation tripled – now reaching 90% of the population³.
Economic reforms have the potential to help Bangladesh evolve its export market, as low-cost manufacturing moves from China to countries such as Bangladesh, Cambodia, Myanmar and Vietnam.
In addition, Bangladesh has a burgeoning middle class of nearly 19 million people, which is growing by more than 10% annually⁴. This has profound implications on the growth prospects of most consumer companies. For example, the packaged food market has trebled in size over the past decade to nearly US$4bn. On our recent trip to the country, we met with companies likely to be beneficiaries of reforms and population growth dynamics.
We continue to believe there is long-term alpha to be captured in these markets, which is not being accessed by broader global or emerging market investors.
AN UNDER-OWNED AND UNDERCAPITALISED ASSET CLASS
Like much of the emerging world over the past couple of decades, many frontier markets have made huge economic strides, as economies and capital markets liberalised. Despite this, the frontier asset class remains under-capitalised and under-owned. While the potential magnitude of frontier growth is not reflected in the scale of the current stock market capitalisation, we expect this to change over the coming years.
In addition, frontier markets continue to have a low correlation with emerging and developed markets. We believe this is due to the idiosyncratic nature of the economies, as well as the fact most are not tapped into the global consumption/trade cycle and are more dependent on earlier stage growth. This keeps us excited about the investment possibilities.
1) Source: International Monetary Fund / Haver Analytics.; 2) Source: Haver Analytics.; 3) Source: Haver Analytics / World Bank.; 4) Source: Haver Analytics / World Bank.
“There is a portfolio diversification benefit because frontier markets are largely uncorrelated to other markets.”
Oliver Bell, portfolio manager of the T. Rowe Price Frontier Markets Equity Strategy, talks to portfolio institutional about inefficiency, opportunity and diversification.
What sits at the core of the investment case for frontier market equities?
For investors today, frontier markets are an attractive source of growth and diversification which have been largely overlooked by investors.
In terms of growth, GDP growth in frontier markets is expected to outpace emerging markets and significantly outpace developed markets over the next decade and likely beyond. In most cases, this is because they are starting from a low base, with significant investment still going into basic infrastructure. If you take that as a starting point, it is similar to how many emerging market countries were 20 or 30 years ago, since when country investment returns have been highly correlated to nominal GDP growth.
When it comes to its diversification potential, whilst frontier is often perceived as being at the riskier end of the spectrum, data shows that in aggregate it is actually one of the least volatile equity regions. Still today few investors have any meaningful exposure to these countries, which means that in a risk-off environment, frontier often tends to hold up relatively strongly compared to the more mainstream emerging markets. Over the last five years, for example, the MSCI Frontier Markets Index has generated returns with approximately just two thirds of the volatility of the MSCI Emerging Markets Index.
Another attractive feature is the heterogeneity of frontier markets, such that historically correlations between individual countries themselves have been extremely low. In most cases, frontier countries are not tied into global manufacturing supply chains, so they are less impacted by global cycles and tend to react more to their own local news-flow. For example, what happens today in Vietnam is independent from what happens in Nigeria, or Romania, Kuwait, and so on.
While there may be pockets of volatility, in our view the longer-term direction of travel is clear and adding frontier exposure can provide significant portfolio diversification benefits.
The outlook for Argentina depends fully on the election.
In which countries do you feel that new opportunities are emerging?
One area we like currently is Vietnam. Labour costs are still around one third of those in China and foreign direct investment remains strong as many global companies look to diversify their manufacturing bases. This is being boosted further as businesses increasingly seek to divert supply chains away from China.
As more and more global companies look outside of China, we see Vietnam benefitting from associated job creation, wage growth and increased demand for housing.
Other economic metrics are strong, the consumer is in good shape and inflation is well contained, so we are seeing opportunities across sectors including banking, IT, consumer and real estate.
Kuwait is another country we like. We are more positive currently than we have been in the past as the country’s banking sector is finally recovering from the aftermath of the 2008 financial crisis.
How important is active management when investing in frontier markets?
It is critical. These are the least efficient markets globally. Sellside coverage is light: on average there are three sell-side analyst estimates per company in frontier. In many cases it is less or even zero. These markets remain vastly under-researched and under-owned, which makes it one of the least efficient global equity groups.
This presents a huge opportunity for those managers willing to spend the time and resources to conduct the same due diligence in their research process as others would for more developed markets. On the other hand, if you are investing passively, you’ll be getting exposure to some companies and countries that perhaps you don’t want exposure to.
In our view, the index is not a good reflection of the compelling opportunity set, and in fact just over 65% of the companies we are invested in today are not currently represented in the MSCI Frontier Markets Index.
If information is hard to come by, how can you truly know what is happening on the ground in countries such as Kuwait, Vietnam and Nigeria if you are sitting in an office in London?
At T. Rowe Price, we have one of the largest in-house research teams in the industry. Myself and six analysts primarily focus on the countries and companies in frontier markets. We are embedded within a global emerging markets team of approximately 35 professionals that provides additional resource. In Eastern Europe, for example, we have analysts looking at Romania and Georgia in addition to my own direct team. This gives us a comprehensive coverage of these companies and countries.
In addition, we have a fixed income team where our sovereign analysts look at every country, at both the macro and the political level, which helps us form a holistic view of each and every country and company.
But there is no substitute for getting out into the region. Our size and scale mean that we can spend much of our time on the ground meeting with company management teams and industry experts in local frontier countries. Just last week, for example, two of my analysts were in Rwanda and Kenya meeting companies, and another was in Nigeria. This week two of the team are in Saudi Arabia, the UAE and Kuwait.
How are you preparing your portfolio for the election in Argentina?
We currently have zero allocation to Argentina. There has been a material change recently as President Macri suffered a resounding loss in August’s primary elections, which leaves his chances of winning the upcoming presidential election slim. Ex-president, Cristina Kirchner, is the running mate to the now likely winner, Alberto Fernandez. This raises concerns for us about capital controls and socialist and popular agendas. Argentina cannot afford to go down that route in this point in time, in our view. The outlook is pretty binary at this point: it could tailspin, but if Macri wins that would be positive.
Adding frontier exposure can provide significant portfolio diversification benefits
What is your view on current valuations in the market?
Valuations across frontier markets are extremely attractive in our view. The growth and fundamentals of most of these companies and countries continues, but this is generally not being reflected in the market, particularly in financials which accounts for a large part of the opportunity set. Here valuations look compelling given the fundamentals, returns on equity and growth being generated.
In your view, why is now a good time to consider an allocation to frontier markets?
Over the past couple of decades, many frontier markets have made huge economic strides, as economies and capital markets liberalised. Despite this, the frontier asset class remains undercapitalised and underowned. While the potential magnitude of frontier growth is not reflected in the scale of the current stock market capitalisation, we expect this to change over the coming years.
In our view, this is an asset class that you should always buy contrarily. Frontier has been largely out of favour for about five years, as evidenced by negative investor flows over that time. That tells you that there is no hot money. It has not been forgotten, but it does seem to be on the back burner. You do not want to be investing in frontier when it is hot and up 30% to 40%. You want to be buying when no-one is talking about it because it will most likely move fairly aggressively if and when investors acknowledge the fundamentals.