Frontier Markets constitute the one segment of the equity market that is typically missing within institutional portfolios. These markets represent developing countries with high rates of economic growth, but small and relatively illiquid stock markets. Frontier Markets are often in their infancy and have attracted attention due to their diversification opportunities and growth potential. Equities listed in Frontier Markets have become increasingly investable, attracting investors that are looking to benefit from early-adopter status in an asset class that some participants believe has the potential to become a significant portion of the global equity opportunity set.
Attractive economic fundamentals
- Higher historic GDP growth rates than their Developed and Emerging counterparts.
- Favourable demographics underpinned by a relatively large and young population.
- Relatively strong fiscal position.
- Rapid urbanization and technological advances, coupled with low labour costs make Frontier Markets attractive destinations for manufacturing hubs.
Lower volatility than perceived
- Many investors ignore Frontier equities as they are perceived to be too risky and volatile. However, Frontier Markets have historically been less volatile than both Developed and Emerging Markets.
- A significant challenge for investors in recent years has been the increasing correlations between asset classes. As traditional Emerging Markets have developed, the correlation between Emerging and Developed Market securities has converged.
- Frontier economies remain more local in character, illustrated by the low correlation with Developed and Emerging Markets. Additionally, Frontier Markets have low correlations with each other, providing further opportunities for diversification.
Valuations remain relatively low
- Frontier Markets trade at a discount to both Emerging and Developed Markets.
- Despite relative higher performance over the past three years, Frontier Markets still trade at a lower PE than their Emerging Market counterparts.
A. Introduction to Frontier Markets
Frontier markets constitute the one segment of the equity market that is typically missing within institutional portfolios. They represent developing countries with high rates of economic growth but small and relatively illiquid stock markets. These markets are often at an early stage of development and have attracted attention due to their diversification opportunities and growth potential. Equities listed in Frontier Markets have become increasingly investable, attracting investors looking to benefit from early-adopter status in an asset class that some participants believe has the potential to become a significant portion of the global equity opportunity set.
All markets were once considered Frontier prior to undergoing economic reform, developing infrastructure, and building platforms and regulations for share trading. 220 years ago the New York Stock Exchange was created under a buttonwood tree in order to facilitate trading amongst brokers in just a handful of listed companies. At the time no one could foresee the United States in its infancy would grow to become today’s largest economy. As recently as 1980, China was widely considered a Frontier Market but is today the second largest economy in the world. Some Frontier Markets did not even exist a decade ago. However, many now benefit from the same technology and exchange platforms used by developed nations that can support and promote rapid growth. Of course there are examples in Argentina and Venezuela (the latter removed from FTSE indexes in 2003) that illustrate slow transitions, and even regression. However the trend over time has been towards global growth and open access to financial markets. If this trend continues, the Frontier Markets of today could become the Developed Markets of tomorrow.
People tend to associate Frontier Markets with low income developing countries but according to the World Bank1, the per capita Gross National Income (GNI) of Frontier countries range from high income (> $12,476) to low income (< $1,045) as of year-end 2013. For example, in 2013 Qatar was ranked second in the world with a GNI Per Capita of $85,550, while Bangladesh recorded a GNI Per Capita of $900. Country Classification is largely independent of GNI or economy size, and instead focuses on a country’s political and market environment. Classification criteria include the depth and breadth of financial markets, legal and regulatory infrastructure, and general ease with which foreign investors can do business.
A major challenge for investors in recent years has been the rising correlations between asset classes, which have reduced diversification. As the traditional Emerging Markets have developed and become more entrenched in global trade, they have begun to take on similar risk and return characteristics as their Developed counterparts. This is illustrated by the convergence, in recent years, of the correlation of the FTSE Developed All Cap Index with the FTSE Emerging All Cap index.
The 5 year correlation (using monthly index returns) was 0.87 as of June 30th 2014. Frontier Markets, on the other hand, remain more local in character, heavily driven by internal economic and political dynamics. The 5 year correlation of the FTSE Frontier Index with the FTSE Developed All Cap and Emerging All Cap indices remain relatively low at 0.58 and 0.52 respectively as of June 30th 2014. Furthermore, Frontier Markets have relatively low correlations amongst each other. This is highlighted by cross-country correlation between Frontier Markets of 0.30 compared with 0.52 for Emerging and 0.70 for Developed. Thus, a Frontier Markets Index offers diversification and low correlation to other asset classes held in a typical index.
Additionally, some academic studies may present an argument for Frontier Markets’ inclusion. For example, the Modern Portfolio Theory (Markowitz 1952) quantifies the benefits of diversification by illustrating the potential for higher returns and lower risk that can be achieved by spreading investments across a larger opportunity set. Furthermore, according to the Efficient Market Hypothesis (Eugene Fama), you cannot beat the market since current prices reflect all available information. The Efficient Market Hypothesis argues that only the “market” portfolio is efficient, and as Frontier Markets represent 1% of total global market cap and 4% of global GDP, it can be argued that Frontier Markets should represent at least a similar allocation in diversified portfolios.
In many ways, Frontier Markets offer a natural evolution for investors who have already embraced the Emerging Markets, and are looking for additional potential high growth opportunities that may increase diversification. Many market participants believe that these markets have the potential to grow at a faster rate than the rest of the global economy in the future by becoming more efficient, improving their infrastructure, and developing more robust regulatory and capital investing frameworks.
B. Economic fundamentals
Investors have been attracted to the high growth rates of Frontier Markets in recent years, and the International Monetary Fund (IMF) estimates that Nominal and Real GDP growth will continue to be higher in Frontier Markets than the more advanced economies for decades to come.
The strong growth of Frontier countries is underpinned by their large and relatively young populations. These countries represent nearly 12% of the global population and, in contrast to many of the world’s advanced economies, most Frontier countries have a higher ratio of working (and soon to be working) population to current or projected retirement population.
This is especially evident at a time when the developed world is aging rapidly. For example, only 12% of the people in Hong Kong, and 13% of those in both Japan and Germany are under age 15, whereas this proportion is much higher in Nigeria, Kenya and Bangladesh at 44%, 42% and 30% respectively. A large ratio of young people to total population can lead to a bigger workforce, as well as a larger consumer base for businesses to sell to.
However, favourable demographics alone do not ensure that a large, young population will result in a more productive workforce. Literacy rates can be used as a predictive measure of productivity and are an important factor for economic success. Countries which lag their peers in terms of literacy may not have equal job opportunities, and may experience sluggish growth, and a slower transition to developed status. It is worth noting that the average literacy rate in Frontier Markets is actually slightly higher than their Emerging Market counterparts, and rates in countries such as Estonia (99.8%) and Botswana (85.1%) are significantly higher than the large Emerging Market India (62.8%).
In addition, a large and growing percentage of the population in Frontier Markets live in, and are moving to, cities. Workers are shifting from low productivity agricultural jobs to high productivity urban manufacturing jobs. Outsourcing and globalization trends continue to create jobs and drive manufacturing growth toward Frontier countries. These developments are expected to continue as regulation (for example emissions limits) and taxation within the developed world continue to escalate. Continued expansion in the labour force, and a rapid pace of urbanization provide potential catalysts for economic growth.
Combined with a growing population, a country’s poverty rate is a reliable indicator of its consumer strength, as it illustrates how much of the population generates disposable income. An important theme in Frontier Markets, as in Emerging Markets, is the rise of a consumer class as more people break out of mere subsistence living. Indeed, this trend is already significantly more advanced in several Frontier countries, (for example Mauritius) compared with some countries in the Emerging and even the Developed sectors (i.e. India and Greece). When ranking countries by the percentage of their populations below the poverty line, it is interesting to note that three of the ten least impoverished nations are Frontier countries. Less than 5% of the population of Frontier countries Lithuania and Tunisia are estimated to live below the poverty line, while over 20% of the populations of Developed countries Italy, Greece and Israel are estimated to be living in poverty. As economic growth continues, poverty rates in Frontier countries have further to fall, thus adding support to the growing number of consumers with disposable income. The companies that supply this already significant and expanding consumer base have significant growth potential.
Strong fiscal position
Another factor that could support growth in Frontier Markets is their relatively strong fiscal position as compared to their Developed counterparts. Global credit and equity growth has exceeded the pace of GDP growth for the past 50 years. Studies show that global debt grew nearly 5 times as fast as GDP over the last decade2. This increasing debt burden was a major contributor to the financial crisis in 2008. In efforts aimed at avoiding future crises, developed markets have placed new regulations on the financial sector which may slow growth in these countries. Compared to their Developed counterparts, Frontier Markets have exceptionally low debt burdens. The average Debt to GDP ratio for Developed countries was 85% compared to 51% for Frontier countries, according to data compiled by the World Bank (2012). Nigeria and Estonia both have Debt to GDP ratios under 15%, whereas the US and Japan have ratios of 94% and 196% respectively.
Credit growth has been more restrained in the Frontier sector. The Frontier Markets of Asia and Africa have a largely undeveloped banking sector, and improvements in this area may lead to substantial growth in the future. The relatively strong fiscal situation in Frontier countries is compounded by the favourable demographics mentioned earlier. These factors can help contain government borrowing, and drive economic growth. The increasing working-age population and strong fiscal position in Frontier Markets should result in budget surpluses that can be reinvested in the economy.
Another aspect fuelling growth in Frontier Markets is their ability to adopt technology that has been developed in the factories and labs of the more advanced economies. For example, frontier countries have skipped the need for expensive fixed-line infrastructure based on copper wire, and moved straight to more efficient wireless, and fiber-optic cables. As technological and infrastructure advances continue, the growth in Frontier Market economies should persist as well. Technology also has an effect on the global manufacturing base. For many years Emerging Markets have been the centre of manufacturing growth, but recently the shift has been to the Frontier Markets. A current example of this trend is the shift in manufacturing hubs from China to Vietnam. As China has grown, so have the labour costs within its borders. Vietnam now enjoys a substantial cost advantage over its neighbour, and many companies have decided to move their manufacturing plants to Vietnam. Profits generated by the manufacture and production of advanced products often gravitate from the original inventors to the ultimate producers. For example, producers of automobiles, televisions and smart phones located in China, Japan, and South Korea have made a greater profit than those who originally invented such devices in Developed countries. This trend is likely to continue and should boost growth in Frontier Markets as they become established manufacturing hubs.
Many Frontier Markets have an abundant wealth of natural resources. As Emerging Market economies maintain their growth and move towards Developed status, the demand for raw materials should continue to rise. For example, as China’s industrial base has rapidly advanced, the country has made large investments in oilfields, mines and farmland in Africa and Latin America. Qatar is ranked third in the world in terms of Natural Gas Reserves (CIA World Factbook 2013), and Botswana is ranked eighth in Copper resource deposits (DB Research 2013). These countries have benefited from growth in Emerging Markets which has led to increased demand for fuel and industrial metals. Raw materials available in Frontier Markets should continue to support their economic growth for years to come.
C. Frontier Equity Markets
Frontier countries have been beneficiaries of international organizations such as IOSCO and regional stock exchange associations. These organizations have ushered in the standardization of existing equity markets and the rapid development of Emerging and Frontier Market stock exchanges. Working with financial and academic support from agencies like the World Bank, IMF and OECD, they have helped Frontier countries to develop the necessary regulatory, legal, clearing and settlement systems needed to attract foreign portfolio capital. The diffusion and availability of trading technology platforms and electronic communication has further enabled the development of market infrastructure. Even with these recent developments, however, Frontier Markets remain very small and illiquid in comparison to their Developed and Emerging counterparts.
Many Frontier economies, particularly those in the Gulf Cooperation Council (GCC), were built around extracting oil and natural resources out of the ground, and creating a banking sector to support these industries. Thus, Frontier Market indexes tend to be overweight financials. Energy stocks are often thought to be a main driver of these markets, but Frontier energy companies tend to be state owned. As a result, Energy actually represents only a modest portion of Frontier indices. In fact, the biggest opportunity may come from the consumer sector, as growing populations and low labour costs (which lead to manufacturing jobs) create an emerging middle class available to purchase goods.
Performance and valuation
Frontier Markets have performed higher than their Emerging counterparts over the past three years, as shown in the table below. In spite of this recent high performance, Frontier Markets trade at a discount to both Emerging and Developed Markets in terms of Price to Earnings Ratio.