InvestmentsFeb 11 2015

Frontier universe to shine

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Frontier universe to shine

Frontier markets have suffered a torrid time in recent months, sparked in part by the fall in the price of oil, which has hurt the large proportion of frontier countries that rely on the black gold.

The MSCI Frontier Markets index outperformed the MSCI Emerging Markets index throughout 2013 and much of 2014. But since the price of oil started to plummet, the index has given up a chunk of that outperformance.

Since the start of October 2014, the Frontier Markets index has dropped by 9.4 per cent, while the Emerging Markets index has risen by 3.7 per cent.

Roberto Lampl, head of Latin American investments at Alquity Investment Management, points out that passive investors in frontier exchange-traded funds will typically have 72 per cent exposure to oil-dependent countries, such as Kuwait, Qatar, the United Arab Emirates and Nigeria.

The remaining 28 per cent is composed of mostly Asian and African countries, such as Laos, Myanmar, Cambodia, Vietnam, Bangladesh, Sri Lanka, Pakistan and Kenya.

“Countries such as Kuwait and Nigeria will suffer from falling oil prices as lower government expenditure, lower investment and, in some cases, depreciation in their home currency impact their economies.”

Baring Frontier Markets fund manager Michael Levy says the sharp decline in the price of oil has led investors to assume this is negative for all frontier economies, not just Nigeria and those in the Middle East Gulf region. However, many other frontier economies are net oil importers and positioned to benefit from lower energy costs.

“The combination of a supportive economic environment and lower energy costs should be positive for companies in countries such as Sri Lanka, Bangladesh and Kenya,” Mr Levy says.

Robert Harvey, portfolio manager at Matthews Asia, thinks investors have now discounted the oil price fall. He remains optimistic that Asia’s smaller frontier economies will continue to grow in the long term, driven by foreign direct investment, growing remittances, domestic investment and consumption.

“Local politics remains a potential risk, but building a diversified portfolio should help mitigate the impact of any single-country event,” Mr Harvey says.

“We therefore remain cautiously optimistic about the outlook for emerging markets and frontier markets in Asia, given they have a relatively low correlation to each other, or to developed markets, and have real long-term growth potential.”

He views the impact of the low price of oil in Asia as mixed, but generally positive for the broader-based economies and for most Association of Southeast Asian Nation countries, with the exception of Vietnam and Malaysia where lower oil revenues stand to impact fiscal budgets and government spending.

He says Bangladesh should benefit from a combination of growing employment –particularly in the expanding garment-manufacturing sector – and rising wages.

“[In the course of] time, higher incomes benefit the broader economy and discretionary consumption in particular, as seen in other emerging economies such as China. Importantly, we see this growth occurring largely independently of economic events taking place in the rest of the world.”

Geopolitical risk, the fear of Greece leaving the eurozone and the looming threat of stagflation have set the scene for a bumpy ride in developed-world stock markets this year.

While frontier markets are not isolated from these concerns, they have a lower correlation with developed markets of just 0.49, compared with their emerging market counterparts at 0.84, according to Mr Levy.

“Frontier markets tend to be driven much more by local factors than large-scale macroeconomic and political developments,” he says.

“We are expecting solid growth across the frontier market universe this year, significantly ahead of most developed or emerging economies and helped by supportive demographics.”

But while frontier markets may be driven by such factors in the long term, the price of oil is still dictating much of the market.

Hedi Ben Mlouka, frontier fund manager at Duet Group, says “frontier Asian” countries (excluding Kazakhstan), as well as East Africa and Egypt, will benefit from lower oil prices. But oil-importing central and eastern European countries face other important headwinds that do not apply to Asia and Africa.

“Among those countries being hardest hit are Nigeria and Kazakhstan,” Mr Ben Mlouka says.

“Nigeria lacks a large fiscal buffer from which to maintain spending or to run countercyclical policies. Kazakhstan is also facing substantial regional pressures from developments in Russia and the rouble.”

He says the picture is complex in that even in oil-dominated Saudi Arabia, most big non-commodity stocks have performed well and generated returns of more than 20 per cent in 2014.

Overall, he expects robust growth in frontier markets in 2015, but with some oil-producing countries seeing greater challenges and coping with them to differing degrees.

“First-quarter growth for oil-producing countries should look worse than in the fourth quarter of 2014,” Mr Ben Mlouka says.

“But either due to fiscal buffers being deployed [such as in the Gulf states and in Kazakhstan] or currency adjustment righting the ship [as political risk clears after elections in Nigeria], the remainder of 2015 should shape up better.”