Final frontiers

Kerry Craig

Let us not mince words. The emerging market asset class is unloved and will remain so for a while. The combined flows into emerging market equities and debt were positive in the first two weeks of April, but this was a drop in the ocean compared to the amount of cash that fled the asset class last year.

Meanwhile, the latest Bank of America Merrill Lynch fund manager survey confirmed the very large underweight to emerging market equities persists, although it has diminished slightly. The weaker outlook for emerging markets – both in terms of economic strength and analyst earning expectations – means investors are looking elsewhere for returns. But perhaps the strangest aspect about the sell-off in emerging markets is that it has not been replicated in the emerging markets’ little brother, frontier markets.

Frontier markets are usually the preserve of those who can handle more risk in their portfolios. These newer economies typically have greater levels of political instability, much less market liquidity and a very weak regulatory environment. However, the MSCI Frontier Markets Index gained 27 per cent in local currency terms (including dividends) in 2013. Compare this to the 3 per cent return of the broad MSCI Emerging Market Index and it is not difficult to see why investor curiosity has been piqued.

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This interest from investors has continued in 2014 and is difficult to ignore, especially for anyone who – having seen the rise of the BRIC economies over the last 30 years – wants to get in on the ground floor of the next long-term investment trend.

The MSCI Frontier Markets Index comprises 26 countries. Ukraine is in the headlines at the moment, but the United Arab Emirates has the largest weighting by market capitalisation, followed by Kuwait, Qatar and Nigeria. The UAE and Qatar are graduating to full emerging market status in May, which means Kuwait and Nigeria will account for a larger share of the index. This could bring down the impressive returns in the near-term, as Nigeria’s equity market has fallen this year, amid uncertainty over the 2015 elections and the suspension of its central bank governor.

But it is the longer term case for frontier economies that really matters. For example, frontier countries have younger populations, which should foster faster economic growth. They also have lower levels of national debt, and less exposure to the big western economies, which means they haven’t suffered the ‘hot money’ outflows that have so often hampered the bigger emerging markets.

It is often argued that many emerging countries are no longer emerging, and the same is true of some frontier economies. South Korea has nominal GDP per capita levels higher than several members of the European Union, while the OECD ranks it in the global top 10 for educational scores. But perhaps an even more robust indicator is the rise of ‘Gangnam Style’, a song about an affluent Seoul suburb. A billion YouTube hits cannot be wrong.

These blurred lines between emerging and frontier economies are extending. Nigeria recently changed how it measures economic output, putting it in line with international standards. The result was that Nigeria’s economy is now larger than South Africa’s.