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If you had to pick the only two regions in the world whose reserves surpass their debt, it’s unlikely your thoughts would leap to Africa. But while more developed markets almost everywhere in the world – Europe, US, Japan, Latin America and Asia – all owe many times more than they have in their reserves, this region is almost unique in being solvent. Only the Middle East is in a similar situation.
It’s a fact that helps explain the changing face of risk in global capital markets, the process in which investors are reappraising the potential of neglected countries in the emerging market universe. These are places that have lurked for years in the shadow of the Bric quartet (Brazil, Russia, India and China).
Cheap technology, industrialization and booming populations are causing attention to shift from the Brics to so-called frontier markets such as Vietnam, Pakistan or Nigeria. Even countries such as Bangladesh are attracting funds from the growing numbers of investors that see capital flows shifting from the northern hemisphere to the southern and eastern halves of the world.
The IFC’s Farida Khambata coined the term frontier market in 1992 to describe small, illiquid markets at an earlier stage of economic and financial development than more mainstream emerging markets. (The term frontier markets is itself an ambiguous one – as well as this wave of new emerging markets, it is sometimes used for specific sets of countries. The MSCI frontier markets index, for example, focuses on a group of 26 countries chosen by Morgan Stanley, just four of which are from Africa while the bulk are from eastern Europe or the Gulf.)
As investors wake up to the returns available in frontier markets, economists are working out exactly which of these newer markets to target. One sub-set is the so-called Civets – Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa – a name dreamed up by Michael Geoghegan, former chief executive of HSBC, who believes the six nations are set to prosper. Including the more established markets of Egypt, Turkey and South Africa in the grouping gives investors access to better liquidity.
The origins of this kind of terminology and approach go back to 2001 when Jim O’Neill, chief economist at Goldman Sachs, coined the term Bric to highlight the potential of Brazil, Russia, India and China to become some of the largest and most important economies in the world.
A few years later, O’Neill introduced the concept of the so-called Next 11 – Korea, Mexico, Indonesia, Turkey, Philippines, Egypt, Vietnam, Pakistan, Nigeria, Bangladesh and Iran – all countries that he tipped as the second wave of emerging markets to deliver outstanding returns. O’Neill has said he created the group simply by listing the 11 most populous emerging markets after the Brics.
The Next 11 has produced annualized returns of 22% since 2001, according to fund management firm Castlestone, more than the 20% managed by the Bric quartet over the same period, and far outstripping the modest 2% notched up by the S&P 500, bellwether of the US economy.
The Next 11 has also surpassed the emerging markets average, which returned 16% each year to investors over the past decade, according to Bloomberg and Castlestone Management.
CATCH-UP TIME
“Frontier markets’ GDP per capita lags those of other emerging markets,” says Daniel Broby, chief investment officer of Silk Invest, a firm specializing in esoteric emerging markets. “But we now see a lot of catalysts to let them industrialize and catch up.”
One such catalyst was the decision by the Paris Club to write off the debt of many of the world’s most impoverished countries. The arrival of cheap information technology is also allowing many countries to industrialize. “It’s to do with the technical revolution making the cost of participation in the global economy much cheaper,” says Broby.
Wireless telecoms have made communications more affordable. “All that’s happening is that industrialization is being rolled out across the world,” says Broby. “There’s no reason these markets shouldn’t take off, if they have the rule of law and protections for investors.”
So far this year, the strongest returns in emerging markets have not come from the Bric quartet, but rather from frontier markets. China’s Shanghai index is down more than 20% from the beginning of the year, according to Castlestone Management. Brazil is down more than 1%, and Russia has returned only a modest 1.5%.
“Emerging markets, especially the Brics, have become mainstream, so people are looking for the next opportunity,” says Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management.
A new type of emerging market investment is producing much more impressive returns than any of the Bric group has managed. So far this year, Bangladesh has returned more than 52% to anyone prescient (or brave) enough to invest in it at the start of this year, a performance that outstrips the modest 5% returned to investors tracking the broad MSCI emerging market benchmark.
The Philippines, also considered “newer”, has given investors 33% returns, as has Indonesia.
Firms whose shares trade on exchanges in “frontier” markets are cheaper than in more popular countries. They sell for cheaper multiples than elsewhere. Olympia Group, Egypt’s largest white goods manufacturer, trades at just eight times earnings, according to Arrash Zafari, fund specialist for an upcoming frontier markets fund at Castlestone Management. That compares to a multiple of more than twice as much for a similar firm in India.
Firms are moving to take advantage of these returns. Silk Invest, a fund manager dedicated to the outer reaches of the emerging market universe, last month launched a frontier equities fund. Some of its largest exposures are in Kazakhstan, Pakistan, Georgia, Turkey, Egypt, Oman, Kuwait, Ghana, Kenya and Nigeria. Castlestone Management aims to launch an investment fund before the end of the year based on the Next 11 concept. BNP Paribas’ Easy ETF arm offers a Paris-listed Next 11 exchange traded fund. HSBC Global Asset Management is looking at launching a frontiers fund.
THE NEW EMERGING MARKETS
There is a growing belief in investment circles that frontier markets are the new emerging markets, as returns from the Bric countries decline. “Frontier markets have the feel of many emerging markets in the early 1990s, when the emerging market asset class first really gained traction,” says Michael Power, strategist at Investec Asset Management. “Places like Nigeria and Egypt have the numbers and momentum that will soon turn them into the Thailands and Turkeys of the 1990s.”
Frontier markets have an in-built advantage over more developed markets – more babies. While population growth in the West is virtually flat, it is around 4% a year in these markets.
It’s not just their populations that are growing fast. GDP is also growing much faster in many of these new emerging markets than elsewhere. For example, in the UK, growth of just 1% is expected this year. Economists predict five times as much for Ghana, and the same for Nigeria.
While the UK will be lucky to manage 2.5% growth next year, Kazakhstan is set for around 6%, Tunisia is on course for 5% and Kenya the same, according to Silk Invest. Ghana is tipped to put on a growth spurt where its GDP will shoot up next year by 23%.
But if frontier is the new emerging, where does this leave the Bric countries?
Investec’s Power is among those who believe the Brics have come of age. So much so that they are no longer emerging. “The Brics deserve to graduate so as to be in a class of their own,” says Power. “The Brics are much more mainstream today than a whole slew of western countries traditionally regarded as developed, many of them in Europe.”
Castlestone’s Zafari says: “The attractiveness of the Bric theme is now much more widely appreciated by institutional investors and, as a result, it’s much harder to find investment opportunities where the long-term growth potential isn’t priced in.”
They might be smaller, but frontier markets are delivering better performance than the Bric juggernauts. Shares in India (trading at 17.4 times earnings, according to Castlestone), and China (almost 16) are more expensive than the average emerging market company (trading at just 12). In comparison, frontier markets such as Pakistan (7.5), Vietnam (9.9) and Korea (10 times) look cheap, even viewed next to other emerging markets.
However, substantial obstacles stand in the way of frontier markets following the path of more established emerging markets. Not least the logistics of getting money in and out of them.
Frontier markets are typically small and illiquid and often almost impenetrable by foreign investors. “One constraint on true frontier markets is their lack of liquidity,” says Poole at HSBC GAM. “It’s difficult for large institutions to get meaningful exposure to these countries. And it’s often difficult to exit.”
Bangladesh, for example, has just one stock with a market capitalization greater than $200 million and daily trading of more than $1 million. Nigeria, often touted as one of the most promising frontier markets, has only four companies that meet those criteria. Even Egypt has only 20 of them, according to Castlestone.
“People are investing mostly through specialist managers operating via regional funds, sometimes via single country funds, occasionally via hedge funds,” says Investec’s Power. “Very rarely are investors going direct.”
Richard Lacaille, global chief investment officer of State Street Global Advisors, says: “We are beginning to look at frontier markets in Africa. We are investigating some of the practical issues involved in investing there, such as custodial services. But the biggest problem is that some of these markets are so small.”
“We tend to find the larger institutions pull back when they see the illiquidity,” says Silk Invest’s Broby. “They need to invest 1% or more of a portfolio to make a meaningful impact on their performance. We are talking about a constrained universe in terms of how much you can put to work, so that is not an option for the majority.”
It can be hard for a larger firm to get that big an exposure in such small markets. Silk Invest has put $500 million limits on each of its range of frontier funds to prevent them becoming so large it cannot invest the funds effectively.
Illiquidity in stock markets is just one of the obstacles facing anyone exploring frontier markets. Currency volatility is another barrier that can destroy potential profit. “You are not just buying the equity story, but also the currency,” says HSBC’s Poole. “The currencies generally have been volatile.”
Lack of regulation can be another issue. However, Silk Invest’s Broby says: “There is a framework in which to invest, which surprises people.”
Despite these setbacks, there is growing evidence of interest in frontier markets, with investors seeing them as the natural successors to the first wave of emerging markets.
If the developing markets universe continues to expand at its present rate, it can only be a matter of time before current war zones eventually become investment targets. The day may yet come when Iraq and Afghanistan make the transition to become frontier markets.