The transformation that frontier markets have been experiencing has accelerated over the past two years. Various key elections, the lower oil price and outflows from equities have coincided with a growing demand for a political change, a sense of urgency to implement fundamental reforms and a need to further open up capital markets in several frontier countries. In several cases, the “necessary evil” that often comes in the shape of painful austerity measures and large currency devaluations (or depreciations) has taken its toll on the markets. Following two years of silent transformation and an arguably disappointing market performance as an asset class, we now believe that the foundations for future performance have either been established or even strengthened in a majority of frontier markets. We therefore think that it is again a good time to build positions in these next-generation emerging markets that rank among the world’s fastest-growing economies.
Chart 1. Currency movements vs USD since 2014
Argentina, for instance, is a market we have been feeling more and more positive towards, as political changes are being accompanied by economic reforms, with the country now fighting back to regain its economic prosperity. A decisive reform process, which was initiated by the recently-elected President Macri, is moving at full speed, with the peso being floated, certain export taxes being removed and various subsidies being cut. More importantly, the country made an historic return to international capital markets in April, by selling a record high USD 16.5bn sovereign debt for the first time in 15 years. What happens next will be determined by how the recovery plays out and eventually by how patient Argentinians are. However, we are more than encouraged to see that the market is strongly up, gaining nearly 25% in USD since we increased our investments at the beginning of this year, and that the MSCI already announced its intention to consider upgrading Argentina back into emerging market status in June 2017. In Argentina, we particularly like the banks, as we think there is a very strong penetration story following years of economic recession that left the banks’ private sector credits to GDP ratio at a mere 14%, compared to Chile’s 82%, Brazil’s 68% and Mexico’s 24%, among regional peers.
Pakistan is another market that we like, due to a combination of perhaps more-stable-than-ever politics and the reform process that took place over the past three years, along with an IMF program. The Pakistani economy is now growing at an annual rate of 5%, while inflation is close to a decade low, at about 4%. Furthermore, the massive USD 46bn (the figure recently increased to USD 51bn) China-Pakistan Economic Corridor (CPEC) investment program already started to kick in, with a clear focus on infrastructure investments. Along with that, MSCI’s decision to upgrade Pakistan to emerging market status has so far been a great push to the market, which has seen a sharp 30% gain this year. Despite the outstanding performance, we think that Pakistani equities are still among the most attractive in the emerging and frontier markets space, with an undemanding price-to-earnings ratio of 8.9x for 2017. We are particularly keen on Pakistani banks and cement companies due to appealing valuations, high dividend yields at 5%, on average, and large investment activity in connection with the CPEC.
Vietnam and Saudi Arabia rank as the markets we think are trying the hardest to intensify efforts to attract foreign investors. This should eventually pay off. Vietnam, which is one of world’s fastest growing economies, with over 6% annual growth, has been easing foreign ownership limitations for several stocks, including the country’s largest dairy company, Vinamilk. Furthermore, a fresh privatisation push has just started, with the listing of the country’s two large breweries, Habeco (Nov 2016) and Sabeco (Dec 2016), as well as its airport operator, ACV (Nov 2016). Vietnamese stocks look somewhat demanding, at an overall 2017e P/E of 14x, but we think that the growth prospects, especially in consumer-related sectors, more than justify the seemingly high valuations. In Saudi Arabia, a major decision was taken earlier in June 2015 to open up the market to direct foreign investments, and the qualified foreign investor (QFI) requirements have been easing since then. The next big step for Riyadh will be to IPO its crown jewel, Aramco, the world’s largest oil producer by a large margin, in a bid to boost foreign investments and improve transparency. An unprecedented reform program is also underway, with considerable spending cuts and an ambitious vision to lower the country’s oil dependence by 2020. With that, the country’s successful issuance of a fresh record high USD 17.5bn sovereign debt in Oct 2016 can be considered as important initial feedback from international investors. Even though we feel that the pressure will be on for Saudi Arabia’s economy, we believe that the strong secular growth stories driven by the nation’s young population offer good long-term opportunities, often with good entry points due to typically high market volatility. As such, we are currently invested in a health insurer and a food retailer due to secular growth stories.
Chart 2. Fiscal adjustments: expected decline in budget deficit to GDP between 2015 and 2018, %
Following their recent decisions to let their currencies float as a consequence of fiscal pressures, Egypt and Nigeria are also willing to change their economic destiny. Egypt, which just saw its currency weaken by as much as 50%, along with a fresh USD 12bn 3-year IMF program, is also coming up with comprehensive measures to turn its economy around. We have recently been increasing investments in the country as we see good opportunities, especially among exporters, due to EGP weakness. Among the exporters, one stock we have been increasing is a carpet producer with exports to more than 60 countries worldwide. Having let its currency float as an important step, Nigeria, too, is looking for ways to strengthen its economy during the cheaper-oil era. However, it remains to be seen how bumpy the road will be for Africa’s largest economy, as the efforts so far have failed to give any meaningful outcome. Therefore, we prefer to remain on the sidelines in Nigeria before considering more investments in this market.
One of the most interesting frontier markets, Iran, has perhaps already seen the worst, after the nuclear sanctions hit the economy badly between 2012 and 2015. Following a few painful years, the Iranian economy is now expected to grow at a pace of 4%. Inflation came significantly down from over 40% to below 10%, and the Rial has stabilized since mid-2015. Eagerly waiting to welcome its foreign investors, the Tehran Stock Exchange has been among this year’s best performing markets, with a 21% gain in USD, and is still looking attractive, with an undemanding 7x price-to-earnings ratio for 2017. While we currently do not have any investments in the country due to a lack of an international custodian, we are closely following the legal and economic framework to see if and when the time to enter this attractive market will come.
Elsewhere, privatization processes are continuing in Balkan markets, including the rapidly-growing Romania and stable Slovenia. One of the things we like the most in these markets is the high dividend yields, which typically go up to high single digits due to a combination of high payout ratios and low valuations. In particular, we invest in a number of banks and insurance companies that offer us an average dividend yield of 7% paid in stable currencies. Miles away, Sri Lanka is also coming up with ambitious plans for a fiscal consolidation, mainly through further tax reforms and efficiency gains in public expenditure. However, we feel that it will take a while for the country’s stock market to become attractive again. In North Africa, Morocco is seeing its fortunes already turning, after it started to lower its twin deficits, its economy is gradually recovering and the stock market is performing strongly, up 18%. Having admittedly missed this rally, we have decided not to chase the market as we are having a hard time justifying the common combination of low growth and high valuations among Moroccan equities.
Chart 3. Market performance in 2016, in USD
It is true that frontier markets as an asset class has lately been performing weaker than its emerging peers. But in case you have not noticed, a considerable number of individual frontier markets rank among the year’s best-performing markets. Considering the above-mentioned developments, we find various reasons to gear up our optimism. We think that the often-unnoticed transformation process that has been accelerating, especially over the past two years, has been preparing solid grounds for frontier stocks to catch up with the performance of their emerging peers. Furthermore, we believe frontier markets combine the advantages of being driven more by domestic growth and reform processes, particularly at a time when many worry about the impact of a weakness in global trade on emerging markets. With major elections over, austerity measures implemented, large currency losses having taken place, and valuations looking more attractive than ever – at nearly 15% discount to emerging and 35% discount to developed markets – we strongly believe that the best is yet to come for frontier markets.
Emre Akcakmak is Portfolio Advisor at East Capital Dubai.
