Three to four years ago, institutional investors were showing strong interest in frontier markets as they sought opportunities for lower correlations with global markets.
But then commodities took a downturn and investors quickly lost interest, says Kurt Reiman, chief investment strategist at BlackRock Asset Management Canada Ltd. “All it took was a couple of years of down markets and poor performance to end the discussion,” he says, noting the slump in commodity prices, specifically oil, had a detrimental impact on frontier markets.
But as oil and commodity prices have recovered, will frontier markets follow suit? There’s a strong argument for investors to reconsider their position, says Reiman. He notes the current outlook for oil prices, along with high dividend yields and cheap valuations, are bolstering the case for taking another look. “They’ve underperformed pretty substantially. . . . But it’s starting to look interesting.”
So for institutional investors that are revisiting frontier markets, what are some notable countries worth exploring and what are the prospects for different asset classes?
Vietnam is very popular among investors because of its growing manufacturing sector, says Oliver Bell, portfolio manager for frontier markets at T. Rowe Price International Ltd. Since Vietnam’s labour costs are cheaper than China’s, it has taken large numbers of manufacturing jobs away from that country, notes Bell. He says foreign companies have a stake in businesses that produce 70 per cent of Vietnam’s exports, which include electronics such as mobile phones, followed by textiles.
The Vietnamese government is also becoming more open to foreign investors by raising ownership limits for local companies, says Bell. But while a handful of companies have had their foreign-ownership limits lifted completely, many still face a cap of 49 per cent, he says.
Vietnam has also invested in infrastructure such as roads and electrical capacity, which has made it easier for the country to export goods efficiently, says Henry D’Auria, chief investment officer for emerging markets value equities at Alliance Bernstein. “Private investors like ourselves can benefit from the lower transport costs of getting goods to market that will come from a better road system. Whether it’s electronic parts or textile, the cost of getting those products to export markets will decline as efficiency of the transport system in Vietnam improves,” says D’Auria.
Pakistan is another frontier market that’s becoming more enticing for investors because of its growing political stability, says Bell.
While Pakistan has struggled with terrorism, the current government has made an effort to bring stability back to the region, says Bell. He notes leaders are also trying to boost the country’s economy by building up its infrastructure. Specifically, the government is working on improving Pakistan’s electrical capacity to address problems of intermittent power in that country. Once the country gets its electrical capacity in order, its manufacturing sector can start to grow, says Bell, adding that Pakistan is also posting solid macroeconomic indicators, such as low inflation and rising gross domestic product.
Pakistan also received financial backing from China as part of a project called the China-Pakistan Economic Corridor in 2015 that included an investment of about $50 billion to help the country to upgrade its infrastructure, according to Bell. The corridor will serve as a trade route for China’s silk exports, he says.
The investment will benefit both countries because China will have a more efficient way to move its exports and Pakistan will be able to solidify its power and transportation networks, says D’Auria. He says investors can benefit by looking at Pakistani companies involved in building the country’s infrastructure, such as those that make cement for roads or banks that provide loans to contractors working on transportation and electricity projects.
Sri Lanka is another country that has attracted Chinese investments because of its potential to facilitate shipments to global markets from India, says Bell. The funding will likely go towards developing the country’s ports, he says. In addition, Sri Lanka’s historical buildings and beaches are attracting tourists and, as a result, are helping to boost investments in the tourism industry, according to Bell. “It’s a beautiful place and there was a civil war seven to eight years ago, but now there’s peace and politics are getting better. . .. So it’s got a combination of factors that’s attracting tourists.”
The stock market also features several companies with attractive valuations despite their rapid growth, says Bell. “Stock market valuations are cheap and, at some point, it will rerate so we’re overweight in Sri Lanka.”
Argentina is another promising frontier market following a change in government in 2015, says Bell. He notes the current president, Mauricio Macri, has worked to make the country more appealing to foreign investors after the previous government shied away from global capital markets. “We now have a government that’s seemingly doing the right things.”
The new regime is focusing on boosting the country’s infrastructure by improving its roads, power stations and airports, says Andrew Brudenell, head of frontier markets at the Ashmore Group. It’s also removing inefficient subsidies and regaining access to the international debt market.
Company valuations in Argentina are attractive, says D’Auria, noting that now is the time to invest because prices should rise over time as the country eases capital controls.
Fixed income at the frontier
While countries like Vietnam and Pakistan are notable from an equity standpoint, their valuations are less compelling when it comes to fixed income, notes Jason Trujillo, senior analyst at Invesco. “Those are less compelling from a risk-reward standpoint, so we don’t think [bond holders] are getting paid as well for the risk.”
Fixed-income valuations are better in Africa, according to Trujillo. He says his team is focusing on sub-Saharan Africa from a debt perspective due to decent yield pickup and a rebound in economic growth. “People think of [the region] as a commodity-driven play, but you have some countries that are much less commodity sensitive,” says Trujillo.
Ivory Coast and Kenya, for example, are less reliant on commodities, says Trujillo, noting gross domestic product is growing rapidly in both countries. They also have low deficits, he adds. “They’re not exposed a lot to the strong dollar, which could potentially be a big pressure for emerging-market countries.”
Trujillo also likes Ghana and notes that while it’s dependent on commodities like oil and cocoa, actions by the International Monetary Fund are encouraging economic discipline there. “The IMF is providing structural reform that will manifest itself to lower debt to GDP, higher tax collection as a percentage of GDP and stronger institutional strength,” he says. “All those things can help Ghana move from being a low-quality and volatile frontier market to being higher in the spectrum.”
Still a hard sell
While frontier markets offer a number of opportunities, they can still be a hard sell for institutional investors when it comes to investing significant resources in them.
It’s uncommon for most institutional investors to designate a substantial chunk of their holdings to frontier markets, says Trujillo, noting more of them are starting to consider incorporating them into emerging-market allocations. “Investors are comfortable with frontier markets being a piece of the risk profile as part of an overall emerging-market strategy.”
Some smaller institutional investors, however, find frontier markets an unnecessary addition to their portfolios. The Nova Scotia Health Employees’ Pension Plan, for instance, doesn’t have frontier markets in its portfolio but it did add emerging-market fixed income and equities to its assets several years ago as a strategic play, says chief executive officer Calvin Jordan. “It had diversification benefits and, more specifically, it improved risk-adjusted returns.”
The plan has eight per cent of its portfolio allocated to emerging-market equity and five per cent to emerging-market debt, says Jordan. But while the plan has invested in emerging markets, Jordan says it hasn’t found a compelling enough reason to explore the frontier side. “Investors have finite resources, time and scope. So perhaps it’s not a bad idea but, frankly, I haven’t looked at it closely enough to assess.”
Jordan notes he also doesn’t like making small allocations in his portfolio. “Anything that doesn’t move the needle simply adds bother and investment policy complexity without having a significant impact.”
While frontier markets can offer advantages such as cheap valuations and reduced correlations, they tend to have a high concentration of investments in the financial sector, notes Reiman. And with many institutional investors already having significant exposure to the financial sector in developed markets, Reiman questions why they’d go to frontier markets for the same result.
But the benefit of financial institutions in frontier markets is they have less involvement in the global banking system, says Brudenell.
Nevertheless, while banks in frontier markets do cater to different clients, they’re still dependent on interest rates and the overall economy, says Reiman. “My point is to be wary of the sector profile of frontier markets, which are heavily weighted towards financials, and in the domestic market cap, we’re already gorging in financials. You’d have to be pretty convinced that the return opportunity is there.”
Frontier markets also offer limited liquidity, which is a big concern for investors, says Reiman. “That’s why you get these price gaps, because there’s not a lot of trading going on.”
Jann Lee is an associate editor at Benefits Canada.
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