The Emerging Prospects of Frontier Markets

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 |  Includes: GAF, GULF, MES
by: Erik van Dijk

Mark Mobius is an Emerging Markets veteran. Mobius is fund manager at Templeton Asset Management, and a guru in his own right. At least in the eyes of other people. When we analyze his Emerging Markets performance using our models and databases we see that Mobius' quality is not so much picking the right strategy when markets are discovered, but more his willingness to take risks before others do. i.e., being a first foreign entrant in a country. In other words: A guy with a good nose for new investment frontiers, because don't forget: the current Emerging Markets were themselves in a way Emerging Markets some 20 years ago. So it is interesting when he talks about Frontier Markets.

Frontier Markets

When we look back in history we see that Frontier Markets have so far done poorly. On the one hand they were not really that much a part of the positive globalization trend that has catapulted main Emerging Markets like the BRIC nations into superior economic growth performance. On the other, whatever internal growth they seemed to generate was often lost in poor government actions, bad governance, corruption and a lack of investors willing to go the extra mile and risk. For more information about Frontier Markets we refer you to the MSCI Frontier Market Index information fact sheet. The Chart below gives us some of the stats over the last five years:

(Click to enlarge)

Chart: Emerging, Frontier and Developed Markets compared- Performance as of Oct 8, 2010

The MSCI Frontier Markets index does not yet exist 10 years. That is why the longest historical comparison captures 5 years of data. It is clear that Frontier Markets have not really excelled when comparing things with the MSCI Emerging Markets and MSCI World indices. However, both LMG Emerge and Mark Mobius (Templeton Asset Management) do believe that things are different this time.

In a way our 'heat chart' does clearly indicate a shift: when looking at the history 'red' and 'orange' dominate in the Frontier Market component of the chart. When looking at more recent time periods we see that it is actually 'green' which now dominates. However, the heat chart does also indicate that extremes are more common in the Frontier Market zone than in larger Emerging Markets or the Developed Countries. Therefore: Only add Frontier Markets to your portfolio if you have sufficient diversification and the accompanying risk profile.

Bad performance so far: Why would it be different this time?

Why would it be different this time? Mobius believes so and as you know from previous articles on the LMG Emerge Facebook Page or our blogs, we agree. The growing wealth in Asia and Brazil has led to a situation in which leading Emerging nations have seen their companies also invest in other emerging and frontier countries (compare what we wrote earlier this week about the IIF report on International Capital Flows between Emerging Markets). Often simply because Western nations are still blocking M&A activity by companies from Emerging Countries because of so-called 'strategic reasons'. They then focus on other Emerging Markets instead.

Chinese investment activities in Sub-saharan Africa and South and Middle America are a clear illustration of this trend. For leading Emerging nations this strategy (invest in other countries) will become an integral part of their overall economic policy, because it is a way to reduce existing upward pressure on their currencies.

Another element is that we expect commodity prices to increase. There are quite a few Frontier Markets (including Mobius' top picks Nigeria and Kazakhstan) who can be considered resource-rich. Also, with mature markets struggling, investors will look for alternatives. Of course, the bulk of that capital will flow to the biggest Emerging markets, but part of it will definitely look for other markets. Reason: you need to properly diversify, especially in a period in which correlations with global markets are increasing rapidly in the mean Emerging Markets. This implies that (in-and-of-itself very risky) Frontier Markets might become attractive on a portfolio basis due to their still relatively low correlations with the world economy.

Third, we will see continued shifts in the world away from traditional development aid toward more 'economic support'- like programs. Not just by governments, but also by big institutional investors and through the activities of Western entrepreneurs who discover those new countries.

Result: This will also attract investment capital into these countries with especially those of them with larger populations being attractive. It is therefore no surprise that Goldman Sachs' concept of the Next-11 contains so many Frontier Markets that can be characterized by large populations.

In combination these factors translate into growth opportunities in Frontier Markets. Markets that are at the moment still attractively priced, although we would be a bit careful with Latin America where prices have gone up rapidly recently (see above heat chart). And that at a time when it is clear that political constellations in the largest Frontier Markets look far better than they used to do. The Nigeria one can invest in today is a different country than the Nigeria of the 90s when general Abacha ruled as a dictator.

Evaluation:

We do therefore agree with Dr Mobius that it will be a Frontier Market decade, with our favorites being mainly Africa and the Middle East. But it will not be a pure Frontier Market age. The trends described above will also lead to good opportunities for countries like Turkey and Egypt. But the biggest opportunity of all is still hidden under a blanket of polemics and agony. And that is Iran. Sooner or later dialogue with Iran will have to be a fact of life. Those willing to understand what the growth potential is of a country that is top 5 in both oil and gas, and that does have the monetary basis to start with via its wealth fund, will watch with interest what is happening there.

But it is still early with the rest of the world blocking the growth potential through sanctions- sanctions that did not bring additional global security. Evidence from the Middle East seems to indicate that terror threats from countries that show good economic development are substantially less than those from countries that struggle. Another reason why it might be not such a bad thing that the Tehran Stock Exchange was one of the best performing exchanges recently.

And watch out, change might be triggered sooner than you think. Current price movements on the Tehran Stock Exchange - with the market hidding record levels earlier this year - do already indicate that investors are keeping the unleashed potential in the back of their head.

Disclosure: Long position with overweight in Emerging and Frontier Markets for our clients