Investment managers such as HSBC and Renaissance are bullish about frontier markets, especially in Africa, and suggest they look better value than emerging markets in Asia and Latin America
Frontier markets (FMs) historically behave as “late cycle markets”, so can be expected to benefit as global markets enter a more mature stage of recovery, according to HSBC Global Asset Management.
Since the outbreak of the financial crisis in 2008, frontier markets have lagged the MSCI Emerging Markets (EM) index. Year to date, the MSCI FM index is up a meagre 0.74% and over five years the index is down nearly 15%. In comparison, the MSCI EM index is up 6.72% year to date and is down only 4.43% over five years.
However, HSBC says this year “may well be a turning point” for frontier markets, as local companies begin to post good end-of-year results. But while these markets are still down, valuations are cheap relative to emerging markets and historical values. Frontier markets are still trading 40%-50% lower than the pre-crisis levels of August 2008, while emerging and developed markets have almost completely recovered.
The region also offers higher profitability than developed markets and typically higher dividend yields than both emerging and developed markets, according to HSBC. Some countries, such as Pakistan, are offering average dividend yields of almost 8%.
Andrew Brudenell, manager of the HSBC GIF Frontier Markets fund, sees particular potential in the banking and consumer sectors, which he expects to continue to benefit from credit growth, and the growing spending power of a larger, wealthier middle class. HSBC’s favourite part of the region is Sub-Saharan Africa, where it sees long-term attractive investment opportunities. Unlike the rest of the frontier region represented in the MSCI FM index, Africa has flourished this year. MSCI Africa is up 35% year to date.
Brudenell points to Nigeria as HSBC’s favourite African country, where the firm has been building up exposure. He says: “Within this oil-rich nation, financials are showing robust potential, while consumer brands such as Nestlé Nigeria are also enjoying strong growth as a result of the rising consumer.”
He also singles out Kenya as a regional hub for trade and finance in East Africa. Here, the telecoms sector is particularly attractive, given its ties to mobile banking, which is a rapidly growing sector in the region.
Renaissance Asset Managers is also making a bet on Sub-Saharan Africa. CIO Plamen Monovski (pictured) says GDP growth in frontier Africa has been “nothing short of spectacular”. GDP in the region has been growing at about 6% on average, fuelled by growing consumption and developing transport, infrastructure and construction.
Apart from this, strong population growth is expected to make the African labour force greater than that of both China and India in just three decades. The IMF predicts eight out of ten fastest-growing economies will be in FMs.
FMs are at an earlier stage of economic, political and financial development than EMs. Apart from increased returns, this also implies higher risks, arising from the lack of liquidity and transparency, and political instability in some regions. There is also a risk of inflation, although recently declining food inflation has reduced this.
HSBC sees opportunity in these market inefficiencies, which allow investors to exploit significant mispricings of FM equities to enter the market at an early stage. These equities have also been less volatile than wider emerging markets, which HSBC attributes to the lack of liquidity and the low expectations for the region.
Apart from this, the correlation within the asset class is one of the lowest globally, which makes diversification within a frontier portfolio easier. For example, correlation between Nigeria and Kuwait, both large oil exporters, is negative at -0.07. The correlation between frontier and emerging markets is also low.
Apart from Nigeria, HSBC’s portfolio has high exposures to Qatar, United Arab Emirates and Saudi Arabia. It also has a relatively positive outlook on Egypt, despite recent political instability.
Asia and Latin America are too expensive, so the fund remains underweight in these regions. Pakistan is the favourite country in Asia, offering cheap valuations and high dividend yields. Exposure to eastern Europe remains small and domestically focused.
Year to end of September the fund has recovered from the losses of the previous year and is up 19.6%, beating its customised benchmark, MSCI Frontier EM Capped, by about 6%.
Monovski also points to “endless opportunities” to make money in African private equity. “There will be a lot more chances to make money in Africa, so watch this space,” he concludes.
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