The valuation challenge in frontier markets

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There is no doubt that the post-2008 investment climate for emerging markets has been challenging, including events such as the Taper Tantrum, and the prospect of a reduction in US liquidity measures generating a considerable amount of volatility. Yet according to Roy Scheepe (pictured), senior client portfolio manager Emerging Market Debt at ING Investment Management (ING IM), it is precisely this volatility in emerging markets that has made frontier markets more attractive.

“It has been a good time to invest in frontier markets. As a group, they are now at a similar stage in the economic cycle that China and Brazil were in 20 years ago. As an investor, it is always more interesting to participate at the beginning of the journey,” says Scheepe. Consequently, more money is flowing into this area of fixed income. But it pays to be selective.


In 2012, the JP Morgan NEXGEM index reported returns of more than 20%. However, in recent months, the index remained flat while a growing divergence between countries highlighted the importance of active selection. Among others, Argentina, Ghana and Honduras performed well, while countries such as Ivory Coast, the Dominican Republic and Gabon faced challenges.

“We believe strongly in the importance of fundamental research, which is why we have developed a model of country scoring which looks at factual basis data. But it is also important to take into account qualitative aspects such as the rule of law, effectiveness of government elections in order to assess if we are seeing a long term trend,” says Scheepe.

However, besides the fact that obtaining reliable data on the respective countries can be difficult, the performance of the local markets is often highly subjective, as the case of Ivory Coast illustrates. Despite the fact that it has a growth forecast of 8-9% for 2014/2015 and a relatively stable political climate, the country’s bond market underperformed.  This is explained by Ivory Coast bonds being seen as relatively liquid and therefore used as a hedging instrument to reduce overall exposure to Africa,argues  Scheepe.

ING IM invests in local currency debt denominated in OECD currencies and overwhelmingly in dollars in order to access markets with practically non-existent banking system. The downside to the approach is that the bonds may be more susceptible to potential changes in monetary policy by the US Federal Reserve. One key risk is that as liquidity measures dry up, the cost of borrowing for already poor countries could increase, triggering sovereign debt defaults.

However, Scheepe disagrees: “It is an interesting feature that at this moment in time, there is a general perception that debt levels in frontier markets are too high but if you look at the actual levels of external debt of countries like Rwanda, Ivory Coast and Mozambique you will find that it is quite low because they haven’t issued in the past. The average debt to GDP level is quite low.” mIndeed according to the IMF, debt to GDP ratios in Sub- Saharan Africa, have dropped from more than 100% in the early 2000’s to about 40%. Similarly, debt to GDP in Latin America has dropped from more than 70% to around 40% today.

Looking ahead, Sheepe remains optimistic: “Of course it is our responsibility as asset managers to value the return potential and the risk, but as it stands now, the search for yield may continue for quite some time and people will continue to look for alternatives to development market  bond yields.”

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