The evolution of frontier markets

Transcription

1 The evolution of frontier markets March 2017 Yerevan, Armenia

2 Contents Introduction 3 Frontier-market equities 4 Case studies 5 Frontier-market debt 6 Opportunities and risks in frontier markets 9 02 of 12 The evolution of frontier markets - March 2017

3 Introduction There has been a growing interest in frontier-market equities and bonds in recent years. It represents the new segment of emerging markets where most investors have limited exposure. By nature, these markets are relatively small and less liquid than mainstream emerging markets and, at times, can be impacted by periods of elevated volatility. Information is often sparse when it comes to companies, public sector expenditures and revenues, and political risk. However, this information risk can provide opportunities for active investors who are willing to take a long-term view. Investment managers that have demonstrated their capabilities in research and investing in frontier markets, both in equities and fixed income, can provide valuable expertise in this specialized segment of the markets. Chart 1: Frontier gross domestic product (GDP) growth outlook remains healthy % Rwanda Ethiopia Côte d'ivoire Senegal Mozambique Bangladesh Tanzania Kenya Uganda Vietnam Egypt Zambia Pakistan Sri Lanka Mongolia Emerging markets Gabon Georgia Namibia Dominican Republic Ghana Cameroon Tunisia Armenia Costa Rica Guatemala Jordan Nicaragua Serbia Ukraine Honduras Paraguay Fiji Angola Papua New Guinea Nigeria Argentina Lebanon Suriname Republic of Congo Jamaica Barbados Croatia El Salvador Iraq Belarus Belize Developed markets Ecuador Venezuela Source: International Monetary Fund (IMF) World Economic Outlook, October Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially. Chart 2: MSCI Frontier Markets Equity country and sector weights Utilities 4.12% Real Estate 6.24% Industrials 3.13% Healthcare 3.12% Consumer Disrectionary 1.14% Information Technology 0.79% Kuwait 19.20% Materials 6.93% Energy 9.05% Financials 43.30% Other 38.97% Argentina 16.14% Consumer Staples 9.07% Telecommunication Services 13.78% Vietnam 7.61% Morocco 8.56% Pakistan 9.52% Total may not add due to rounding. Source: MSCI, January 31, For illustrative purposes only. aberdeen-asset.us 03 of 12

4 Frontier-market equities As an asset class, frontier-market equities lie on the periphery of global equities investing, falling outside of even the emerging markets category. But while they are peripheral from the point of view of industrial scale and geography, these are vibrant economies with thriving private enterprise and a high level of entrepreneurship. Many of these countries have transformed themselves over the past two decades, with progress on several fronts: literacy, access to credit, a communications revolution, improved public sector accountability and an entrenchment of democracy. These advances have elevated the sustainable growth rate for many frontier countries while also helping reduce risks. Local exchange-listed companies are among the greatest beneficiaries of these developments. Those who have been in the asset management industry long enough may remember that in 1988, the newly launched Morgan Stanley Capital International (MSCI) Emerging Markets Index represented less than 1% of the world s market capitalization; today, emerging markets comprise 13%. We believe a similar fate awaits frontier markets, given that (under the broadest definition) they comprise over 100 countries accounting for over 30% of the world s population and almost 10% of global gross domestic product (GDP). These are lofty ambitions for the asset class, and time will ultimately be the determining factor. In the interim, we think that mainstream investors may continue to consider the asset class esoteric in that it is small in terms of market capitalization and poses various risks. This is perhaps not a bad thing, as this is still a small asset class with limited capacity to absorb large flows. The term frontier markets was first introduced by the International Finance Corporation (IFC) in 1992, referring to a subset of smaller markets within its emerging markets database that had lower levels of market capitalization and less liquidity. Standard & Poor s launched the first frontier index in October 2007, closely followed by the launch of the MSCI Frontier Markets Index the most widely used benchmark today later that same year. Although frontier markets are mostly associated with lower-income countries with a nascent level of development yet generally high GDP growth rates, that is not exclusively the case. Argentina is categorized as a frontier market despite being considered an upper middle-income country by the World Bank; Kuwait is also in the MSCI Frontier Index, but is ranked the fourth-richest country in the world in GDP per capita terms. When classifying a country, index providers look less at a country s economic standing instead focusing more on its equity capital market size, liquidity and openness to foreign investors. Taking a look at MSCI s classification of frontier markets, there are significant concentrations in terms of countries and sectors, some of which appear quite incongruous. Several highly populous yet low-income nations are dwarfed by small and wealthy ones, for example, simply due to the relative size of their equity markets. It becomes clear, in our opinion, that many frontier markets have little or nothing in common with each other. Andes, Bolivia 04 of 12 The evolution of frontier markets - March 2017

5 Case studies Currently, within the frontier markets universe, we are drawn to companies in Africa and Frontier Asia, with several promising businesses emerging in Kenya, Vietnam and Pakistan in particular. Kenya Kenya s economy has been enjoying strong growth of around 6% per year supported by lower energy costs, investment in infrastructure and a robust agricultural sector. Despite the country s sizable twin deficits, the IMF remains supportive of the government s structural and economic reforms, and has extended a US$1.5 billion package to the government. Additionally, a lower oil price has seen the current account deficit narrow substantially, while inflation has stabilized and the government has committed to further spending cuts; all of which has brought greater stability to the shilling.. Kenya s capital, Nairobi, is one of the most dynamic cities in the African continent, home to several highly entrepreneurial businesses. While there are a variety of opportunities that exist in Kenya today, a particularly interesting example is an innovative mobile operator that has revolutionized financial inclusion through its mobile money platform, which is now used by over half of the country s population and serves as a benchmark for telecommunications companies anywhere in the world. Vietnam Vietnam is set to be one of the fastest-growing markets globally over the next decade, with a forecasted annual GDP growth of 6% to 9%. Foreign direct investment (FDI) has boomed as the country continues to open up to free trade, with FDI rising from $2 billion per year in the early 2000s to closer to $10 billion per year in The government has also made great strides in improving access to education and developing much-needed infrastructure relative to other frontier markets, which again bodes well for future growth. Despite the corporate sector still being prone to state interference, there are opportunities to invest in well-run businesses. One such company is a dominant player in the local dairy industry that is wellplaced to benefit from continued growth in domestic consumption. Pakistan Pakistan has long been ignored by foreign investors due to a poor security situation, severe energy shortages and a messy political environment. But things are falling into place for this nation of 200 million people. This includes a serious crackdown on militancy, willingness from both the private and public sectors in the country to resolve the energy situation and a rosier economic outlook driven by better wage competitiveness relative to the rest of the region, falling oil prices, and the prospect of significant infrastructure development driven by Chinese investment. Compelling investments include one of the leading financial institutions, which enjoys a strong deposit-gathering franchise and a professional management team that will drive increasing credit penetration as the economy grows and demand for borrowing increases. Ha Long Bay, Vietnam aberdeen-asset.us 05 of 12

6 Frontier debt While access to international capital markets has improved in recent years, as evidenced by the growth of new Eurobond issues, frontier markets remains a small part of the overall emerging market universe. Issue sizes of up to US$1 billion, along with limited issuance, ensures these new issues are easily absorbed by the market, however. Such issues are typically associated with higher yields, as evidenced by the graph below. And with today s persistent low-yield environment, it s no surprise we ve seen an increase in appetite from both dedicated and non-dedicated frontier market investors. Chart 3: Frontier-market bond yields are higher than core emerging markets Yields (%) Emerging markets local currency sovereign Emerging markets hard currency sovereign Emerging markets hard currency corporate Frontier markets sovereign Source: JP Morgan, 31 December For illustrative purposes only. Indexes: EM Local Currency Sovereign = GBI-EM Global Diversified, EM Hard Currency = EMBI Global Diversified, EM Hard Currency Corporates = CEMBI Broad Diversified, Frontier Markets = NEXGEM Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. The growth of local currency markets has been hindered by various structural issues, such as the lack of local institutional investor base that has also been unwilling to take duration risk, having traditionally preferred short-term instruments. But there are exceptions. Nigeria is an example of a country with a fairly developed pension fund industry and other local investors who have appetite for long-dated bonds out to 20 years. Nigeria would be an appealing market for offshore investors if they were to allow for a market-determined exchange rate rather than trying to micromanage the currency following the most recent devaluation in mid Ghana has made some headway over the past several years in building out a yield curve to ten years while attracting strong offshore interest in three- to five-year bonds. Offshore investors are still restricted from purchasing bonds with maturities of up to one year in the primary market, however. A removal of this would inevitably lead to further progress, although authorities have so far been reluctant to fully liberalize the local market. Some countries apply withholding taxes on local bonds, which have discouraged participation of offshore investors. There are limits on the growth of frontier bond markets, but we believe it has merits as a standalone asset class given the high yields, diversification benefits and low correlation to U.S. Treasuries. Frontiers have always had a low correlation with U.S. Treasuries 10 years as of Dec. 31, 2016 EM Hard Currency Sov 06 of 12 The evolution of frontier markets - March 2017 EM Local Currency Sov EM Hard Currency Corp US Inv Grade Credit US High Yield Developed Market Sov US Treasury EM Equities US Equities Frontier Market Sov Frontier Market Sov US Equities EM Equities US Treasury Developed Market Sov US High Yield US Inv. Grade Credit EM Hard Currency Corp EM Local Currency Sov EM Hard Currency Sov 1.00 Source: JP Morgan, December 31, For illustrative purposes only. Benchmarks used: EM Frontier = JPM NEXGEM, US Equities = S&P 500, EM Equities = EM Free, US Treasury = JPM GBI US, Developed Market Sov = JPM GBI Global, US High Yield = JPM US HY, US IG Credit = JPM JULI, EM Hard Currency Corporate = JPM CEMBI BD, EM LC Sovereign = JPM GBI-EM GD, EM HC Sovereign = JPM EMBI GD. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index.

7 Frontier markets are a very small subset of emerging-market debt Latam/Caribbean Africa Europe/Asia Frontier bond market capitalization Belize Angola Armenia Hard currency Sovereign $95.83bn Bolivia Cameroon Bangladesh Corporates $31.52bn Costa Rica Congo Georgia Local currency Sovereign $370.74bn Dominican Republic Cote D Ivoire Iraq Quasi/corporates $22.73bn Ecuador Egypt Jordan Total frontier-market debt $520.82bn El Salvador Ethiopia Mongolia Total emerging-market debt $16.4tn Guatemala Gabon Fiji Honduras Ghana Pakistan Jamaica Kenya Sri Lanka Paraguay Mozambique Vietnam Suriname Namibia Nigeria Rwanda Senegal Seychelles Tanzania Tunisia Uganda Zambia Frontier markets are less than 4% of total emerging-market debt. Source: JP Morgan, January Korean-owned textile company in Addis Ababa, Ethiopia Bond markets: growing, gaining traction From a geographical standpoint, Africa is most associated with frontier markets. As a region, it meets the criteria of a frontier market, although Sub-Saharan Africa (SSA) is also becoming an increasing part of overall emerging market portfolios due to the inclusion of more countries in the main benchmark emerging market bond indices. Over the past decade, going back to Ghana s 10-year Eurobond in October 2017, there s been over $30 billion of Eurobonds from SSA sovereigns, which has provided a number of relative value opportunities among the various issuers. Banks and corporates, primarily from Nigeria, have also been able to tap the Eurobond market. Outside of SSA, there are a number of countries that are part of the frontier universe, such as Dominican Republic, El Salvador, Costa Rica, Guatemala, Sri Lanka, Vietnam, Mongolia, Pakistan, Egypt and Iraq. These countries have been a part of the main hard currency index for many years and therefore are more familiar to emerging market investors compared to some of the SSA issuers. However, their economic, political and social characteristics would place them in the frontier market category. Frontier-market bonds were a relatively late comer to the index world. There was no dedicated bond index until the introduction of the JP Morgan Next Generation Emerging Markets (NEXGEM) Index in December The NEXGEM now consists of 32 countries, defined as the smaller, less liquid emerging-market economies with less developed capital markets. They represent a small but growing portion of the more established JP Morgan EMBI indices (a well-established index that tracks total returns for U.S. dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities). To be eligible, countries must have a weight of less than 2% of the JP Morgan EMBI Global Diversified Index for the past 12 months, be rated Ba1/ BB+ or lower by both Moody s and S&P, 1 and cannot be a member of the European Union (EU) or be engaged in the process of securing EU membership. There are no indices for hard currency frontier corporates and local currency bonds. The NEXGEM now consists of 32 countries, representing a small but growing portion of the more established JP Morgan EMBI indices 1 Moody's is an independent, unaffiliated research company that rates fixed income securities. Moody s assigns ratings on the basis of risk and the borrower s ability to make interest payments. Typically securities are assigned a rating from Aaa to C, with Aaa being the highest quality and C the lowest quality. Standard & Poor s credit ratings are expressed as letter grades that range from AAA to D to communicate the agency s opinion of relative level of credit risk. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB- aberdeen-asset.us 07 of 12

8 Frontier bonds are benefiting from index inclusion Chart 4: Key characteristics of JP Morgan NEXGEM Index Chart 5: Frontiers have 20% weight in the benchmark EM index Country weights (%) US$bn % Dominican Rep Sri Lanka 10.6 Ecuador Costa Rica 7.3 El Salvador 5.8 Pakistan Jamaica 5.1 Cote D'Ivoire 4.5 Zambia Ghana 3.2 Egypt Kenya 3.0 Paraguay 2.7 Iraq Angola 2.4 Guatemala 2.3 Mongolia Gabon 2.1 Vietnam Nigeria 1.7 Jordan 1.6 Bolivia Georgia 1.2 Honduras 1.2 Senegal Armenia 1.2 Tunisia Ethiopia Cameroon 0.9 Suriname 0.6 Mozambique 0.5 Belize NEXGEM Market Cap (US$bn) EMBIG Global Div Market Cap (US$bn) Source: JP Morgan, December 31, For illustrative purposes only. JP Morgan Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses NEXGEM are % reflected. Wgt in EMBIGD Individuals (RHS) cannot invest directly in an index. Dec 01 Jan 03 Feb 04 Mar 05 Apr 06 May 07 Jun 08 Jul 09 Aug 10 Sep 11 Oct 12 Nov 13 Nov 14 Dec 15 Jan 17 ESG The analysis of environmental, social and governance (ESG) risk factors is an integral part of Aberdeen s credit risk assessment process. When it comes to assessing sovereign risk, ESG risks are more focused on social and governance indicators than environmental factors as they generally have a more direct link to a country s liquidity and solvency profile. Intuitively, adequate social protection empowers a higher percentage of the population to participate in the economy, allowing the government to collect more tax revenue. A stable government with peaceful elections is also more likely to honor its debt obligations throughout economic cycles. Environmental risk, on the other hand, generally does not have an immediate effect on government s ability or willingness to pay its creditors. But environmental concerns can be significant to citizens well-being. For example, the problem of heavy pollution might manifest itself through social grievances, which could destabilize the society. When conducting sovereign research, it is important to analyze a country s demographics, political structure and election dates. We gain external input from the World Bank s Doing Business Report, World Bank s World Governance Indicators, Yale University s Environmental Performance Index, Transparency International s Corruption Perception Index, Sustainalytics Sovereign ESG assessment and the UN Sanction List. These inputs are presented at our sovereign strategy meeting every six weeks. Based on the metrics listed, we have developed a proprietary ESG scoring model. The model scores countries based on their rankings on each metric and then provides a rating for all three aspects of ESG. With each factor, we also look at the historic trends of each country s performance. External input from sources such as the World Bank s Doing Business Report, World Bank s World Governance Indicators, Yale University s Environmental Performance Index, Transparency International s Corruption Perception Index, Sustainalytics Sovereign ESG assessment and the UN Sanction List can be valuable in this analysis. Other factors investment managers should consider when developing an opinion on the ESG factors of countries include each country s historical performance and its present trajectory. Analysts forward-looking assessments can help capture recent events, and can be compared with an investment manager s own forecasts of each country s near-term trajectory. These outputs can be supplemented by regular country visits by the investment manager and other qualitative factors, such as political and event risk, which could have an impact on market prices and credit quality. 08 of 12 The evolution of frontier markets - March 2017

9 Opportunities and risks in frontier markets Expectations for robust economic growth Frontier market economies are projected to have some of the highest economic growth rates in the world over the next five years, driven by factors such as the low penetration of goods and services, favorable demographics, rapid urbanization, technology transfer, and increasing availability of credit to the private sector. Favorable demographics In contrast to many developed countries, frontier markets have a young, growing population that will contribute to a developing workforce and increased domestic consumption. Improvement in governance and accountability Encouragingly, governance and accountability have found their way up the agenda in recent years. Political leaders generally understand the need for orthodox economic management to maintain a stable economy and attract inward investment. The electorate tend to be much better informed, which means corruption and accountability are now heated topics during elections. Several of the most populous frontier nations, including Pakistan and Nigeria, have seen a genuine entrenchment of democracy, while others such as Myanmar and Sri Lanka have emerged from decades of obscurity. Convergence and diversification benefits 2 Investing in frontier markets also offers the potential for valuable diversification benefits. Correlations relative to developed markets have generally been lower than their emerging markets peers, as have intra-country correlations within frontier markets itself given the highly diverse nature of the asset class. As these markets open up to foreign direct investment (FDI), correlations are likely to increase. But there will be other benefits, including the adoption of global best practices on the part of local corporates and better access to funding and more advanced technologies from abroad. Greater prevalence of mispricing and other market inefficiencies For fundamental, research-driven investors like Aberdeen, there are opportunities to capitalize on market inefficiencies that occur because of short-term liquidity squeezes, weak intelligence or corporate analysis, and naturally fewer market participants. Credit risk showing some signs of fatigue Sovereign default risk is generally a low concern at present although there are a handful of countries with high debt levels due to worsening fiscal positions and softer growth over the past few years. A number of countries have sought IMF support to help mitigate financing concerns, which in turn has helped to reduce risk premiums. However, this will not necessarily prevent a credit event from occurring. Interest rate risk has been falling amid lower inflation The risk of interest rates increasing due to fundamental or technical factors is a key risk for local currency bonds. The former is a risk that could occur from poorly managed monetary policy or a terms of trade shock that could lead to an inflation spike, whereas the latter is arguably a lower risk given the small size and low foreign ownership of local market bonds. Political risk is typically high As countries with fundamentally weak institutions, political risk tends to be higher compared to mainstream emerging markets, which in turn can result in a less predictable policy environment. The prevalence of dominant political parties, or in some cases one party rule, can often result in deteriorating policies which in turn can erode willingness and ability to pay. Liquidity risk comes with the territory Of all the risks, liquidity risk differentiates frontier markets the most from more mainstream emerging markets. By nature, frontier equities and bonds are more thinly traded than mainstream emerging-market assets, with generally higher trading costs. Liquidity in particular varies greatly, with several markets lacking scale and depth in comparison to more mature emerging markets. Currency risk is food for thought Currency risk could have an impact on valuations on equities and local market bonds due to the lack of liquidity in foreign exchange markets. This can result in large market movements that are not necessarily associated with fundamental factors. A limited history of central bank independence and persistent threat of inflation in some countries that is usually driven by food inflation can also have a great impact on currency valuations. Summary Frontier markets are an interesting investment opportunity for a long-term investor, offering the potential for significant growth and development over time. Given their diverse nature and lack of analyst coverage, investors seeking exposure to frontier markets should consider working with an experienced investment manager that has a deep knowledge of these markets and a history of successfully investing in them. While this may be a new asset class for some investors, it will be very familiar to a skilled investment manager who has a solid track record of investing in frontier markets. 2 Diversification does not ensure a profit or protect against a loss in a declining market. aberdeen-asset.us 09 of 12

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11 Contact us To learn more about how our strategies can potentially benefit your or your clients portfolios, contact your Aberdeen representative today. U.S. Institutional Business Development aberdeen-asset.us/institutionalinvestor Canadian Institutional Business Development aberdeen-asset.ca U.S. Financial Institutions aberdeen-asset.us International Wealth Management - Americas offshore.aberdeen-asset.us IMPORTANT INFORMATION PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. 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