A Relook at Frontier Markets PERSPECTIVE FROM TEMPLETON EMERGING MARKETS GROUP

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1 Topic Paper 25 May 2017 A Relook at Frontier Markets PERSPECTIVE FROM TEMPLETON EMERGING MARKETS GROUP Mark Mobius, Ph.D. Executive Chairman Templeton Emerging Markets Group Stephen Dover, CFA EVP, Head of Equities, Franklin Templeton Investments Chief Investment Officer, Templeton Emerging Markets Carlos Hardenberg Senior Vice President, Director of Frontier Markets Strategy Templeton Emerging Markets Group Ahmed Awny, CFA, CAIA Senior Vice President, Senior Executive Director, Portfolio Manager, Franklin Templeton Investments (ME) Limited David Haglund Senior Vice President, Senior Executive Director, Portfolio Manager, Franklin Templeton Investments (ME) Limited KEY POINTS Frontier markets delivered positive returns in 2016 overall, with many of the underlying frontier economies ranking among the year s best-performing markets, and continued their good performance in the first quarter of In terms of development, we believe frontier markets are where today s emerging markets were around 30 years ago. So, for investors with a longterm investment horizon, frontier markets can provide access to attractive growth potential from a diverse universe that ranges from Africa and the Middle East to economies in Asia, Eastern Europe and Latin America. In our view, the case for the frontier-market asset class centers around: (1) expectations for robust economic growth, (2) continued macroeconomic development, supported by the ongoing reform agenda and a recovery in commodity prices, (3) the deep valuation discount it trades on compared with historical levels and relative to global and emerging-market equities, and (4) the lower correlation opportunity, as frontier markets tend to be more influenced by local market growth drivers rather than global macroeconomic developments. Summary Frontier markets delivered positive returns in 2016 overall, with the MSCI Frontier Markets Index advancing 3.2% in US-dollar (USD) terms, and many of the underlying frontier economies, including smaller emerging markets with similar economic characteristics to frontier markets, ranking among the year s bestperforming markets, as highlighted in Exhibit 1. Following on, frontier markets have continued their good performance in the first quarter of 2017, returning 9.1% (in USD terms), as a group. Despite the marked improvement in performance, we remain constructive on the frontier-market asset class over the medium to long term. Frontier markets are considered to still be in the nascent stages of development, with lower foreign investor ownership and underresearched market coverage compared with larger emerging markets. In essence, we believe frontier markets are where today s emerging markets were around 30 years ago. According to MSCI, emerging markets consisted of just 10 countries, representing less than 1% of the world market capitalization in Today, however, emerging markets consist of 23 countries, representing 11% of world market capitalization. Drawing parallels, frontier markets made up less than 1% of the world market capitalization in April So, for investors with a long-

2 Exhibit 1: Top 10 Performing Equity Markets, % in USD Terms 2 Country 2016 Country 1Q17 Brazil 69.1 Venezuela 38.4 Kazakhstan 61.4 Ukraine 31.1 Peru 60.9 Argentina 24.0 Russia 52.2 Kuwait 22.7 Pakistan 46.4 Kazakhstan 21.6 Namibia 39.2 Poland 18.0 Venezuela 36.9 South Africa 17.0 Hungary 31.0 Mexico 17.0 Morocco 28.0 Chile 16.9 Colombia 23.9 India 16.6 Source: Bloomberg. Bolded countries are frontier markets. Past performance does not guarantee future results. term investment horizon, we believe that frontier markets provide access to attractive growth potential from a diverse universe of investment opportunities that ranges from Africa and the Middle East to economies in Asia, Eastern Europe and Latin America. In fact, over the years, these markets have been going through transformations necessitated by the demand to move toward economic prosperity, and we believe these efforts should support the catch up of frontier markets with the rest of the world. The Case for Frontier Markets Frontier markets initially suffered from the immediate impact of falling commodity prices in the period, followed by a second wave of volatility in 2016 from currency devaluations and reductions in government spending. (In local currency terms, though, frontier markets returned around 9% in 2016.) However, we believe these factors have now largely played out as progress with structural reforms and a recovery in commodity prices have since provided a more supportive macroeconomic backdrop. Looking ahead, we remain optimistic on the outlook for frontier markets and believe several factors may underpin the performance of the asset class, including the high growth potential in many of the frontier markets, driven by a combination of economic data such as favorable demographics and productivity growth. We also believe frontier markets are attractively valued, with the discount to emerging markets and developed markets currently as wide as we have ever seen (see Exhibit 5). Additionally, frontier markets have significant domestic drivers that tend to lower their correlation with their more developed counterparts and provide potential diversification for investors, especially during periods of heightened global market volatility. Therefore, we believe, investors should consider an allocation to frontier markets as they offer a distinct return-risk dynamic compared to developed and emerging markets. Higher Growth Potential in Frontier Markets Frontier markets have continued to exhibit greater economic potential than their developed- and emerging-market counterparts. Even though a number of frontier economies may face occasional headwinds, expectations are that frontier markets may grow faster, especially since these economies are building from a lower base. Exhibit 2: Frontier Markets Gross Domestic Product (GDP) per Capita Income Is Low but Rising As at 31 December 2016 USD ( 000) $70 USD $2,500 $60 $50 $2,000 $40 $1,500 $30 $20 $1,000 $10 $500 $0 $0 Bangladesh Kenya Nigeria Pakistan Vietnam Source: Economist Intelligence Unit. China, Kenya, South Korea and Vietnam data for 2016 are estimates. There is no assurance that any estimate will be realized. A Relook at Frontier Markets 2

3 Exhibit 3: Frontier Economies Have a Younger Working Population As at 31 December 2015 Median Age 40 Exhibit 4: Urbanization May Spur a Growing Domestic Market As at 31 December 2015 % of Total Urban Population 90% 60% 20 30% 0 Nigeria Kenya Pakistan Bangladesh Vietnam China United States Source: United Nations (UN) Department of Economic and Social Affairs, Population Division, % Kenya Bangladesh Vietnam Pakistan Nigeria China United States Source: UN Population Division, World Urbanization Prospects, Factors that may drive and support this economic potential are: Favorable demographic and urbanization dynamics: In contrast to developed markets, most frontier markets have a higher population growth and an expanding working population, which, when combined, creates a competitive labor force that supports these economies to be the new drivers of manufacturing output globally. Case in point is Bangladesh, with a population of more than 169 million, which has developed a strong niche in world-class textile production. Bangladesh is extremely efficient, with the knowledge and skills to integrate into the global trading network. In addition, the textile industry has fairly high barriers to entry, so we expect Bangladesh to retain its leadership position in this area for the foreseeable future. More pertinent to investors, in our opinion, is the pace of urbanization in frontier markets, which, when coupled with the higher population growth and lower penetration of basic services, creates potential opportunities to tap into a growing domestic consumer market as well as for these economies to diversify and become more resilient to commodity cycles. Technological leapfrogging: Investment and infrastructure remain vital cogs for the economic engine. Through rapid advances in technology, though, frontier markets may be able to bypass economic infrastructure and benefit from efficiency gains. For example, mobile banking is revolutionizing financial services in Africa. A success story that is touted globally is a mobile phone-based service in Kenya that has a growing subscriber base and has enabled unbanked and under-banked users to have a secure means of remitting and receiving funds. Users of the system grew dramatically in the 10 years to March 2016, with a corresponding exponential growth in the value of transactions. The value of transactions passing through this system equated to around 80% of Kenya s GDP as at 31 March As a result, mobile banking has spread rapidly to many other countries globally, substantially boosting financial inclusion. Beyond banking services, mobile phones are connecting users to other sectors of the economy such as retail, education and health care, leapfrogging the need for traditional brick-and-mortar assets and linking to the burgeoning population in frontier markets. Political stabilization and ongoing reform agenda: Over the past few years, a common theme identified in emerging and frontier markets has been the push for structural reforms that support macroeconomic development. Populist policies, lower commodity prices and equity-market declines over the past few years have prompted the election of pro-growth governments and the demand for structural reforms to kick-start the economy. Across frontier markets, we can see many governments pushing ahead with reforms. A Relook at Frontier Markets 3

4 Argentina s political change has been viewed positively by many investors, encouraging considerable inflows that have boosted the equity market. Led by President Macri, the new government has already undertaken an impressive array of reforms, including floating the exchange rate and agreeing to a deal with holdout bond creditors, enabling the country to once again raise sovereign debt in international markets. Saudi Arabia has implemented several market reforms, including Vision 2030, with the aim of raising the private sector contribution to the economy, selling stakes in government entities, including its prized asset, Saudi Aramco, in order to increase non-oil revenue and cut unemployment over the coming years. In addition, the regulator, together with the stock exchange, is implementing wide market reforms in pursuit of institutionalization of the capital market, which remains very retail oriented, and targeting the development of the local asset management industry. In the past, Pakistan was often overlooked as an investment destination because of negative macroeconomic sentiment. However, Pakistan s economy and capital markets have done exceptionally well over the years, benefiting from government efforts to reach fiscal consolidation, steady progress in achieving structural reforms under the International Monetary Fund (IMF) program and ongoing support from regional partners (China announced plans to invest US$46 billion to develop infrastructure and energy projects in Pakistan as part of the Economic Corridor). In addition, inflation and interest rates have come down, driven in part by lower commodity prices. As a result, the country s economy has been growing by over 4% per annum in recent years and the improvement in transparency and liquidity in the equity market has led to international index providers such as MSCI upgrading Pakistan to emerging-market status. These positive developments in the economy coupled with the emerging-market status upgrade have provided further impetus to Pakistan s equity market, which returned 46.4% in 2016 (in USD terms). While progress has been made, the country s focus is to continue these efforts in order to maintain its growth trajectory. Additionally, investors could benefit from the development and deepening of frontier capital markets. Vietnam is a bright spot among frontier markets, with a growing export industry and a large domestic consumer market. Today, there is a long list of international companies that manufacture goods in Vietnam, including electronics, textiles and furniture. Foreign direct investment (FDI) continues to increase, with new FDI driven by multinational companies across different industries, keen to establish and expand their presence in Vietnam, taking advantage of its skilled and low-cost labor. Moreover, Vietnam s relatively steady political environment, stable currency, controlled inflation, high GDP growth and young demographic structure adds to its appeal. However, while Vietnam s economy has grown, this has not been reflective of the opportunity set in the equity market, which has been hampered by restrictions. Yet the government has announced reforms, including scrapping the 49% foreign ownership limit, which is expected to expand the depth and liquidity of the market as well as encourage further initial public offering (IPO) listings. Similarly, the government and central bank announced they would increase the foreign ownership cap to allow foreign investors to own more than 30% of a Vietnamese bank, which may attract more FDI to a new segment of the economy besides the manufacturing sector and, in general, bring more investor attention to Vietnam over the coming years. Frontier Market Valuations Are Cheaper, Providing an Attractive Entry Point for Investors Over the last few years, frontier markets have been impacted by macroeconomic headwinds including geopolitical events, sharp declines in commodity prices, currency volatility and outflows in equities, but we re now seeing signs of improving fundamentals, paired with a rebound in commodity prices, that could support the asset class s long-term performance. What s more, frontier markets continue to trade at a discount to global- and emergingmarket equities at the end of March 2017, frontier markets traded at 11.6x trailing price-to-earnings (P/E), while global A Relook at Frontier Markets 4

5 Exhibit 5: Frontier Markets Have Had Attractive Valuations Trailing P/E (x) 20 Exhibit 6: Frontier Markets Have Had Higher Dividend Yield Dividend Yield 7% 16 6% Year Average 5% 4% 8 3% 4 2% 1% 0 12/07 1/09 1/10 1/11 1/12 2/13 2/14 2/15 2/16 3/17 MSCI Frontier Markets Index MSCI Emerging Markets Index MSCI World Index Source: FactSet. Past performance does not guarantee future results. 0% 12/07 1/09 1/10 1/11 1/12 2/13 2/14 2/15 2/16 3/17 MSCI Frontier Markets Index MSCI Emerging Markets Index MSCI World Index Source: FactSet. Past performance does not guarantee future results. equities traded at 19.2x and emerging markets at 14.0x. 3 Furthermore, frontier markets are trading in line with their own historical levels and this, coupled with the momentum in earnings growth driven by domestic growth and ongoing reform could create an attractive entry point for investors, in our opinion. A number of other valuation metrics also paint an encouraging picture for frontier markets. For example, the dividend yield offered in frontier markets remains considerably higher than that in either global developed- or emerging-market equities. Frontier Markets May Offer Diversification Benefits Historically, the correlation of frontier markets with global developed equities has been low as frontier markets tend to be more influenced by local market growth drivers rather than global macroeconomic developments. Over a 10-year period, the correlation of frontier-market equities with global equities has been around 0.7 (compared with an emerging-market correlation range of ). Exhibit 7: 10-Year Correlation, in USD Terms MSCI Frontier Markets Index MSCI Emerging Markets Index MSCI World Index S&P 500 Index MSCI Frontier Markets Index 1.00 MSCI Emerging Markets Index MSCI World Index S&P 500 Index Source: Morningstar. Exhibit 8: 10-Year Correlation, in USD Terms MSCI Argentina Index MSCI Kuwait Index MSCI Morocco Index MSCI Pakistan Index MSCI Vietnam Index MSCI Argentina Index 1.00 MSCI Kuwait Index MSCI Morocco Index MSCI Pakistan Index MSCI Vietnam Index Source: Morningstar. A Relook at Frontier Markets 5

6 Additionally, individual frontier markets are relatively uncorrelated among themselves due to low levels of foreign ownership, driven more by domestic fundamentals and flows rather than international developments. This offers additional potential diversification benefits to investors when investing across frontier markets as these markets are less connected, reducing the risk of contagion. Importance of Active Management Having addressed the structural case for the asset class, we believe it is also important to discuss the passive and active approaches to frontier-market investing. For a passively managed strategy that tracks a frontier-market index, a key limitation is the index design, which generally uses market capitalization as a construction-weighting methodology, to create uneven geographic and sector concentrations. As we know, frontier markets are at various stages of capital-market development, and a marketcapitalization based weighting approach will, in our view, magnify distortions in the country and sector weight of the indexes the two largest country allocations account for around 35% of the MSCI Frontier Markets Index (as at March 2017) thereby making index-tracker funds more susceptible to market volatility. Frontier-market indexes are additionally impacted when index providers upgrade specific frontier countries to emerging-market status, creating potential imbalances in the frontier-market indexes by removing some of the more liquid markets. An active approach, on the other hand, is not constrained by an index and an active manager has the flexibility to invest in underresearched and under-owned companies. These can include offbenchmark stocks and exposure to countries that exhibit frontier characteristics. These features can include a lower GDP to capita, an earlier stage of development, a relatively limited number of securities, under-researched market coverage, under-ownership by international investors and tight liquidity. Saudi Arabia is a good example of a market where we continue to find what we view as attractive investment opportunities, despite it being off the radar of frontier-market indexes. Hence, by investing in these markets early and with a long-term view, active managers can seek to exploit the inefficiencies inherent in the frontier universe. Overall, by focusing on individual countries and companies, we believe an active approach has the potential to better determine which frontier companies may succeed over the long term and could therefore enhance risk-adjusted returns compared to a passive, index-based approach. WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a portfolio focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a portfolio that invests in a wider variety of countries, regions, industries, sectors or investments. Investing in smaller company securities that may have limited liquidity involves additional risks, such as relatively small revenues, limited product lines and small market share. IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. A Relook at Frontier Markets 6

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This is not an offer to sell or a solicitation of an offer to purchase securities in any jurisdiction where it would be illegal to do so. 1. Source: MSCI. 2. Brazil represented by Brazil Ibovespa Index. Kazakhstan represented by Kazakhstan KASE Stock Exchange. Peru represented by S&P/BVLP Peru General Index. Russia represented by Russian RTS Index. Pakistan represented by Karachi 100 Index. Namibia represented by Namibia Overall Index. Venezuela represented by Venezuela Stock Market Index. Hungary represented by Budapest Stock Exchange Index. Morocco represented by MASI Free Float Index. Colombia represented by Colombia COLCAP Index. Ukraine represented by Ukrainian Equities Index. Argentina represented by Argentina Merval Index. Kuwait represented by Kuwait Stock Exchange Price Index. Poland represented by WIG 20. South Africa represented by JSE Market Index. Mexico represented by Mexico IPC Index. Chile represented by Chile Stock Market Select. India represented by S&P BSE Sensec Index. 3. Source: FactSet. Frontier markets as represented by the MSCI Frontier Markets Index, global equities as represented by the MSCI World Index and emerging markets as represented by the MSCI Emerging Markets Index. CFA and Chartered Financial Analyst are trademarks owned by CFA Institute. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at Please visit to be directed to your local Franklin Templeton website. franklintempletoninstitutonal.com. Copyright 2017 Franklin Templeton Investments. All rights reserved. 5/17