Investors tread in explorers’ footsteps

IFR IMF/World Bank Report 2014
10 min read

After being hammered in 2013, emerging markets have seen investor appetite slip through their fingers and land on less familiar but excitable frontier markets. The latter’s fan base, a cross-section ranging from risk-loving individuals to conservative wealth funds, expects them to shine again in the year ahead.

The past year has seen frontier markets come of age as investors plough money into markets from Argentina to Nigeria to Vietnam, desperate for returns in the low to mid-teens. No single band of people better personify the contrarian human desire to overpower, tame and label than the explorer. From Magellan to Cook to Amundsen, history is littered with the brave and foolhardy, enduring the worst of the planet’s elements, then rushing home, like eager schoolboys, to give the rivers, mountains and gulfs of their conquered lands a name.

So it is with the investing world. The more adventurous funds love risk – or, more precisely, love the yield that accompanies it. And in our oppressively low-yield world, risk often only exists in genuine quantities in securities and markets far from the home of the archetypal investor, in the wilder and woollier reaches of Africa, the Middle East, Asia, and emerging Europe.

In time, investors have found ways to corral their tagging-and-labelling fixation. First, they created the emerging market asset class, covering everyone from South Koreans to Russians to Brazilians. Dissatisfied with their work, they spawned a second asset class, spanning the world’s wilder and woollier frontier-market states, typically those offering higher growth and yields.

The past year has seen many of those frontier markets come of age. Investors are ploughing money into markets from Argentina to Nigeria to Vietnam like never before, desperate for returns in the low to mid-teens.

In the first eight months of 2014, global investors pumped US$2.2bn into frontier markets, according to data provider EPFR. Even the most obdurately conservative investors have become believers. In June, Norway’s US$886bn sovereign wealth fund added frontier markets to its portfolio.

Oddly, the waxing of frontier markets has coincided with a waning global appetite for emerging market securities. Marcus Svedberg, chief economist at East Capital, points to a “curious” recent phenomenon wherein emerging markets have, since mid-2013, “underperformed, while frontier markets did quite well”.

Capital usually trickles through emerging markets and on into frontier markets, but in recent quarters, the former have been bypassed almost entirely, a situation Svedberg said was “actually rather strange”.

Data bear this out. Foreign funds withdrew US$720m from emerging markets in the first eight months of the year, according to EPFR. And while the MSCI Frontier Markets Index gained 17% in the year to August 22, the MSCI Emerging Markets index rose by 10%, and MSCI World benchmark by just 5%.

In part, that divergence can be explained by last year’s “taper tantrum”. When former Federal Reserve chairman Ben Bernanke in May 2013 announced his intention slowly to reduce the Fed’s pace of bond-buying in response to firming market conditions, he sparked a mass sell-off in emerging market securities.

That led to the creation of another investor-labelled box filled with the so-called “fragile five”, a diverse group of nations from Brazil to Indonesia. All had large current account deficits and were deemed to be overly dependent on external financing. Global funds fled the likes of India and Turkey, economies accustomed to a certain level of global investor adulation, yet now viewed as inherently risky, offering slowing growth, political uncertainty, and currency volatility.

Keen to reallocate capital to markets offering higher yields and returns, many funds opted to plough a new furrow in frontier markets. To their surprise, they discovered that the asset class offered not added danger but a “relatively benign risk-aversion environment”, said Benoit Anne, head of emerging markets strategy at Societe Generale. This was in large part due to the protection afforded by the markets’ relative isolation.

Small is beautiful

Small in this scenario is beautiful. Nigeria’s stock exchange may be large in African terms, and Nigerian securities may account for one-fifth of the MSCI Frontier index. But the country comprises a tiny sliver of the global capital markets. Only battle-hardened funds have in the past bought the west African nation’s debt or currency, so there is less to sell when the far larger emerging-market asset class takes a bath.

That frontier states are “less correlated and connected to global factors”, said SG’s Anne, helps rather than hinders their development. That works at all levels and across all regions. In illiquid African markets, focused to a great extent on inward foreign direct investment, the lack of dependence on portfolio capital “has shielded it from the worst conditions” roiling leading emerging markets, said Angus Downie, head of economic research at pan-African lender Ecobank.

“Islamic finance is a very exciting area of fixed income. I was intrigued by Senegal’s move, and I’m looking forward to seeing which other countries [in Africa] follow suit”

Benevolent conditions have also facilitated a series of well-received bond sales. In the year to August 22, frontier market sovereigns issued US$143.7bn in fresh debt, according to data from Thomson Reuters, against US$129.6bn over the same period a year ago. In July 2014, less than four years after defaulting on its debt, Cote d’Ivoire returned to the capital markets with a US$750m, 10-year bond issue with a yield of 5.625%. In April 2014, Pakistan, which agreed last year to a US$5.5bn IMF bailout, sold US$2bn worth of US dollar-denominated bonds, its first international sale in seven years.

Hotbed of innovation

Africa is also proving to be an unlikely hotbed of innovation. In June, Senegal became the first Sub-Saharan African state to issue sovereign sukuk, raising CFA Fr100bn (US$200m).

In late August, South Africa announced its intention to become the second non-Muslim country (after the UK) to issue a Sharia-compliant sovereign bond. The move boosts the prospects for Islamic finance in a continent with at least 400m practising Muslims.

“Islamic finance is a very exciting area of fixed income,” said Robert Hersov, chairman of London-based advisory firm Invest Africa. “I was intrigued by Senegal’s move, and I’m looking forward to seeing which other countries [in Africa] follow suit.”

Not all frontier markets are cut from the same cloth, of course. Some markets – Malawi, Mozambique in Africa, say, or Myanmar in Indochina – are more “pre-emerging” than frontier states, and are likely to remain that way for a good few years. They typically lack a diverse economic base and are heavily reliant on benevolent weather and strong commodity prices.

But other frontier states are increasingly beloved of investors: take, for example, the Republic of Rwanda, which plans to launch its second international bond offering in 2015, raising up to US$1bn in order to finance the construction of an airport and power plants. In May, the International Finance Corporation launched the first international issue in Rwanda’s local debt markets, raising RFr15bn (US$21.7bn) at a yield of 12.25%.

Of course, yield isn’t everything. Investors covet it, but not when it comes at a dangerous price. They also seek out debt issued by central banks with the tools to provide currency stability, and the ability to “intervene in foreign exchange markets to boost stability”, said Anne. Nor has political stability gone out of fashion. Anne points to the “upsurge in investor activity in Egypt, a country that is actually turning itself around after some challenging times”.

Africa is a mixed bag, offering fast growth and a strong consumption story but also power and infrastructure deficits and, in the continent’s western reaches, uncertainty surrounding the Ebola outbreak.

Ghana’s troubles – rising public debt; yawning fiscal deficit – have shocked some investors, though its willingness to engage with the IMF in order to work through its problems is heartening. (See “Africa”.)

Hersov highlights the potential of Kenya, Cote D’Ivoire and also the Democratic Republic of the Congo, which boasts, he said, a “strong group of rising political stars … trained on the benefits of liberal democracy and capitalism”.

He adds that while Nigeria remains “on everyone’s hot list”, a country with confidence and a rising middle class still needs to “strip out corruption and cronies, and realise its potential”.

In emerging Europe, East Capital’s Svedberg points to huge potential in Serbia, a country that boasts, he said, “one of the most reformist governments I’ve ever come across”. He also singles out Slovenia, Estonia, Latvia and Bulgaria as countries likely to benefit directly from a eurozone-wide QE programme currently being considered by the European Central Bank.

The past year has been a curious one for the developing world. Emerging markets once favoured by global investors have lost some of their lustre, while frontier markets finally had their day in the sun. A growing army of institutions, from risk-loving investors to the world’s most conservative national wealth funds, expect them to continue to shine in the year ahead.

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Investors tread in explorers’ footsteps