Emerging markets: New frontier hands Brics a blow

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Frontier markets may not lend themselves to an easy acronym. But they deserve plenty of attention from the world’s emerging market investors.

Nigeria’s population will reach 900 million by the end of this century, according to UN forecasts. It will be only 20% smaller than China: although today the population of China is more than six times bigger than Nigeria’s.

Deutsche Bank analysts question the assumptions on fertility rates underlying these. But what if the UN is right?

Maybe frontier markets can take the place such economies as Brazil, Russia, India and China held during the past two decades, as growth decelerates and investors tire of the Brics.

GDP growth in countries now classed as emerging markets, according to Citi, will peak in this decade at 5.1%, while growth in countries now seen as frontier markets will peak in the next decade, at 6.4%.

Emerging market funds have suffered $35 billion in outflows since March. However, far from being even more fearful of frontier markets and shying away from them, investors are turning to them to replace the growth they see tapering away from bigger emerging markets.

Assets in dedicated frontier market funds have risen by 40% over the past year, according to EPFR figures quoted by Citi. Average daily equity trading volumes in frontier markets over the past three months were more than double volumes in December 2012.

In the year to end August, the MSCI Frontier Markets Index was up 15%, compared with an 11% drop in MSCI’s key Emerging Markets Index. Debut sovereign bonds are expected from Kenya, Mozambique and Tanzania this autumn as fixed-income markets ripen too.

Decelerating Chinese demand for raw materials adversely affects sectors on which these markets have historically relied quite heavily.

But if China moves to a model that is less oriented to exports, frontier markets might be able to build more value-added manufacturing industries.

Moreover, there are internal drivers. More difficult financing conditions mean that in some frontier markets there have been greater foreign pressures for reform. More confidence in Africa’s elites also means fewer internal obstacles to investor-friendly reform.

Frontier-market funds are only about 2% of the size of emerging market funds, and about 0.2% the size of developed market funds. But in some ways, these markets’ underdevelopment means they have more scope to grow in investors’ allocations.

Banking-sector penetration, particularly in retail, tends to be lower (in Nigeria especially). The establishment of credit bureau, and improvements in transport, education and local capital market infrastructure, all hold vast opportunity.

Frontier markets are classified as such without regard to differing demographics, levels of personal income and education, and regional trading partners. Hence Ukraine, Nigeria, Kuwait, Lebanon, and Vietnam, for example, present vastly differing advantages and challenges.

However, they do share equity markets whose characteristics mirror wider non-western idiosyncrasies in their institutions of capitalism. This can generate idiosyncratic uncorrelated busts – and uncorrelated recoveries – but also governance that outsiders find hard to understand and predict.

Rapid population growth also poses risks as well as benefits, although government reaction to protests in countries such as Turkey – previously highly valued for relative political stability – means political risks in frontier markets seem less unusual.

It remains to be seen whether this year’s upsurge in enthusiasm for frontier markets will give way to longer-term aversion (as happened, to a degree, in 2008).

The small range of investible assets heightens the danger of bubble stocks. In the longer term, however, frontier markets still deserve much greater attention from investors – by their very nature as frontiers.