As more mainstream emerging market (EM) economies continue their path towards a developed classification, global investors are starting to explore the potential of less established markets. Here, investment specialists from Newton Investment Management, Insight Investment and BNY Mellon Asset Management North America (AMNA) consider the potential risk and reward these emergent emerging markets present, as well as their development needs and accessibility.
From an investment perspective, what is your favorite emergent emerging market (sometimes called “frontier” markets) and why? Is the universe of these markets growing?
McDonagh: There are a number of markets which, in our view, offer compelling value. Firstly, the banking sector in Nigeria. Non-performing loans should peak as the economy strengthens and capital levels are robust. Secondly, Kazakhstan’s sovereign debt. Moody’s recently upgraded the country to a “stable” outlook, and we believe that production from the Kashagan oil field will underpin government revenues in the medium term, even if technical difficulties have caused some short-term delays.
Finally, we like sovereign debt issued by the Ivory Coast, where economic growth is expected to recover sharply in 2017 and we believe market pricing already reflects the effect of lower cocoa prices on government revenues.
The universe is growing, which is likely to deliver further opportunities to active managers. This year alone has seen a number of large deals from countries such as Lebanon, Nigeria and Romania—all of which have seen strong demand.
Marshall-Lee: We have kept an eye on Nigeria for several years but are still waiting for its currency and economy to correct before we seriously consider taking any exposure. Unfortunately, corruption is widespread within the country and recent uncertainty over the leadership of the Central Bank of Nigeria has not helped underpin confidence in the market. Beyond that, though, there are some good companies in Nigeria. The country also has strong demographics, low credit penetration and entrepreneurial people, so we believe there will be serious investment opportunities there in the future.
Garcia Zamora: Uruguay has fostered a very strong structure for growth, especially given the various regional crises it has faced, such as Argentina’s default in 2001 and regional hyperinflation. The economy has surged since last year’s recession. Uruguay has shown a commitment to fiscal discipline. Despite relying upon fiscal stimulus last year, which some countries become dependent upon after emerging from recession, Uruguay’s government has shown a commitment to cutting back spending and moving toward a more balanced budget. Uruguay also has incredibly high levels of foreign exchange reserves and it expects to earn quite a bit from interest payments on the foreign debt they hold. Additionally, inflation has slowed at an unexpectedly positive rate. This has helped Uruguay’s local currency and its efforts to build a local yield curve.
From a geopolitical, economic and financial perspective, what do these countries need to do to move into a mainstream emerging classification?
Marshall-Lee: There is a large divergence across the emergent emerging or frontier markets, though many are still basically commodity-led economies and market classification is not simply based on how much GDP per capita any country generates. Other factors, such as governance and capital market development, are also very important and market liquidity levels must also be taken into consideration. Many of the emergent emerging economies are making progress in these areas but more can and will need to be done to improve their infrastructure and political frameworks before they can become attractive investment propositions.
McDonagh: Develop, reform and diversify. Frontier markets are countries which are at an early stage of development, often with a high proportion of state involvement in their economies and economic concentration towards a single sector or trading partner. Liberalization and improving property laws will attract private capital and can lead to rapid economic growth. Where there is an overreliance on a single economic driver, such as commodities, then investing in infrastructure and broadening the depth of the economy can reduce economic risks.
Over time, rising wealth levels and deepening capital markets will see the country shift towards a mainstream classification. Strong, stable government is also critical and is needed to help ensure that rising wealth does not lead to corruption, or cause social unrest if income inequalities grow.
Garcia Zamora: By way of example, take Uruguay. We believe it needs to lower its high rate of dollarization (the process of aligning a country’s currency with the U.S. dollar), which reduces the efficiency of its monetary policy, though this should be remedied in part by the slower rate of inflation.
Despite our general optimism about Uruguay, we have held it to a solid BBB- rating. This is primarily because of its high debt-to-GDP ratio, which is currently at 59%; 40% of that debt is held in foreign exchange. The debt stock remains too high, preventing an upgrade in the foreseeable future unless the government makes meaningful progress in reducing it. Uruguay also remains highly dependent on commodities, namely agricultural goods.
What are the investment risk/reward levels in being exposed to these types of economies and how do these compare with more established emerging markets?
Marshall-Lee: These markets do not always offer both higher risk and, ultimately, higher rewards. From a risk perspective, many of these markets were historically driven by commodities and the long bull run in that sector, driven by Chinese demand, looks unlikely to repeat itself. The direction of travel of politics and governance are also important in any EM country.
Interestingly, even some of the more established emerging markets have shown signs of regression in recent months. In our view, from a governance perspective, Turkey, Poland and Hungary have all been traveling backwards. Greece, which lost its developed market status in 2013, has also been one of the worst-performing emerging markets, which underscores the point that reward doesn’t always correlate with risk.
McDonagh: Frontier markets tend to be countries developing very rapidly from a low income base. Political reforms and economic liberalization can lead to high levels of economic growth and, as underlying fundamentals improve, potentially high returns. A smaller investor base can also lead to valuation anomalies, presenting opportunities, which would be more rapidly exploited in mainstream markets. The risks come from lower liquidity, greater political risk and more concentrated economies which can be more vulnerable to changes in the external environment.
Frontier markets will generally have low credit ratings relative to mainstream emerging markets and only a limited number of bonds in issue. Careful analysis is needed to pinpoint how to best extract higher returns while minimizing the associated risks to an investment portfolio.
Garcia Zamora: Frontier markets have different return drivers than EMs and good sovereign analysis can still uncover opportunities for compelling returns.
Frontier economies may offer fixed income investors an opportunity for high carry, potential capital gains and reduced correlation to U.S. Treasury moves, albeit with idiosyncratic risks. Those whose creditworthiness is improving provide an alternative to established emerging markets, such as Chile and Hungary, which are approaching graduation to developed market status and are highly correlated with U.S. Treasury moves and investor risk sentiment.