Frontier Markets Semi-Annual Outlook
FM: More than a Trump Card
Growth in frontier markets (FM) is likely to accelerate this year, aided in some cases by a recovery in commodity prices. As a crude approximation, the IMF is projecting growth in low-income developing countries to rise by one percentage point from 2016 to 4.7% yoy this year. Reformist countries are expected to return to growth after painful, but necessary reforms last year (e.g. Argentina), while others that have progressed further with this agenda are likely to be aided by a strong pickup in investment (e.g. Morocco, Pakistan). Meanwhile, at the other end of the spectrum, countries that have impediments to reform could also post better growth amid higher commodity prices (e.g. Kuwait, Nigeria), but we view these recoveries as fundamentally unsustainable absent supportive policies.
Meanwhile, the risk from a more protectionist America under President Donald Trump varies across FM and for many, exposure to the US via exports is not large. In some cases, China is a more important export market (see chart 1), which bodes well given that China’s expansionist view on trade. Longer-term a more protectionist stance from America could reduce foreign investment into FM. This is important since the savings ratio in frontier is not high (estimated by Credit Suisse to be 20%, compared to 36% for EM). Given the early stage of development of FM economies and the consequent need for investment, this leaves these countries reliant on inward FDI. However, even here, the US is not a major contributor. Instead, it is the EU that is the largest contributor to FDI, accounting for around half of the total, even in FMs outside Europe. Thus, disintegration of the EU is a greater risk to FM than the Trump administration’s policies. While the former risk could rise after key elections in the Netherlands, France and Germany this year, we view a breakup as still unlikely given the strong political and institutional will to hold it together.
Private sector leverage remains low in FM and is something that could become a key growth driver as it relates to increased investment, employment and economic growth. Private credit, currently 38% of GDP, has yet to recover to its 2010 high of 41% and is far below the average EM (107%), with some FMs (Argentina, Pakistan and Nigeria) less than 15%. Moreover, many countries have banks with low levels of leverage, with a loan to deposit ratio of 79% against 87% for EM and so, less balance sheet constraint. However, while credit supply might not be a limiting factor, demand can be. Private sector credit demand can be hampered by costs and risks outside that of interest rates which could make projects financially unfeasible (e.g. costs associated with corruption). In addition, lack of participation in the formal economy would make access to formal credit very difficult. Some countries are pushing forward with private-public partnerships (PPP), which should encourage private sector participation in the formal sector. Countries that can leverage this advantage to value-added activities could raise the economy’s growth potential.
Although external factors matter for FM, domestic policies are likely to be just as important for growth trajectories. For example, improvements in competitiveness in FM are required to move towards the EM level. As the Asian model has shown over the past 20 years, creating a manufacturing export base is a way of alleviating poverty, raising living standards and creating a strong middle class.
Chart 1: FM Exposure to US and China (% of GDP)
Strategy: More of the Same
Given the politically charged atmosphere globally and increasingly protectionist rhetoric espoused by global (and potential) leaders, it is tempting to view FM as vulnerable. However, fundamentals suggest otherwise. Moreover, the performance of FM since Trump’s election victory has been superior to that of both emerging and developed equities. FM outperformed by 5.9% and 0.7%, respectively, through end-January. Valuations for the asset class are not cheap, with the P/E of 14x at a post-crisis high. However, we believe this is counterbalanced by improving fundamentals, generally low exposure to a protectionist US and an attractive dividend yield (4%), all of which should support continued healthy returns.
This is not to say that there no risks, as illustrated by countries that are slow to reform, but more that frontier economies are generally progressing and this is being reflected in market performance. We view reformist countries favourably, expecting a greater degree of shelter in an increasingly volatile environment. For these reasons, our allocation is broadly unchanged from August. We keep Morocco and Argentina as core overweights given reformist governments, whereas we stay underweight Kuwait, Kenya and Nigeria amid ongoing political risks.
With a potentially increasing home bias among global investors, it is arguably now more important for FM economies to distinguish themselves from others. Those that, for example, set up economic free zones and make it easier to do business are likely to be key beneficiaries of financial flows and to post superior investment performance.
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