Frontier Markets Semi-Annual Outlook

Tighter Times Ahead

Frontier markets (FM) have benefited from the favourable backdrop of ultra-loose monetary policy and easy financial conditions in the past few years. Financing costs for many countries have fallen significantly since the global financial crisis. This has enabled many countries, with sound fundamentals or otherwise, to fund debt at favourable rates and thereby post healthy growth.

However, with a more hawkish stance by the major central banks, there is a significant risk that funding costs move up sharply in the next 6-12 months. This is likely to leave those countries with a substantial debt stock and/or refinancing needs particularly vulnerable. At worst, global tightening could lead to macroeconomic instability, but FM countries that fit into this category are more the exception than the rule. As a result, we expect tightening conditions to impact some FMs, but the vast majority should continue to benefit from favourable domestic and external demand conditions.

Overall, balance sheet dynamics are healthy. The spectrum in FM ranges from those with large current account surpluses and foreign assets, such as Kuwait, to those with widening twin deficits (Kenya, Romania) and high financing needs (Nigeria). Many countries, including Kenya, are posting wider current account deficits as infrastructure build out requires increased imports, while others have witnessed a rise in foreign investment in an attempt to ramp up production, as has been the case in Vietnam’s electronics sector.

Meanwhile, political risk in FM is higher than it was six months ago. This ranges from the contested election in Kenya in August to upcoming mid-term elections in Argentina, which will be a key test for the Macri administration and its ability to progress with its reform agenda. In Nigeria, the absence of President Buhari for over two months, as he received medical treatment in London for a second time this year, casts doubt over his ability to continue in the role and raises the possibility of a political struggle between northern and southern politicians. A positive here is that the country has implemented policies in his absence and economic conditions have improved. Conversely, the smooth transition of power in Pakistan, where PM Sharif resigned after a Supreme Court ruling against him was upheld, and Romania, where delays in implementing policy led to the dismissal of PM Grindeanu, demonstrate the strength of these democracies and accountability of their leaders. This bodes well for governance over the medium-term.

We continue to favour reform-centric countries and those that are implementing policies in line with economic orthodoxy. These countries are increasing in number in FM, with Argentina the most high-profile. However, other countries are also moving towards a market-based economic model, including Morocco which has made changes to its FX regime as part of a move towards floatation of the dirham. Nigeria also established an ‘Investor and Exporter FX window’ to improve FX liquidity and the subsequent alignment of the ‘Nafex’ rate and the interbank rate is a step towards unifying the country’s multiple FX rates.

Market Strategy

We expect FM as a whole to prove resilient in the face of tighter global financial conditions. Part of this is due to robust economic fundamentals as the majority of the index does not have a high vulnerability to rising rates. At the same time, valuations are unchallenging, with the FM P/E discount to emerging markets (EM) around its long–term average (see Chart 1).

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