Frontier markets – no extra growth to compensate for added risk
Given the consensus that China and other emerging economies will be the drivers of global growth, investors are likely to look toward smaller, new emerging areas, generally described as ‘frontier markets’, for the next trend. While our own upbeat outlook for emerging economies has positive implications for frontier markets, they lack many of the strengths that characterise the emerging markets of the 1990s. Emerging countries, having weathered the crises of that period, embarked on investments and reforms that underpin their economic growth prospects and financial stability today.
Frontier markets will benefit from our expectations for a continuing emerging-economy led global economic recovery, which will drive demand for commodities. With growth remaining patchy in the debt-burdened developed markets, investors looking for growth are likely to move into those markets which are linked to the growth nexus of emerging economies and those sectors which supply needed raw materials and services. Frontier markets fall within this broad category and are likely to see considerable investment flows as interest rates in the developed economies remain at rock-bottom levels through 2011. Growth opportunities, yields and even currencies look attractive, while frontier equity markets have lagged the main emerging-market indices.
However, country-specific risks are high in frontier markets. The largest geographical segment is the Gulf region, where energy-dominated economies dominate and the financial crisis in Dubai continues to cast a shadow. Similarly, political risks remain high in frontier markets, with a significant proportion of these countries experiencing political violence or armed insurgencies in recent years. However, these issues should not be overplayed – half of the frontier markets have a sovereign credit rating of above the investment grade standard, highlighting the individual strengths of countries within this diverse group.
In the final analysis we would focus on equity valuations, which in aggregate are in line with the global and emerging-market averages. The underperformance of frontier markets is linked to a weaker earnings recovery. This suggests that the additional risks associated with frontier markets as a whole are not compensated by a better potential valuation or growth outlook compared with the better-established emerging markets. However, we would still anticipate positive, albeit volatile, absolute returns.
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