Why Frontier Markets Hold Promise, with an Asterisk
Political unrest still can upend otherwise impressive growth in places like Kenya and Sri Lanka.
Art by Melinda Beck
Far-away places with strange-sounding names, many you barely know. That embodies frontier markets, the little brothers and sisters of emerging markets like India. And boy, frontier countries can be risky. The potential payoff, though, may be large for patient investors. Especially if a frontier nation gets promoted to emerging market status.
How well can they do? Consider Vietnam, whose market rose 9.8% annually in the decade through 2018. That includes a 48% increase in 2017 and also a 27% slide in 2011. For comparison, the S&P 500, the signal benchmark for the world’s most powerful economy, was up 11.8% yearly over that period. Vietnam’s market appreciation was within hailing distance of the premier American index. Not too shabby.
When you match up all 21 frontier nations (as determined by MSCI, the world’s largest index provider) with the US’s stock performance, the S&P 500 does better. That’s no big surprise: During the recovery from the Great Recession, American economic growth and hence share price increases have overshadowed those of most other places. During the past five years, the S&P 500 has advanced 10.7% yearly, compared to minus 1.2% for the frontier index. (MSCI began its frontier index nine years ago, so there is no 10-year performance available.)
The picture is more mixed when it comes to emerging markets, which were up 5% annually over five years, besting frontier markets. As slowdowns vexed many developing economies world-wide this year, however, the EMs have eked out a 1.9% showing, compared to 10.5% for frontier stocks.
Definitions for frontier markets differ, although MSCI’s is the most widely accepted. MSCI, formerly known as Morgan Stanley Capital International before the investment bank spun it off in 2009, requires that its frontier nations have at least two companies worth around $800 million each. They also must be at least partially open to foreign investments and business ownership. “The index is trying to juggle wealth and the ability to access capital,” said Phil Torres, global co-head of emerging markets for Aegon Asset Management.
An advantage for frontier markets is that they are usually uncorrelated to the rest of the world, although large geopolitical forces, such as the US-China trade war, can have an impact. Because their governments often get hit by internal turmoil, they can encounter sudden selloffs. Sri Lanka’s main stock index dropped 10% last fall after a constitutional crisis—the president fired the prime minister and installed a crony in his place.
The difference between frontier markets and their emerging counterparts is stark, vis-a-vis market valuation. Taking total market cap, frontier markets are $715 billion, while emerging markets are $20 trillion. Yes, EMs are more than 20 times these fledgling markets.
Frontier nations range from Southeast Asia to Africa, the Middle East, and eastern Europe. Most of these countries have large impoverished populations. Their per-capita gross domestic product tends to be on the low side, such as Bangladesh’s $1,698, although eastern European members are much higher, like Romania’s $12,301, the World Bank found. In terms of economic growth, they make the West look like plodders. Bangladesh, for instance, grew 7.9% in 2018.
While frontier nations usually strive to be upgraded to EM status, which gives them greater access to investment from the developed world, that promotion can carry some penalties. Pakistan was elevated to the EM level in 2017 but ran into a selloff by foreign investors in the next year amid a mounting debt crisis: Seeking to elevate its shoddy infrastructure and expand its economic offerings beyond rice and textiles, Pakistan borrowed heavily from China. Recently, it took a $6 billion International Monetary Fund bailout.
Kuwait, the largest member of the MSCI frontier index, is the latest frontier nation to be selected for a climb to EM status. With its solid banking sector, low debt levels, and ample financial reserves, the oil -rich emirate already is a power on the Arabian Peninsula. It will make the move to the EM index next year.
Several frontier nations illustrate the promise, and sometimes the worries, that accompany frontier in them:
Bangladesh. The creation of this country after British rule ended was fraught. Pakistan, which also is a Muslim nation and a much larger one, initially controlled Bangladesh, and bloody fighting broke out. Widespread massacres in the early 1970s provoked international dismay. After that came a long spell of authoritarian rule, with periodic coups. Finally, in the 1990s, Bangladesh set up a representative government system.
This is a fast-growing economy, up 7.9% last year, with textiles, steel-making, and shipbuilding as major industries. China and India’s economic expansions have benefited Bangladesh. The soil is enormously fertile, with the Ganges River providing water supply, and agriculture the biggest employer. The nation also has the prospect of developing a thriving energy industry, with large natural gas reserves found offshore in the Bay of Bengal.
Sri Lanka. It’s a tribute to this Asian island nation that it resolved its political crisis after its top court ruled against President Maithripala Sirisena’s ouster of the prime minister. The nation’s 27-year civil war ended 10 years before, but the recent fracas was a reminder that the rule of law can be fragile in frontier countries. Commendably, it prevailed in Sri Lanka. Perhaps as a result of the troubles, though, GDP growth last year only came in at 3.2%, down from over 5%.
With the aid of the Chinese, Sri Lanka is busily improving its port facilities and has become a tourist destination from elsewhere in Asia. When the one-time British colony, then called Ceylon, won its independence, it embarked on a three-decade experiment with socialism, ending in 1977 as it turned to the free market. In 2016, its mounting debt resulted in an IMF rescue. Booming India, just off its coast, is its major trading partner.
Vietnam. This is a land where the American military was embroiled in a vicious war in the 1960s and early 1970s, whose communist-controlled north the US Air Force chief of staff, General Curtis LeMay, pledged to “bomb back into the Stone Age.” Despite the US’s might, North Vietnamese forces conquered US-allied South Vietnam and imposed strict Marxist rule.
Like China, its giant neighbor to the north, Vietnam has transitioned from an agrarian economy overseen by central planners to a mixed economy, with capitalism encouraged. Unlike China, Vietnam welcomes lots of foreign investment. The results have been spectacular, as the nation has become a global manufacturing and export powerhouse. Exports account for a stunning 40% of GDP. With its proximity to China and lower wage base, Vietnam has attracted manufacturing operations that used to be the province of the Chinese. Vietnamese workers are paid half the going wage in China, but they are 30% less productive than the Chinese, said Charlie Wilson, a portfolio manager at Thornburg Investment Management. Still, over time, Vietnam’s productivity will improve, he added.
Vietnamese exports continue to be strong this year, despite diminished global growth, according to a consensus of economists, as compiled by Focus Economics. Referring to foreign direct investment, the groups recent report marveled that during “the year to September, the value of new FDI projects rose 22% year-on-year, likely supported by trade diversion thanks to the U.S.-China trade spat.”
With GDP growth at 7.1% last year, and only slightly slower expansion expected for 2019 and 2020, Vietnam has also sported good stock gains, albeit with some hiccups. This year, its market is up 13%.
Kenya. The modern world came early to Kenya, which boasts a thriving tech industry and an energetic start-up culture. Two-thirds of the country has internet access. With the largest and most advanced economy in east and central Africa, it has developed a diversity of industries, including an extensive financial services sector. GDP rose 6.3% last year. “This is a stable and robust economy,” Aegon’s Torres said. “It’s a country to be optimistic about.”
Kenya has had its share of political problems, with a 2017 presidential election that had to be run twice, provoking street violence. The election ended with Uhuru Kenyatta, the son of the nation’s first president (Jomo Kenyatta), winning a second term. During the tumult, economic growth ebbed, although it has recovered since. Kenya also struggles with trying to end its endemic corruption.
Romania. The home of Dracula is now a fast-growing economy, with more than 70 industrial parks, a well-educated workforce, and prodigious outside money coming in. Its shift from communism to capitalism and its membership in NATO signify how much it has broken from its past under the thumb of dictator Nicolae Ceaușescu.
With a 4.1% growth rate last year, Romania has benefited well from its European Union membership. Once a backwater part of the Soviet bloc, it has developed strong middle-and upper-classes, who have sparked a humming consumer economy. Bucharest, the capital city, is now a financial center, and its vibrant manufacturing base churns out autos, chemicals, machinery, and electronics. It is also a significant oil and gas producer.
Romania also has become a tourist destination for the rest of Europe. Bran Castle is advertised as Dracula’s residence. Unlike the un-dead count, Romania has a lower tolerance for sucking the lifeblood out of its citizens: In 2005, the government replaced Romania’s progressive tax with a 16% flat tax, among one of the lowest rates in the EU. This has helped spur its economy, as well.
Once upon a time, the western half of the US was the frontier. That didn’t turn out too badly for Americans. Investors who proceed with due caution in what was once called the Third World may find themselves similarly rewarded.
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