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No longer the wild frontier

Article - April 17, 2015

Emerging and frontier markets are shedding their image as a risky area to which investors should dedicate only a small portion of their portfolios. Robust economic growth, along with more open capital markets, are making these countries an increasingly attractive investment destination.

Not many years ago, the markets characterized as “emerging” and “frontier” were regarded as the wild west of investing — a perilous place on the outer reaches of the financial world, and not for the faint of heart. Today, these markets – particularly those in the Asia, the Middle East and Latin America — are playing an ever-greater role in the global securities industry, as investors view them as a way to spread risk and make their portfolios less vulnerable to events in the developed countries.

More than a hedge against risk, investing in emerging and frontier markets is seen as a bet on the growth of their economies, which are home to more than half of the world’s people, and already produce more than a third of global Gross Domestic Product. Although emerging markets as a whole suffered from the oil price collapse in 2014, global investors are still drawn to the most rapidly-expanding economies among them.

“High economic growth rates will remain a key attraction of many emerging markets in 2015,” Mark Mobius, Executive Chairman of Templeton Emerging Markets Group wrote on his website recently. “Even with major economies like Brazil and Russia slowing down, overall economic growth in emerging markets during 2015 is expected to be comfortably in excess of developed markets, with China and India likely to drive the Asian region to particularly strong growth.”

The IMF’s Economic Outlook for 2015 supports this view. It forsees average growth of 5% among emerging economies this year, compared to 2.3% among developed economies.

In recent years, investors have abeen anticipating this trend and adjusting their portfolios accordingly. According to iMF direct, the International Monetary Fund’s global economic forum, emerging and frontier markets represented 13% of the developed countries’ investment portfolios in 2012, up from 5% in 2002.

Emerging or frontier?

While the definitions of what constitutes an emerging or frontier market may vary, the standard for categorizing them is the Morgan Stanley Capital Indices. The MSCI today ranks 24 coun-tries as “emerging” and another 33 as “frontier” — as a function of the size and liquidity of the securities traded and the accessibility of the market to foreign investors.

When MSCI published its first emerging market index in 1988, the list contained only 10 countries and the traded compa-nies together represented only 1% of world market capitaliza-tion. Today, the indices contain over 800 securities, accounting for 11% of global market cap.

The indices are reviewed regularly and an upgrade from “frontier” to “emerging” can mark a difference in foreign in-flows. Such was the case in Qatar and the United Arab Emirates, both of which were upgraded to “emerging” status in June, 2013. Meanwhile, Saudi Arabia, despite having a $531 billion stock market, is classified as “frontier,” although that could change as it eases restrictions on foreign investment in 2015.

How to get in

Most international investors enter these markets through Exchange Traded Funds (ETFs) — funds which can be bought and sold on stock markets, and whose underlying investments consist of a basket of securities across differ-ent emerging or frontier economies. For example, the SPDR S&P Emerging Markets Dividend ETF, invests in basic materials, telecommunications, financial services and technology stock in five countries: Brazil, Thailand, Taiwan, South Africa and China.

There are also industry-specific options. Anyone optimistic about the rise of telecommunications stocks in the developing world, for example, could purchase an ETF based on the MSCI Emerging Markets Telecommunications Index.

Winners and losers

Although ETFs have made emerging and frontier markets more accessible, they still contain an inherent degree of risk from currency volatility, political instability or regulatory uncertainty — not to mention the possibility of nationalization. The motive for investing in them is simple: greater risk, greater return.

The conventional wisdom has been that these markets were a way to diversify risk, as they are decoupled from events affecting the major world econo-mies. This notion has been challenged of late, as some emerging economies have begun to move in tandem with the developed world, while frontier markets are less affected.

This occurred in 2014, which opened with a surge in emerging markets. However, the collapse of world oil prices, starting in September, was a game changer. The upshot was that oil exporters suffered and importers recovered, with the latter likely to do even better this year, provided crude prices remain weak.

A case in point is Egypt. While its Middle Eastern neighbors were reeling from the oil market debacle, Egypt, a net importer of petroleum, was benefitting from lower crude prices and from growing domestic political stabil-ity. According to the Financial Times, the Egypt was “the best destination for stock market investors in 2014,” as it yielded a total return of 30%, including dividends and increases in share prices. This compares to a 14.5% total return on stocks in the U.S., the best—perform-ing among the developed economies.

Go with the growth

However, emerging and frontier mar-kets are more than just a reflection — or not — of what happens in the developed economies. They have a growth story of their own, more often than not linked to the flowering of their economies or to policy reforms which make them more attractive investment destinations. Even more compelling is the fact that more than half the world’s population today lives in economies classified as “developing” and that their needs will produce a growing demand for goods and ser-vices over the coming decades.

McKinsey & Co. has called this phenomenon “the biggest growth op-portunity in the history of capitalism.” In a 2012 study, the global consulting firm predicted that by 2025, consumer spending in emerging markets will account for half the global total, or some $30 trillion (up from $12 trillion in 2010). Given the increasing urbanization of the populations, market—friend-ly economic policies and the removal of trade barriers, the consuming popula-tion in emerging economies will nearly double to 4.2 billion, out of a total world population estimated at 7.9 billion.

“As a result, emerging-market consumers will become the dominant force in the global economy,” McKinsey & Co. said.

The big winners in this opportunity are likely to be companies that respond to this demand: producers of consumer goods or providers of services such as construction, telecommunications and banking.

The stars: China and India

Much of this growth is expected to take place in China and India, the two leading emerging economies, where financial markets are already showing strength, even in the face of short-term disap-pointments in key indicators.

Although China’s economy grew at its slowest pace in 24 years in 2014 (7.4%), the benchmark Shanghai Shen-zen CSI 300 index closed the year with an increase of nearly 52 percent. The index rose 25% in December alone, marking its best month since April 2007.

In India, meanwhile, the $1.7 trillion equities market continued a rally — significantly, driven not by exporters but by stocks which are dependent on domestic demand, such as banks and infrastructure companies. The benchmark Sensex index rose nearly 30% in the year, its best showing since 2009. Foreign investment in Indian stocks totaled $16.2 billion, the most of any Asian market outside Japan. Investors from abroad were attracted by the political stability following the Indian elections and by optimism over forecasts for the country’s medium-term growth.

With the bull market continuing at the start of 2015, small wonder that India Exchange Traded Funds are being touted as the best among emerging markets this year.

More than a peripheral play

Besides simply acting as an alternative for global investors, securities markets in emerging and frontier economies are increasingly serving their basic function as a source of capital for local companies. Seeing that they cannot rely on banks to provide financing, entrepeneurs are turning increasingly their countries’ capital markets.

In Africa, where stock markets as a whole suffered in 2014, the number of Initial Public Offerings (IPOs) nearly doubled. The Johannesburg Stock Exchange, the continent’s stellar performer, had 23 new listings and has more in the pipeline for 2015. All told, African equity markets raised $11 billion from IPOs and follow-on proceeds, almost equal to the total of the previous two years.

The same is true of the Middle East, where the total number of IPOs in 2014 was 27, with a total value of $11.5 billion, and the best year for new listings in the region since 2008, according to global consultants Ernst & Young. The offerings included the $6 billion IPO by Saudi Arabia’s Commercial Bank, the region’s largest ever — and the second largest in the world last year after Ali Baba’s debut on the New York Stock Exchange.

With more listed companies, greater liquidity, and a wider range of choice for investors, the emerging and frontier markets are likely to account for a growing share of global investment portfolios in the years to come. As Wasatch Capital, in a report on frontier markets, put it, they represent “a vast opportunity for investors willing to do their homework and put boots on the ground”.

By Edward Holland