James Johnstone
Across the frontier and smaller emerging markets, equity valuations are cheap relative to history. There are some risks emanating from the global macro picture, but the uncorrelated and secular growth opportunities in frontier markets should drive equity returns over the medium term.
The deflationary fears in the global economy combined with low interest rates actually assist in the economic reform process in many frontier markets which historically struggled with high levels of inflation. As global forces keep exogenous input prices low (e.g. oil, food), governments are able to implement structural reforms in a relatively low nominal and real interest rate environment which results in nominal GDP growth rates far higher than experienced elsewhere (e.g. Pakistan/Kenya/Bangladesh with +8 to +12% nominal growth rates).
The strength of the US dollar over the last seven years is also abating and this should ease the pressure on global emerging markets’ economies – as well as on commodity prices. In particular we believe that oil supply will become increasingly constrained due to the significant price decline of the last 18 months and we expect oil prices to recover over the next year. This will support a recovery in the hydrocarbon economies (e.g. GCC, Nigeria, Kazakhstan), but will not jeopardize the growth in the light manufacturing economies of frontier Asia, Africa and Europe.
The challenges and opportunities in frontier economies remain linked to:
- an economic growth story that is relatively insulated from global factors,
- structural reform being underway,
- improving regional security, and
- companies having little reliance on unsustainable subsidies and are broadly aligned with their minority shareholders.
Pakistan comes the closest to meeting all these criteria, with the China Pakistan Economic Corridor (CPEC), a growing counter-militancy and anticorruption drive, an India détente, private sector-driven corporates and an additional boost from a potential MSCI EM upgrade. Other examples include Bangladesh, Vietnam, Kenya, Romania and Argentina.
The theme of consumer growth remains an interesting opportunity in the frontier market landscape. As the world has seen repeatedly in many emerging markets over the last three decades, there is a remarkable and repeated pattern of consumption growth as populations move from an agrarian, subsistence existence towards a light-manufacturing, educated, urban lifestyle. Labour wage arbitrage attracts investment in early-stage emerging markets in job-intensive industries, such as textiles, and this in turn increases employment, which itself drives higher disposable income among a larger workforce.
People all over the emerging world with more money to spend then want to consume the same things as workers do in developed markets. If you wear it, wash with it, eat or drink it, you immediately want more of it and of a better quality as your income increases. Similarly parents then want a better education for their children and higher levels of healthcare. Cars and household appliances become attainable goals especially with the growth of credit advances and ultimately household formation leads to increased demand for better-quality properties and homes. Overall, it is highly likely that the advance of consumption trends in frontier markets will be remarkably similar to those of the emerging markets: so growth in Pakistan as it was in Malaysia and in Romania as it was in Poland.
James Johnstone is portfolio manager, frontier market equity strategies at RWC
