Caution towards risky frontier markets perfectly justified
Frontier markets (FMs) have proved to be a lucrative investment over the past three years.
The equity markets of FMs - low to middle income countries with underdeveloped and illiquid capital markets compared with their more advanced emerging market (EM) peers - have risen 8 per cent, with the Latin American and African components of the MSCI FM index surging 23 per cent and 13 per cent respectively.
The stocks of EMs, on the other hand, have barely risen during this period, with the Latin American and East European components of the MSCI EM index even falling 13 per cent and 11 per cent respectively.
Yet this year, the trend has reversed, with EM shares up nearly 10 per cent (and nearly 7 per cent since the start of this month), compared with a decline of more than 2 per cent for FM stocks. Indeed even the Asia component of the FM index - which includes countries such as Pakistan and Bangladesh and which performed relatively well over the past three years - is down 7 per cent.
The underperformance of FM stocks is, on the face of it, quite puzzling.
The main reason why EM equities have risen sharply this year is the perception on the part of investors that the US Federal Reserve is likely to put off raising interest rates until September - and possibly wait until early next year, according to some analysts.
The prospect of a tightening in US monetary policy and the resurgence of the dollar have damaged sentiment towards developing economies, which are heavily reliant on inflows of speculative foreign capital. It is therefore surprising that FM equities have not benefited from bets that the Fed is likely to refrain from raising rates as early as June.
Still, sentiment towards EMs this year can hardly be described as exceedingly bullish.
Despite the recent rally in EM stocks, outflows from EM equity funds already amount to $13 billion this year - nearly half the total outflows for 2014, according to JP Morgan. Many of the currencies of developing economies, moreover, are under significant strain because of the strength of the dollar and the strong likelihood that the Fed will raise rates this year.
It stands to reason, therefore, that equity investors - who are skittish at the best of times - should be much more cautious towards riskier and more illiquid FMs which are on the sharp end of the fallout from the collapse in oil prices and the resurgence of the greenback.
The case of Nigeria, Africa’s largest economy and one of the more established FMs, is a good example.
With oil accounting for 95 per cent of Nigeria’s exports and more than half of the country’s fiscal revenues, sentiment towards Nigeria has deteriorated significantly over the past year or so, with Nigerian stocks down a whopping 22 per cent over the past year in dollar terms. Indeed since the beginning of this year, Nigerian equities have fallen more than 2 per cent.
This lies in stark contrast to the MSCI index for Russia, another large oil exporter and a major EM, which has risen a staggering 36 per cent in dollar terms this year.
Even FM net oil importers, which are supposed to be benefiting from the plunge in oil prices, are faring poorly sentiment-wise. The equity markets of Pakistan and Vietnam, two prominent FMs, are down 7.3 per cent and 3.2 per cent respectively this year.
Yet this is not the whole story.
In the bond markets, FMs have actually outperformed EMs this year. According to JP Morgan, returns on the bank’s benchmark Next Generation markets index (NEXGEM), which tracks dollar-denominated debt issued by FMs, have risen 5.4 per cent so far this year. This compares with returns of 3.7 per cent and 3.3 per cent for EM dollar-denominated and local currency bonds respectively.
Indeed according to JP Morgan, the yield spread (or risk premium) on the bonds in the NEXGEM index is the tightest it has ever been relative to yields on EM dollar-denominated debt.
This means that while equity investors may be differentiating between FMs and EMs, bond investors appear to be much less discerning - mainly because of the strong demand for higher-yielding debt amid record low government bond yields in advanced economies due to the effects of ultra-accommodative monetary policies.
Given the deterioration in the economic conditions in most FMs, bond investors ought to be far more cautious. The bearish stance of equity investors in FMs is perfectly justified.
Nicholas Spiro is managing director of Spiro Sovereign Strategy