A Good Time for Another Look at Frontier Markets

Asha Mehta, CFA

Senior Vice President, Portfolio Manager

June 2016

In the trailing 12 months, frontier equities have notably outperformed emerging equities ahead of the EM index by 8.6%.* Portfolio Manager Asha Mehta discusses some of the forces driving this differential in the current environment and reiterates Acadian’s philosophy that frontier equities merit inclusion in an asset allocation strategy as a reasonable-risk, diversifying, and highly inefficient segment of the market.

Why are Frontier Markets Leading Emerging Markets This Year?"
 
Top-performers in the MSCI Frontier Markets index over the past year include representatives from Eastern Europe (including Croatia and Romania), as well as Argentina and Morocco. On the emerging side, all markets have realized negative market performance with the exception of Hungary. China’s performance has been particularly grim, trailing the broader EM index by 10.9% with a -28.5% return over the trailing 12 months, while representing 23.6% of the index.*

Behind the relatively steady frontier performance trend, we see a few key themes playing out. First, fundamentals appear strong throughout much of the asset class. We find that these markets are ripe for earnings expansion, multiple expansion, and capital deepening. Frontier countries are not only growing faster than emerging countries, frontier companies are also growing faster than emerging companies. At the start of the year, analysts expected near-zero FY1 earnings growth for emerging companies, while they expected growth among frontier companies in the double digits.

Beyond this, individual country-level fundamentals are supportive in many cases. For the Eastern European markets I mentioned earlier, we have seen limited sociopolitical risk along with concerted efforts to build the private sector, increase foreign investment, and improve corporate growth and earnings. Morocco is supported by stable growth in a relatively peaceful, low-risk African nation with exposure to rapid development in the francophone regions of North Africa. Meanwhile, Argentina is buoyed by the newly elected technocratic president’s reforms, which are relaxing capital controls and supporting the business environment—leading to speculation about potential inclusion in the MSCI EM index.

How do drivers of returns differ in these markets?
The country-specific nature of frontier fundamentals contrasts markedly with the case in emerging markets, where pervasive concerns about China seem to be dampening sentiment across the asset class. We see evidence of this in a couple of aspects of emerging markets’ performance.

First, drivers of returns. It is fair to say that global themes, including oil prices, matter more to emerging markets than to frontier—as evidenced by the higher long-term correlations between developed and emerging than we have seen between developed and frontier markets. We can take this a step further by examining the broader co-movement across emerging markets. Over the trailing 12-month period, China led performance downward, driving nearly all emerging market countries into negative territory, particularly neighboring Taiwan and South Korea.

This trend contrasts with frontier markets. To be clear, there are examples of distress within frontier. Nigeria, for example, likely faces a material currency devaluation given their oil dependence and bleak macroeconomic backdrop. But we don’t see material risk of contagion from these cases. And the diversification benefit of low correlations among frontier markets held up even over the past year when global markets were under stress. Well diversified frontier portfolios exhibited a fraction of the volatility of emerging market returns.

Consistently, returns in emerging countries co-move together more than frontier returns do. In emerging markets, the pairwise correlation of returns is approximately 0.55, contrasting with approximately 0.28 in frontier markets, where country drivers tend to be more idiosyncratic and country-specific.1

What about current valuation levels?

Frontier markets continue to trade at a discount to their emerging peers. Despite stronger company-level fundamentals, some valuation discount is warranted based relative liquidity. But we think the gap is too wide given current market and political risk.

At the start of the year, frontier markets traded at 10.0x trailing PE, while emerging markets traded at 12.9x. As shown below, this discount is steeper than the average discount since inception of the MSCI Frontier index in 2007 and has created what we see as an attractive entry point for frontier markets investors.

Price/Earnings

Price earnings 

Source: MSCI Frontier Markets, MSCI Emerging Markets. Copyright MSCI 2015 All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.

Footnotes
 * Index Source: MSCI Frontier Markets, MSCI Emerging Markets. Copyright MSCI 2015 All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
1Source: Acadian. Correlations referenced on a monthly basis over the trailing 10-year period.

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