2020 vision: the changing face of frontier markets

June 7, 2017

Oliver Bell, portfolio manager of the T. Rowe Price Frontier Markets Equity strategy, assesses the continuing growth in frontier market countries and how they are likely to shape up in coming years.

At T. Rowe Price, we believe many frontier market economies are experiencing a common long-term path to prosperity. Despite what is often heard in the press, there is currently more peace across the world than at any other time in history, with only a handful of conflicts occurring.

This has allowed democracy to take hold in an increasing number of frontier outposts, with politicians incentivised to make widespread economic improvements in order to stay in power. These economic reforms often lead to an influx of foreign investment, which in turn leads to strong economic growth and provides a tailwind to the corporate sector.

Pakistan’s upgrade to the MSCI Emerging Markets (EM) Index earlier this week means the number of countries in the MSCI Frontier Markets Index has fallen from 24 to 23. But as more and more countries move along this path to prosperity, what will Frontier look like in 2020…?

Pakistan – upgraded to EM status last week

Pakistan, a market we have been overweight since our launch in 2014, joined the EM index earlier this week. We have seen a transformation in Pakistan’s fortunes over the past few years, but further reform and development will be needed for Pakistan to make the jump to be a true ‘Asian tiger’.

Despite the upgrade, Pakistan’s impact in the EM index is just six stocks, making up about 0.1 per cent of the index. The number of companies going from Frontier to EM is reduced, due to liquidity reasons. This means Pakistan is essentially a rounding error – are active investors going to bother? In my view, a country should probably not be upgraded unless it is a minimum of 0.5 per cent of the index.

Argentina – likely upgrade to EM status in 2018

I would expect Argentina to be announced for an upgrade shortly, leading to an entry into the MSCI EM index next year. Argentina’s reversal of fortune dates back to October 2015, when we witnessed much-needed change in politics through the election of business-friendly Mauricio Macri as president. Macri swiftly implemented reforms that returned some form of normality to Argentina and the markets rallied strongly.

We now need to see further political reforms and inward investment to deliver sustainable growth in the economy. If Macri can consolidate power in the October legislative elections the reform drive can continue. 

Saudi Arabia – likely jump to EM status in 2019

Saudi Arabia is currently classified as a standalone market, but is essentially treated as Frontier by investors. The Saudi economy has slowed down – with lower oil prices revenues having put pressure on the fiscal deficit, international reserves and liquidity. Saudi needs to diversify its economy away from oil and the 2030 Vision provides some encouragement that there clearly has been a mindshift in the kingdom. 

I would expect Saudi Arabia to go on a watchlist to move straight into the EM index. This could happen in 2018, for a 2019 entry into the EM index.

Peru – on the edge of a downgrade to Frontier status

Peru is teetering on the edge. Peru has been able to achieve a decent level of economic diversification, with a number of reputable businesses housed within its bank, property and retail sectors; it has long been and still is one of Latin America’s strongest growth performers.

However, Peru’s status remains ‘on watch’, given only three of its stocks (one of which is US-listed) meet the liquidity requirements of the MSCI Emerging Markets index – with three being the minimum number needed to meet this threshold. The downgrade was ruled out a year ago, but it still could happen.

Peru has done a lot of lobbying to stay in the EM index, as it does not want to lose the tracker money. My argument, using my own calculations based on likely MSCI Index methodology, is that this money only goes into three stocks; that would increase to 12 – which would be 15 per cent of the index – if Peru moved to Frontier. The broader economy would benefit over time from increased scrutiny from foreign investors.

Nigeria – could be moved to standalone status

There is a chance Nigeria comes out of Frontier to be a standalone market, similar to Saudi Arabia today. This is because of inadequate liquidity in the FX market. Nigeria has struggled due to falling oil revenues, despite some positive under-the-radar developments in the country since the arrival of president Muhammadu Buhari in 2015.

Nigeria would still attract investors if it exited, but this would have major ramifications for the remaining weightings in the Frontier index. 

Iran – the great unknown

Iran is the major unknown. We went on a fact-finding mission to Iran about 18 months ago, prior to the lifting of sanctions. What we found was a real eye-opener and exposed many of our biases as wrong. Iran appeared more like Turkey than Saudi Arabia – Tehran being a very cosmopolitan city with a much more liberal attitude than we expected, with women appearing fully integrated into society.

Importantly, the country is educated, entrepreneurial, and asset-rich, but remains cash-flow poor because of the sanctions that have been in place since 1979. Putting aside the politics, the established and diverse stock market would be a welcome addition to Frontier.

Korea, Taiwan and China – change at the top?

There is a view that Korea and Taiwan should already be classified as developed markets, not EM. However, there are clearly both political and FX considerations to any reclassification. The bigger issue in my view surrounds China A shares, which at some point will need to enter the EM index.

If fully included in time, A shares would become close to 40 per cent of the EM index. It means there are some major questions ahead. Perhaps it is time for China, the world's second-largest economy, to have its own classification, similar to Japan. This would arguably make EM more interesting, as all other markets would be granted a larger weighting in the index. 

Myanmar and Cambodia – ones to watch post 2020

Other countries to watch for potential upgrades to Frontier are Myanmar and Cambodia. However, any such moves will come well after 2020. Both Myanmar and Cambodia could follow the path of Vietnam and Bangladesh in cheap labour and textile production. Myanmar is certainly a large and interesting country, which we have exposure to through a US-listed company. It does not have a domestic stock market, but it is currently seeking to develop this.

In summary, we fully expect the MSCI Frontier index to transform over the years to come, and with many moving parts, it is hard to predict with any certainty and accuracy. Changes at the economic, political, market and corporate levels are all in play. 

Investors should remember though that we have seen a similar transition with EM over the years – for example Malaysia was once over 30 per cent of MSCI EM and is just 2.5 per cent today, Russia and India were not even in the index in the early days, and China A shares are still not represented today.

Furthermore changes in freefloats, foreign ownership limits and state sell-downs will also increase our opportunity set. So while it seems like a lot of change is occurring in Frontier, we should expect this, and keep looking for opportunities at the stock level. Frontier markets have structural growth and there are always well-managed, fast-growing companies for us to invest in.

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