Alternatives: The frontier markets to invest in

In the current low-yield environment, emerging markets have attracted many investors in search of growth and higher yields. However, frontier markets, or countries in the early stages of their development, offer investors even greater potential.

While most established emerging markets are expected to continue growing in the coming years, replicating the same degree of strong outperformance of the past decades will probably be difficult as they have developed and risk premiums have declined.

Frontier market debt captures the potential of the next generation of emerging markets: higher economic growth, favourable demographics and higher return opportunities. They can also deliver ample diversification possibilities to investment portfolios due to their low correlation with other asset classes.

Frontier markets have many of the same characteristics that emerging markets did when they were first identified as an investable group in the 1980s. Most frontier markets are still only at the very early stages of economic, political, financial, institutional and business development and therefore have attractive long-term prospects.

Growth drivers

The story of frontier markets is one of catch-up and convergence. Their economic growth is supported by favourable demographics and rising productivity, while foreign direct investment, improvements in the quality of institutional frameworks, and debt levels which have not been inflated are helping to drive expansion.

They have relatively high economic growth. The vast majority of the 25 fastest-growing economies over the past decade are in the frontier market category. Their growth outlook is reasonably good in the medium term and very good in the long term. Among frontier markets, the African and South Asian economies in particular should continue to expand faster than their peers. The IMF is forecasting average growth in the 4.5 per cent to 6 per cent per year range for these economies over the next five years.

Favourable demographics

Frontier markets also benefit from relatively higher population growth, thereby keeping the median age of the population lower and creating the potential for higher and sustained growth, via demand for goods and services, an expanding workforce, increasing savings etc. The low productivity levels mean there is plenty of room for improvement.

Medium to longer-term outlook

The medium-term outlook for frontier market debt is constructive. While developed economies are struggling with high and rising debt levels, emerging and frontier markets are coping much better. External debt as a percentage of GDP in frontier markets is lower compared to emerging markets and the G7 economies.

They are already outperforming other markets: in 2016 they outperformed the broader market with a rise of 14.76 per cent in 2016. In Africa, for example, some of the bonds rallied significantly, the likes of Ecuador are up over 40 per cent in 2016 and Zambia and Ghana are up more than 30 per cent over the year.

At present, there are some particularly good opportunities in Africa, especially if commodity prices improve further. We are also positive on El Salvador, where near-term cash constraints should be alleviated by new bond issuance, and Mongolia is expected to perform well on the back of a potential IMF programme and a recovery in its relationship with China.

Risks

Investment in frontier markets does come with higher risks than investment in developed or emerging markets. Many of them have been confronted with political and economic instability in the past decades. By definition, frontier markets lack many of the institutions that developed and more stable economies take for granted. In the event of panic triggering potentially large outflows and ‘fire sales’, liquidity could become an issue while a strong appreciation in the US dollar could hurt the recovery in commodity prices on which many frontier markets depend.

But these risks can be addressed by stock-picking assets and adjusting portfolios using rigorous credit and liquidity analysis of individual countries.

Partly due to the low correlation with other markets, frontier market debt is a great diversifier for investment portfolios and their attractive long-term investment potential is increasingly being recognised by savvy investors searching for yield.

Roy Scheepe is senior client portfolio manager emerging market debt at NN Investment Partners