FIS Group 2017 outlook for frontier markets titled, “Big Winners in the Neglected Frontier Universe”
Frontier markets were mixed in 2016, with most of the Middle East and Africa lagging the rest of the universe and a few markets surging ahead 30-40% on the year. We discuss the leading markets individually (below), but we also would like to note the significant structural changes afoot in the MSCI Frontier Markets (FM) index. In 2016, several of the largest markets left in the frontier were flagged for promotion to emerging markets status. These include Pakistan (already emerging markets [EM] in FTSE/Russell and will re-upgrade to EM for MSCI in May 2017), Argentina (watchlisted for EM upgrade by MSCI), and Romania (watchlisted for EM upgrade by FTSE/Russell). Meanwhile Nigeria may be on its way out of the major indices (watchlisted for expulsion by FTSE/Russell) if it cannot sort out its own exchange rate and convertibility issues soon. Although Vietnam has been busy adding significant breadth and depth to its own market, we still see a dramatic concentration of the opportunity set currently defined as “frontier” on the horizon over the next two years. Overall, the liberalized access to these markets that such upgrades represent is positive for investors, if somewhat dizzying for index watchers. For our investment outlook, we see little directional change from last year’s views, and remain bullish on Argentina, Vietnam, frontier Europe, and temporarily Pakistan (new call) and bearish on most of the Middle East and Africa. Overall, frontier markets remain very attractively priced relative to all other major market segments with much lower valuations and ROEs comparable to the S&P 500 (see Chart 1 and Chart 2).
|Summary of our 2017 Themes and Investment Recommendations|
|Argentina||Reasonable valuations, continued market reforms, added liquidity, and falling inflation and interest rates all point to good news. There are some risks to this view, but Argentina appears to poised for a few years of bull market returns. Long Argentina and/or overweight vs FM.|
|Vietnam||New regulatory and structural catalysts are adding depth and liquidity to a market where 10 years of growth are not fully reflected in the opportunity set. Long Vietnam and/or overweight vs FM.|
|Pakistan||Positive structural reforms are bringing local investors back to the market in a meaningful way. Interest rates are way down, which is positive for risk assets, and the market is being upgraded to EM this year. Long Pakistan through May and/or overweight vs FM.|
|Frontier Europe||Improving Eurozone growth and a turnaround in the Russian market (which helps regional funds with frontier Europe exposure) will add liquidity and access to a reasonably priced, and long neglected region. Overweight Frontier Europe vs FM.|
|GCC (Saudi, Kuwait, etc.)||Fiscal pressures and policy uncertainty with uncompelling valuations make this region unattractive again. Underweight (even zero weight) vs. FM, unless you’re really bullish on oil prices climbing above $75/barrel.|
|Sub-Saharan Africa (Kenya, Morocco, Nigeria)||Nigerian consumer stocks remain overbought while financials are very attractive, at least relative to Nigeria, but only modestly compelling compared to the rest of FM. Kenya is poised for some macro-adjustments and policy uncertainty in the financial sector portend little upside to the market this year. Morocco’s macro situation is improving and relatively good for the region, but valuations are at their post GFC highs, though some premium to the market is justified. Underweight Nigeria/overweight Nigerian banks within any Nigerian allocation while staying clear of pricey consumer names. Stay clear of Kenya and neutral/slight underweight in Morocco.|
Frontier Markets – 2016 Report Card
2016 portended a year of great change, as reformist President Mauricio Macri began his experiment with market-friendly policies to undo the decade of Peronist populism that left Argentina in stagnation under the previous regime. On the heels of removing export taxes, most capital controls, and allowing the currency to free float at the end of 2015, Macri began 2016 with the priority of reintegrating Argentina into global capital markets. Following a charm offensive in Davos, Macri and his finance team secured a deal with the “holdouts”, i.e. the remaining holders of Argentine sovereign debt dating back to their 2001 default. With the majority of the easiest-to-implement aspects of Argentina’s market friendly shock therapy in place, Macri then turned to lifting the massive fuel and electricity subsidies and bringing billions back into the economy through a major tax amnesty in an effort to reduce the fiscal deficit (tax revenues were up 34% y/y in 2016).1 In addition to the fiscal benefits, this tax amnesty offers its own unique upside to the market, as it has netted about $10 billion in new private investments from wealthy Argentines that are most likely to be deployed into an array of new real estate and infrastructure funds. The investments themselves will buoy construction and real estate while the fees from the funds will accrue to the banks and asset managers that will administer the funds, which has contributed to our own tactical position in Argentina which we have held since the Spring 2016 in our tactical accounts with EM exposure. For context, the listed segment of Argentina’s entire financial sector is a mere $12 billion in market cap. The Argentine market will get a further boost, with the removal of the final barrier to re-opening the local stock market to foreign investment with the capital markets law currently in Congress and whose passage is expected by March.
With access to the global debt pool reopened, Argentina spent much of 2016 splashing into it like a kid on a hot summer day. Reports indicate that about $30 billion in new foreign debt was issued (about $20bn from the federal government and $10bn from the provinces) with expectations for more to come in 2017. Some of those proceeds were used to refinance debt including the buyout of the holdouts from Argentina’s last default, but much will go into new spending to cover the fiscal deficit. Looking ahead, and perhaps most importantly, this public debt issuance will also pave the way for the critical relevering of an economy with a mere 18% private debt to GDP, which compares very favorably globally and to its regional peers (see Table 2). Argentina’s banks are especially underleveraged (see Chart 3) and uniquely underexposed to external debt (see Chart 4) offering further runway to reasonable re-gearing and thus economic expansion.
But releveraging will not occur in the absence of lower interest rates, which in turn necessitates lower inflation, which had been running at over 25-30% under the previous government. The initial results appear very promising on both fronts with the most recent inflation data pointing to a mere 14.4% annualized inflation (see Chart 5) and interest rates coming down concomitantly. But herein lies the biggest risk to Argentina and Macri’s agenda is that they fail