Fresh out of business school in 1995, I joined Montgomery Asset Management, a firm that was among the earliest to invest in emerging markets. Emerging markets were considered a high-risk segment of the investment universe, avoided by many investors based on concerns about immature economies, illiquid stock exchanges and uneven respect for property rights.
My Montgomery colleagues saw potential despite the risks, believing that emerging markets would benefit from economic growth and political reforms. Emerging markets were thought to provide return enhancement as well as portfolio diversification, providing returns that weren’t highly correlated with that of developed markets.
Much has changed in recent years. Emerging markets is now a mainstream asset class, representing a meaningful portion of global stock market capitalization and commonly included in investor portfolios. South Korea has “graduated” from an emerging to developed market in the eyes of many investors, with China and Taiwan not far behind. Emerging market economies are more integrated with that of developed economies, leading to some erosion of the diversification benefits once provided by emerging markets stocks.
Enter the Frontier?
Frontier markets have much in common with the emerging markets of 1995. In their article, “The Case for Frontier Equity Markets,” Lawrence Speidell and Axel Krohne wrote that “ The entire world is moving, albeit with irregular progress, towards understanding and implementing the basic conditions for economic growth based on rule-of-law and incentives. As countries move along this path, the greatest rewards will come from places that have the greatest improvements to make.” Speidell and other investors in frontier markets cite favorable demographics, improving political stability and increasingly pro-growth government policies in support of their investment thesis.
Africa offers an example of Speidell and Krohne’s thinking, featuring a land mass that is bigger than the U.S., China and Europe combined, and GDP of only 6% of the world’s GDP. The potential for growth is significant.
Some of the world’s fastest-growing countries are included in the frontier markets universe, and projected growth exceeds that of developed and emerging markets.
Labor force growth, anemic in most of the developed world, is expected to be robust in the frontier world (see Chart 1 below). Dependency ratios – the number of non-working age people to working age people — are projected to decline steeply in frontier markets while the opposite is expected to occur in developed markets.
Frontier markets have been beneficiaries as formerly low-cost emerging market countries evolve economically and cede some manufacturing jobs to lower-cost countries. For example, rising wages in China is a catalyst for some manufacturing activity to move from China to countries such as Bangladesh and Vietnam.
The frontier markets investment universe includes resource-rich countries such as Nigeria and Kazakhstan as well as less commodity-dependent countries such as Bangladesh, Pakistan and Sri Lanka.
Argentina, relegated from the emerging markets investment universe to the frontier markets universe after decades of economic mismanagement and leftist political control, has become an investor favorite under the market-friendly leadership of Mauricio Macri.
Pakistan, helped by strong GDP growth, a robust banking sector, and improving security and infrastructure, is another country gaining in popularity among frontier markets investors. Estonia was one of the best performing frontier markets in 2015, helped by the success of a cruise and transport ferry operator that benefited from low oil prices.
Saudi Arabia is an interesting case, as it isn’t included in the MSCI indexes for emerging or frontier markets, but has its own stand-alone index. Some investors think of Saudi Arabia as a frontier market, while others speculate that it will skip directly into the emerging markets indexes after the public offering for Saudi Aramco.