Frontier markets: safe haven for stability seekers

November 15, 2012

Frontier markets have an air of adventure and unpredictability about them. One is tempted to ask: Who knows what will happen next?

The figures tell a different story.

In fact, emerging markets overtook frontier markets in terms of volatility of returns as long ago as June 2006, as a recent HSBC report shows. And a more significant milestone was passed a year later, in June 2007, when even developed markets overtook frontier markets in terms of volatility of returns.

Since then, frontier markets have without fail stayed more stable than developed and emerging markets. In 2012, the gap between the closely-correlated developed/emerging markets bloc and frontier markets widened even further as returns in the latter seem to be becoming even more stable. According to David Wickham, EM investment director at HSBC Global Asset Management:

Low correlations across frontier market countries, and indeed with commodity prices, can surprisingly result in low volatility. While it may sound counterintuitive, the volatility of frontier markets can, in fact, be less than emerging and developed markets.  One needs to have a truly global approach in order to reap these potential low cross-country correlation benefits.

What is meant by a low cross-country correlation is that a frontier market such as Kenya is less likely to be impacted by a blow-up in, say, Hungary or even another frontier market such as Nigeria. That makes FM  less prone to swings.

Above is a graphic  that compares the volatility of returns in frontier markets with their more developed counterparts.

Some other pluses, according to HSBC:

Dividend yields, on a 12-month trailing basis, are almost double those in emerging markets. Second, frontier stocks are cheap — they are still trading 40%  lower than the pre-crisis levels of August 2008, whereas emerging markets and developed markets have almost entirely recovered the losses. As HSBC puts it:

Higher returns and lower volatility than mainstream EM.

Equally optimistic, BlackRock comes to the same overall conclusion — lower volatility.  BlackRock sees frontier markets as an investment opportunity similar to that offered by emerging markets 20 years ago.  In 1991, the GDP of the MSCI emerging markets index reached $2 trillon, the same as MSCI frontier markets GDP today, fund managers there say.  What’s more, emerging markets back then also had the same market capitalisation as frontier markets do today.

So are frontier markets thus less of an adventure? Emerging markets have been outperforming their more exotic frontier counterparts since early 2009, after the worst slump in stocks caused by the financial crisis.

Surely there are some risks? First, frontier markets hold the majority of reserves in oil, iron ore, zinc, cobalt, bauxite and cocoa production. Obviously, this exposes frontier markets more to commodity price volatility – a risk especially in less liquid markets.

Inflation is also higher in frontier markets than in emerging markets. Politics, of course, remains a volatile factor in frontier markets. Tunisian shares, for example, lost almost 15 percent in the first quarter of 2011 when the popular uprisings in the Arab world began with the self-immolation of a Tunisian vegetable vendor — a case that highlights the importance of a “global approach” in frontier markets.

By Shadia Nasralla

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