Global Investing

Frontier markets: safe haven for stability seekers

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.

Too much correlation

Globalisation is evident in this graphic put together by James Bristow, a global equities portfolio manager at BlackRock. It shows the correlation between the U.S. S&P stock index and counterparts in Europe, Australasia and the Far East.

Basically, what happens these days on Wall Street is matched everywhere else, or vice versa.

It is a bit of a problem for long-term investors. One of the best ways to diversify used to be to buy outside your domestic market. Not so now. This is likely to push more institutional investors to non-correlated assets and hedge funds.

The Big Five: themes for the week ahead

Five things to think about this week:

HOLDING UP — FOR NOW 
- A good run in equities has so far been helped rather than hindered by U.S. company results. Some are questioning how long the upward momentum can be sustained given cost-cutting rather than improved revenue streams flattered profit margins. The European earnings season, which cranks up a gear this week, and the release of U.S. Q2 GDP data could be potential triggers for a pullback, but the sensitivity to bad news may depend on how much money is chasing the latest push higher. 
    

EARNINGS 
- European earnings flooding out in the coming weeks may paint a less rosy picture of the banking sector than seen on the other side of the Atlantic. While investment and trading activities should be supportive, bad loan provisions will be particularly closely scrutinised, as will the central and eastern Europe exposure of the likes of Erste. The supply/demand outlook for key commodities plans will also be in the limelight given the battery of oil and chemical firms reporting in Europe and the U.S. 

CORRELATIONS 
- There are signs of some breakdown in the lockstep moves that financial markets had become accustomed to seeing in FX/stocks or stocks/bonds. Calyon research shows correlation between the bank’s proprietary risk aversion barometer and exchange rates has been less robust in the past month. While this correlation nevertheless remains stronger than that between FX and interest rate differentials, the markets’ thoughts are turning to new linkages that might prove better trading guides.