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Beyond the Wall: Frontier Markets  

Fear of the Unknown

 In the popular television series “Game of Thrones”, “The Wall” refers to a massive block of ice that separates the civilized world from the dangerous unknown. What lies beyond “the Wall” invites equal parts dread and fear not unlike the emotions that frontier markets trigger among most investors. With headlines mostly trumpeting coups, strikes and terror attacks, its no wonder investors don’t look beyond emerging markets for above average returns.

But if it is the long game that matters, then investors could do well by having another look at the frontier market opportunity set. The MSCI Frontier Markets Index was launched in November 2007 and has 25 countries with 142 constituents and a free float adjusted market cap of  $142 billion. Many of today’s emerging markets were once frontier markets. There could be enormous upside potential as these nascent markets make the transition to emerging market status. Some of the fear inducing events mentioned above can trigger political instability and these moments often provide the perfect time to gain exposure to these markets.

Challenging Assumptions

 The assumption that stomach-churning volatility is part and parcel of frontier market investing has been challenged recently.  A recent study by New York based fund manager LR Global looked at weekly returns for ten years (2004-2013) from 80 different stock exchanges across developed, emerging and frontier markets. The research showed that frontier market volatility (measured by standard deviation) was lower than emerging markets and was sometimes lower than developed markets over certain periods.

This lower volatility could be partly explained by the fact that frontier markets are not exposed to the global ebb and flow of hot money. At the same time, frontier markets are very diverse economies mostly driven by local money. Not only do they have low correlation with the global market but they also have very low correlation amongst themselves offering significant diversification benefits. We believe an active management strategy that takes advantage of the occasional frontier market crisis to initiate positions at reasonable valuations, can produce outsized returns over the long run. 

New Asset Class

 Frontier markets have now emerged as a credible asset class. While the definition of frontier markets and what countries constitute this group is still a work in progress, its important to take a note of some of the important developments that have taken place in this sphere. Many frontier markets have been working to strengthen their policy-making, reduce red tape and lower trade restrictions. Debt reduction has freed up funds for investments in physical and human capital. Frontier Markets like Nigeria and Vietnam have deepened their financial markets. Countries like Tanzania and Zambia have been able to tap international financing while Mongolia and Kenya have been making efforts to reduce their debt.

While the MSCI Emerging market index was flat in 2013, the MSCI Frontier Market Index was up 26%. As of the end of June 2014, the MSCI Frontier Markets Index was up another 16% prompting even Norway with the world’s largest sovereign wealth fund ($890 billion) to boost investments in frontier markets. Norway’s sovereign fund is knows for making smart long term bets, which means frontier markets could gain further credibility in the investment community.

With over 1.2 billion people with a median age of 30, frontier markets provide the largest future middle class opportunity. To reduce risk an investor can invest in the local subsidiary of a multinational like Nestle Nigeria while simultaneously gaining exposure to the consumer story. Our approach to frontier markets investing remains the same as the one mentioned in “The Emerging Markets Handbook”. We use the ten-driver model to sort out the strugglers from the standouts. Then we pay special attention to liquidity, corporate governance and valuation before we make an investment. As frontier markets grow and their capital markets become deeper, there will be many opportunities for investors to benefit from this exciting new growth story.

By- Pran Tiku CFP & Vikram Kondur CFA

Our comments, opinions and analysis are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Markets and economic conditions are subject to rapid change, comments, opinions and analysis are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

“Own Goal?: Brazil’s World Cup of Woes”

If you are a planning to travel to the FIFA World Cup in Brazil you probably have sun soaked beaches, costumed parades and a carnival atmosphere in mind. Unfortunately, you are more likely to be greeted by street protests, civil unrest and a growing opposition to the World Cup from the most football-obsessed nation on earth. As shocking as it sounds, this would like Canadians turning their backs on ice hockey and Indians falling out of love with cricket. Brazil won the bid to host the World Cup in 2007 during the days of President Lula Da Silva and it was meant to be a coming out party for the nation. But the glory days from 2002-2010 when Brazil grew over 5 percent seem like a distant memory. How did Brazil end up scoring an own goal when most investors thought its time had finally come?

Bureaucratic Squeeze

In spite of all the progress made so far, the reality is that Brazil’s stifling bureaucracy has managed to grow and keep a lid on its potential. According to the World Bank, it still takes 13 bureaucratic procedures and 107.5 working days to open a business in Brazil. If you want to build a factory, it takes 400 days to get construction permits and 58 days to having running electricity. This same bureaucracy has failed to deliver essential public services promised to ordinary Brazilians while sparing no expense to deliver infrastructure for the World Cup, which has largely benefited the rich and corrupt in terms of government contracts. As a result, most of the protesters are urban, educated, middle class Brazilians who would normally be enthusiastic supporters of their much vaunted football team.

You know its time for reforms when pizza costs over $30 in your country. In the “Emerging Market Handbook” we noted how there was a Brazil cost or “Custo Brazil” to doing business in Brazil. Add inflation and currency overvaluation to the mix and you have a recipe for the kind of unrest that has plagued Brazil the last few weeks. As noted in the previous column “Made in China? Think Twice”, it costs more to manufacture in Brazil than in some developed countries thanks to inflexible labor laws, high taxes and high interest rates.

Boom and Bust

Before discussing how Brazil can get out of this mess it is important to understand how it got here in the first place. In many ways it is easy to conclude that the Brazilian leadership got complacent but there is more to it than meets the eye. The benefits of a solid foundation of reforms instituted by the much underrated President Cardoso created a wave ridden by the much loved President Lula Da Silva. While President Dilma Rouseff got to partially ride the wave in her first term, the benefits quickly evaporated as her government failed to take some of the harder measures needed to sustain the pace of reforms. The commodity boom driven by China and rapid urbanization masked most of the problems afflicting the economy today.

Now with the commodity boom having come to an end and with little room for the workforce to grow, Brazil’s problems are there for all to see. Ordinary Brazilians could afford their expensive cars, TV’s and washing machine’s thanks to a liberal lending policy by banks which was encouraged by the government. Now most consumers are stretched to the limit in terms of debt which has resulted in a slow down in domestic consumption which was one of the key drivers of the Brazilian economy.

The Big Fix

There are three key area’s that we believe needs the urgent focus of the government and any signs of change in these area’s could be a positive signal for investors. Firstly, investment in infrastructure would reduce the cost of goods and raw materials coming from the Brazilian hinterland to its cities. Secondly, simplification of its notoriously complex tax code would reduce compliance costs and the size of the informal cash economy while raising government revenues. Thirdly, investment in higher education to boost the productivity of its workers as the easy gains that come with adding new workers have been exhausted.

While there is overriding pessimism when it comes to Brazil these days, investors only need to look at some of the multinationals that are still thriving in Brazil. They continue to invest in underdeveloped area’s of the economy and sell their products to the rapidly rising lower middle class of Brazil. Unemployment remains near record lows and wages are rising. Perhaps a World Cup win will lift spirits and a change of guard after the October elections will get the country back on the road to prosperity.

By- Pran Tiku CFP & Vikram Kondur CFA

Our comments, opinions and analysis are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Markets and economic conditions are subject to rapid change, comments, opinions and analysis are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy

Made in China? Think Twice.

A quick pop quiz:

Which of the following countries is the lowest cost manufacturer in Western Europe?

  1. Spain
  2. Germany
  3. United Kingdom

If most of you answered Spain and some of you Germany, then its time to take a harder look at the global competiveness landscape. The correct answer is the United Kingdom. Most of us have outdated views of which countries are low cost and which ones are high cost. Often the easiest way to sort this in our head is to classify emerging market countries as cheap and competitive and the developed world as prohibitively expensive for manufacturing. But a new study on global competitiveness challenges these simplistic assumptions.

The big shift

With the world focused on big-ticket issues like the Crimean crisis and impending tapering by the Federal Reserve, valuable nuggets of news tend to slip under the radar. One such nugget was the release of the Boston Consulting Group’s (BCG) Global Manufacturing Cost Competitiveness Index. This new index tracks changes in production cost of 25 exporting countries over the last decade. The index is based on four drivers of manufacturing competiveness that include wages levels, energy costs, productivity growth and currency exchange rates.

The results of the ranking process are fascinating with Mexico emerging as less expensive than China, UK turning up as the least expensive nation for manufacturing in Western Europe and Brazil ranking as one of the most expensive countries for manufacturing activity. The two biggest positive surprises were Mexico and United States, with the latter making big strides thanks to cheap energy costs due to falling natural gas prices, rising productivity and stagnant wages.

Investment perspective

So what does it all mean for the Emerging Market Investor?

Several emerging economies covered in The Emerging Markets Handbook including Brazil, Poland, China and Russia have lost competiveness in terms of manufacturing over the last decade. At the same time many emerging markets are no longer cheaper than the US. Identifying the next export powerhouse could mean the difference between outperformance and below average results for emerging market investors.

As we have explored in our book, almost all emerging countries have used manufacturing and exports as the fuel of rapid GDP growth. It could also mean identifying companies in developed nations that could benefit tremendously from expanding domestic capacity and exporting to emerging markets. An investor could also shift his/her portfolio allocation from export-focused emerging market companies to companies that benefit more from domestic consumption. There could also be tremendous opportunities in frontier markets that would be happy to see a manufacturing shift from their new high-cost neighbours.

In order to develop a long-term view of emerging market trends, it pays to take a closer look at some of the underlying factors/drivers that determine change in rankings like the one put out by BCG. Often insightful research and interesting trends get drowned out by noisy headlines of the day. It is up to the thoughtful investor to ferret out these insights and profit from them.

By Pran Tiku CFP & Vikram Kondur CFA

Our comments, opinions and analysis are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Markets and economic conditions are subject to rapid change, comments, opinions and analysis are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

India: The Great Election Hope Trick

Election fever

The world’s largest democracy goes to the polls this month. The collective wisdom of 800 million people is likely to produce an outcome that could have huge implications for the global economy. Recent exit polls project a win for the coalition led by the pro-business Bharathiya Janata Party (BJP), headed by Narendra Modi, whose promises include “minimum government and maximum governance”. Financial commentators and pundits seem to have taken to overly simplifying the election outcome in binary terms. A win for Mr. Modi would mean reforms and rapid economic growth while any other outcome would be an absolute disaster for the Indian economy. In a complex country like India the truth lies somewhere in between.

Crumbling BRIC?

To say that the last twelve months have been challenging times for the Indian economy would be an understatement. First came the ignominy of being part of the underperforming BRICS (Brazil, Russia, India, China and South Africa). Then came the dubious honor of joining the Fragile Five, a term coined by Morgan Stanley for countries with high inflation, weak currency, slumping growth and large external deficits. With this in mind, does a new elected government really have a chance of reviving the economy? The Indian stock market definitely seems to think so and it has seen a strong rally since the first exit polls started coming out in February 2014. But investors must realise that this is a hope-based rally. The hard reality of fixing a complex economy like India will set in once the election fever subsides.

Magic wand

Mr. Modi’s pro-business credentials and his reputation for speedy execution have raised expectations among the Indian public and foreign investors that a wave of his magic wand will heal India of its self-inflicted wounds. But historic precedent suggests that the impact of structural reforms is felt many years after the first shot at fixing a country’s problems. Take the case of Brazil, whose cycles of boom, bust and chronic inflation made it a basket case of economic mismanagement in the 1970s and 1980s. It took a visionary in the form of Fernando Henrique Cardoso to break the back of inflation and pass through reforms that succeeded in putting Brazil on the economic map. His time as finance minister and two terms as President from 1995 to 2002 set the foundation for Brazil’s rapid growth trajectory. It took close to ten years of reform before results were visible to the Brazilian public and the investment community at large. Successive governments under Presidents Lula Da Silva and Dilma Rouseff have ridden the wave created by President Cardoso.

Rocky road

The lesson from all this is that deep structural reforms take time to be implemented and it takes years before they show up as solid economic growth. A recent report by Credit Suisse indicated that only a quarter of investment projects in India are stuck under the federal government. This means Mr. Modi will need active cooperation from the State governments to implement reforms and push through investments. In India’s cacophonous democracy, implementation is bound to take time. Also, most of the “easy” reforms have already been implemented leaving the new government with the unenviable task of pushing through tougher unpopular reforms to correct the course of the economy. These include labour reform, reforms in land acquisition, judicial reform, streamlining India’s gargantuan bureaucracy and allowing FDI in retail.

Even with the best-case scenario of having a federal government with a strong mandate, it could take two years to start seeing results on the ground. The challenge of doing all this while keeping a lid on inflation and rising unemployment will be no mean task.

Demographic dividend

So why the urgency to implement the above mentioned reforms? As noted in The Emerging Market Handbook, the simple one-word answer is demographics. There is no precedent in world history where one nation has been gifted with so many young people entering the workforce at the same time. With an average age of 28 years, India’s demographic edge is expected to last another 40 years. The next ten years will be crucial to reap the benefits of this enormous “natural resource”. A resurgent Indian economy has the capacity to carry global economic growth on its back the way China has done for the last two decades.