What constitutes a “frontier” market?

Per Heather Timmons’ piece from The New York Times, “some investors and deal-makers call them ‘frontier’ markets, but there are plenty of other names for these nations. A Merrill Lynch analyst refers to them as ’emerging emerging’ markets, for example, while Goldman Sachs focuses on the N-11, or Next 11, developing countries.”

Perhaps a more exact definition, if one exists, hinges on the notion that true frontier markets are “one step below the recent maturation” seen in the bona fide BRICs–the original Goldman Sachs term coined back in 2001 for the four economies of Brazil, Russia, India and China, the then-and-still-now leaders of the “emerging markets.” But don’t let the ‘one step below’ label fool you. By the year 2050, Goldman maintains, the combined economies of the N-11 could reach two-thirds the size of the G-7 nations.

While the upside of such markets is readily apparent–“there are deals to be done where valuations can be quite rich and yields are much higher” than in Europe or elsewhere, according to Yvonne Ike, senior country officer for sub-Saharan Africa at JPMorgan Chase–so too should be downside. “Deal-making in these countries involves local connections, long courtships of governments and industry titans, as well as a double layer of due diligence,” writes Timmons. Not to mention the dangers of nationalization, civil war and genocide. Take Kenya, for example. Once one of the world’s fastest-growing stock markets is now mired in political uncertainty and itinerant violence. “No one should expect Kenya to play a stabilizing regional role again anytime soon,” warned one pundit.

Another apparent danger is that such markets are truly ripe for speculative asset bubbles, meaning that those interested solely in short term profits must time their entry and exit points with precision. But thus far this somewhat abstract criticism of the frontier markets has been unwarranted. In fact, any investor who has not had at least some exposure to these markets in the past 5-10 years has been missing out. Consider, for instance, that the Standard & Poor’s Frontier Markets index returned an annualized 37 percent over the past five years, topping the 32 percent average yearly gain of the MSCI Emerging Markets index. “As a group, frontier markets are less volatile than you’d expect, argues Christian Deseglise, HSBC’s global head of emerging markets. “The individual countries can be very volatile, but consider the likelihood that Nigeria would move in sync with Vietnam.” Frontier markets’ low correlation to developed markets thus means more diversification potential for individual portfolios. That said, January 2008 saw a 11.3% drop of the MSCI Emerging Markets index. And any rebound in the dollar, as is expected by some economists, won’t mean good things for either commodity or oil prices.

Surging prices in commodities–oil, metals and agriculture, for example–have been driven by increased demand, increased speculation augmented partially by low real interest rates in the U.S., and by the Fed’s loosening of the dollar and have fueled the initial interest in frontier markets. High commodity prices have yielded windfall profits for the region’s leading producers of raw materials, and growing demand for energy, metals, and minerals, particularly in China, has so far driven unprecedented levels of foreign investment.  But the increased liquidity in these markets in not solely driven by foreigners.  A consumer explosion can be found in many of these nations, and includes a rising urban middle classes that “snaps up cell phones, cars, television and appliances,” according to The Washington Post’s Jane Bryant Quinn.

Joseph Rohm, an analyst for the T. Rowe Price Africa & Middle East fund (TRAMX), points out that the investing climate is improving so much in certain African countries, for example, that investors are finding bargains in such sectors as financial services (i.e. banks, which are often among the first beneficiaries of economic growth), wireless carriers, and construction companies, which implies that prospects for continued growth may eventually decouple from commodity rates per se. “For the first time ever in Africa’s history, there has been major spending on infrastructure,” explains Rohm.  Quinn agrees, noting that “because the IMF has forgiven much of Africa’s debt, governments there have been left with surpluses to invest in electricity, telecommunications and roads.”

Right now, investors and fund managers alike have several different viable indexes to serve as “frontier guides,’ so to speak. The Dow Jones DIFC Arabia Titans 50, for example, tracks the leading companies in countries like Bahrain, Egypt, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar, Tunisia and the UAE. And in March 2008, Merrill Lynch came out with a frontier-market index that focuses on companies that have large trading volumes and a market capitalization of at least $500 million. Half of the 50 companies are located in the Middle East, 23% in Asia and the rest are spread throughout Africa and Europe.

Naturally, the indexes are heavy right now on financial firms and oil and gas outfits, which means that it is quite susceptible to short term shocks. And while “companies and governments are eager to find money for projects that range from bridge building to telecommunications tower installations, [and] investors looking for higher returns are racing to provide this cash, and deal-makers are reaping the rewards,” the infancy of frontier markets is such that financial liberalization has yet to materialize. “The banking systems don’t function that efficiently yet,” explained Norman Villamin, head of research and strategy group investments for Citi Global Wealth Management, Asia Pacific, “so foreign money flowing in tends to be quick, sometimes inflating prices and causing an overdone regulatory reaction.”

Using macroeconomic stability, political maturity, openness of trade and investment policies and quality of education as the criteria, Goldman Sachs’ Jim O’Neill, M.D. and the firm’s head of Global Economic Research, named in his 2005 Global Economics Paper No: 134 Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, South Korea, Turkey and Vietnam as the newfound N-11, albeit with the caveat that “of them, only Mexico and perhaps Korea have the capacity to become as important globally as the BRICs.”

Of immediate concern for any of these countries is how to sustain the ongoing growth momentum in an environment of macroeconomic stability. Then-Prime Minister of Pakistan, Shaukat Aziz, noted at the time of the report for example that linked with the problem of maintaining growth are “the challenges of job creation, poverty alleviation, improving social indicators and most importantly, strengthening the country’s physical infrastructure to support 6 to 8 percent growth in the medium term.” To encourage economic development, Pakistan’s Salman Shah, advisor to Prime Minister on Finance and Revenues, needed to fully leverage its human capital, and accordingly the country would need to begin “investing heavily in human resource development through education and technical education.”

In the case of Pakistan, O’Neill’s paper pointed out that its “infrastructure except rail [was] not able to provide required backing to its economic development.” O’Neill concluded that $4.5 billion per annum investment in infrastructure would be required to sustain the current projected GDP growth rate. Moreover, Goldman Sachs asked Pakistan to “enhance the joint role of public and private sector in infrastructure development, allow incentives to encourage investment and increase gross savings, improve policies to tackle the problem of law and order situation, put in place long-term initiatives to enhance political stability and continued focus on education for its rapid economic development.”

A tall task, no doubt, and similar recommendations, which this blog will delve into in time, echo throughout the remainder of the N-11, as well as a handful of nations neglected by the Goldman Sachs paper.