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Are Frontier Markets Worth the Risk?

Stockholm (Ekonamik) – Given the disappointing performance of emerging markets lately, investors might start looking for returns in markets further afield. The returns are extremely appealing and the recent behaviour of the sovereigns is rather reassuring, but ratings and a longer view suggest frontier markets are not for the faint-hearted.

“There are high yields and good investment opportunities in local currency Frontier markets, including in Egypt, Ghana, the Dominican Republic and Nigeria” says Kevin Daly, Senior Investment Manager at Aberdeen Global Asset Management.

The line dividing Emerging markets from Frontier markets can appear to be somewhat arbitrary. According to a review by MorningStar, Frontier markets are supposed to be a subset of those economies defined by the World Bank as developing countries. They are supposed to be distinguished from the latter due to lower levels of economic development, size, liquidity, market accessibility and political uncertainty. However, Estonia, a member of the EU and of the OECD which enjoys a high level of human development according to the UN is included in the MSCI Frontier Market index.

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Nevertheless, taking funds and index classifications at face-value, we can see that Kevin Daly has a point when he singles out the performance of frontier markets (“NEXGEM”, below).

The main deterrent of Frontier markets is their risk. For investors primarily guided by credit rating classifications, Frontier markets present a concerning prospect given typically non-investment grade credit ratings. Taking the example of Aberdeen’s funds, its Frontier Markets Bond fund has a “highly speculative” “B” rating while the Emerging Markets Local Currency fund enjoys a Lower medium investment grade rating of “BBB”. The frontier market fund is six grades below the emerging market.

To a large degree, this stark contrast in credit rating reflects the history of default of the two groups. Following the MSCI distinction between the two market segments, and based on the Canadian Central Bank’s CRAG sovereign default dataset, between 1960 and 2016, the rate of years in default for Frontier market countries was 43.25% whereas it was 25.12% for Emerging market countries.

This long history includes long periods of post-independence civil wars that appear unlikely to be rekindled for the many of the African markets that make up Frontier markets. This recent stability has borne its fruit as Aberdeen’s Emerging markets fund is much more volatile over the last three years than the Frontier one.

Frontier markets might not be for everyone, but for those that have the stomach for it, the differential appears set to remain, with the World Bank predicting higher rates of growth on average there than in Emerging markets for 2019 and 2020.

Picture from Pixabay

Filipe Wallin Albuquerque
Filipe Wallin Albuquerque
Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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