Any “frontier” left in frontier markets?

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Adam Kutas | Portfolio Manager

June 2019

Over the past year we have seen fairly significant changes in country classifications by the index provider MSCI. Saudi Arabia was classified as “emerging” and Pakistan and Argentina were upgraded from “frontier” to “emerging.” And Kuwait was put on the watch list for a potential upgrade to “emerging.” This has many clients wondering: Will there be any countries left in the MSCI Frontier EM Index?

It is a good question, and I will try to answer it in three parts. First, a changing country mix is a normal part of index construction, and has been seen in the MSCI EM Index over the past 30 years. Second, there is a deep pool of countries for the frontier index that are still at the very early stages of their economic and capital market development. Many do not have stock exchanges, but that could soon change. Finally, I would argue that the recent and upcoming country upgrades are positive for frontier investors, because they are creating a more purely “frontier” index – and as a result, investors will have more exposure to the assets they seek.

Let’s walk through each of these observations. To start, part of the framework of frontier investing is thinking of the frontier countries as being at the same economic stage of development as traditional emerging markets 30 years ago. Emerging markets developed at different speeds, and companies were listed on the stock exchange at different times, so the index composition was constantly in evolution. As seen in Chart 1, the country weightings of the MSCI EM Index have changed significantly from the makeup in 2018. China, now the largest country weighting, at over 30%, wasn’t even in the Index 30 years ago. My expectation is that the Frontier EM Index will evolve in a similar way.

Chart 1: MSCI EM country weightings – 1988 vs. 2018
Chart 1: MSCI EM country weightings – 1988 vs. 2018
Relative weight of countries shown as at December 31, 2018.
Source: BAML/FMR.

The next likely question from investors is, “Are there any more Chinas out there?” This brings us to the second part of the discussion: countries that could eventually join the Frontier EM Index over time. There are many current candidates, including Angola and Ethiopia. Both countries are driven by their government’s current focus on privatization of state-owned companies, which should help to drive growth. Another is Iran, with its large domestic stock market and history of equities. It is always on the horizon, but sanctions keep that market off limits. More broadly speaking, however, there remains a broad universe of countries in the frontier category that could one day become investment opportunities.

As seen in Chart 2, the frontier group has almost 60 countries that either have no stock exchange or are classified as “stand-alone” by MSCI. Of course, most of these countries are quite small compared with China. But as Chart 3 shows, those countries, taken together, add up to almost 700 million people – so there is a lot more “frontier” on the horizon still to come.

Chart 2: Number of countries classified as standalone or without a stock exchange
Chart 2: Number of countries classified as standalone or without a stock exchange
Source: MSCI. Based on MSCI Index Country Classification.
Chart 3: Number of people with no access to stock exchanges
Chart 3: Number of people with no access to stock exchanges
Source: MSCI. Based on MSCI Index Country Classification.

Finally, let’s consider the impact on frontier investors that changes to the Frontier EM Index will have. Currently, countries are classified as “frontier” for three reasons: undeveloped economies (e.g., Vietnam, Bangladesh), undeveloped capital markets (e.g., Kuwait, Oman), or a combination of developed economies and capital markets and bad investing rules for investors (e.g., Argentina). Some investors suggest that countries from the latter two categories make for a less purely “frontier” index; they claim that countries like Oman or Bahrain are unlikely to have strong growth prospects, because they are wealthy countries but have immature capital markets. If that is the case, advancing Argentina and Kuwait to “emerging market” status will make the FEM index more “pure” – that is, it will provide investors with more exposure to the growth opportunities they seek as the proportion of undeveloped economies and undeveloped capital markets becomes predominant in the FEM index. As shown in Chart 4, if we see these changes take place over the next year, the FEM Index should become over 95% “pure.”

 

Thanks for reading,

Adam J. Kutas, CFA

 

Chart 4: MSCI FEM countries categorized by three characteristics
Chart 4: MSCI FEM countries categorized by three characteristics
Source: MSCI.


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