In the fixed-income investment world, many investors pay close attention to the global bond rating agencies’ upgrades and downgrades for both countries and companies. These changes can have an impact on the value of a security from the effect of passive fund flows (for instance, inclusion in an index can create more passive fund buyers for certain bonds), as well as investability, given certain funds’ mandates (e.g., investment-grade bonds only).
In the emerging market and frontier market equity investment universe, a similar variable to watch is upgrades and downgrades by MSCI. This index provider classifies all countries as “developed,” “emerging” or “frontier.” And with the rise of passive index funds (or exchange-traded funds), any country upgrades (and any resulting index change, for instance from emerging to developed, as was the case for Israel in 2010) can generate a significant impact on that country’s equity market performance. A country upgrade may also lower the cost of capital for its respective listed companies (with inflows pushing up market values, more valuable companies can usually borrow funds at lower interest rates). This change is driven by the much larger capital pools in developed markets than in frontier markets; that is, the passive funds that track developed markets are much bigger than ones that track emerging or frontier markets.
Over the next 12 months, we have such a situation in frontier and emerging markets, specifically for countries in the Middle East. These markets are becoming more important from an index perspective (and maybe from a lower cost of capital perspective), because the region is rising sharply in both the emerging market equity and bond indexes.
As seen in Chart 1, the Middle East has risen from 0% back in 2014 and will likely reach 5% with the inclusion of Saudi Arabia. The changes by MSCI are driven by capital market reforms (in the case of Saudi Arabia) and higher foreign ownership limits (FOL) over the past few years (in the case of UAE, Qatar and Kuwait).
Chart 1: Middle East countries as % of MSCI EM Index
On the bond side, as seen in Chart 2, all Middle East fixed-income sovereign bonds are moving from 0% currently to a predicted 12% weight by this time in 2019, driven simply by more issuance at the sovereign level by the respective governments.
Chart 2: Middle East countries as % of JPM EMBI Global Bond Index
Will this have much impact on stock performance? I am not sure, but with a rising oil price, it’s not too surprising that the region has some of the best-performing markets year-to-date in U.S. dollar terms.* Valuations are generally attractive, fundamentals for many companies have likely bottomed out, and the region is likely not showing up much on most global equity investors’ radars. This factor is even more apparent for Saudi Arabia, which recently opened up to global investors. As seen in Chart 3, less than 5% of the equity market is owned by foreigners, while it is near 50% for more traditional markets such as Brazil.
Chart 3: Total foreign ownership of the equity market (% of market cap)
Source: National Exchanges and Credit Suisse, as at Q1 2018.
The frontier funds are positioned in these markets, with exposure to the banking, consumer retail and fuel transport sectors.
Thanks for reading,