Sale of the century: The 2018 outlook for frontier emerging markets

Photo over llooking riiver and bridges in Prague

I recently attended the largest eastern and frontier European investment conference of the year, in Prague, Czech Republic. I have been attending this conference every year for over the past ten years, and it’s always a great insight on the trends in a unique part of the world. The conference had its highest-ever attendance, with 250 investors meeting over 200 companies.

I met with Romanian, Ukrainian and Polish companies (among others) that offered generally positive updates as that region continues to emerge from a ten-year recession that began in 2007, when their property bubble peaked. Many of Fidelity Frontier Emerging Markets Fund’s key holdings from this region performed well in 2017 as the market awoke to this economic shift. Accordingly, as a value-oriented investor, I am happy with the Fund’s positioning in frontier Europe. As we kick off 2018, however, current valuations dictate that we train our sights elsewhere to seek out the next set of opportunities.

One of the big trends in the new year, in my view, will likely be the ongoing growth of privatizations in emerging and frontier countries as they continue to rebalance their economies following the fiscal stress caused by the ten-year global commodities bear market that started in 2007. As seen in Chart 1, which uses copper prices as a proxy for global commodities, the decline since the peak in 2011 has forced government spending cuts in commodity-oriented countries, which sharply impacted their growth outlook.

Chart 1: General government expenditure of commodity-exporting countries (annual, US$ billion) vs. copper prices
General government expenditure of commodity-exporting countries (annual, US$ billion) vs. copper prices
Source: Oxford Economics and Thomson Reuters.

 

To help plug the fiscal gap created by this decline in government revenue, many governments, in addition to making fiscal cuts, began selling stakes in outright government-owned companies in the stock market (See Chart 2, which tracks these transactions by number and value).

Chart 2: Emerging and frontier M&A deals where government- or state-owned enterprise (SOE) is the seller
Emerging and frontier M&A deals where government- or state-owned enterprise (SOE) is the seller
Source: Dealogic.

 

In emerging Europe and Africa, this trend is occurring in countries such as Romania and likely South Africa. In the Middle East, the trend is playing out in an even more pronounced manner. For example, in the UAE, the national oil company, Abu Dhabi National Oil Co., completed an initial public offering (IPO) for its gasoline retail chain in December 2017, now valued at over $9 billion.

The clearest point of evidence for this trend, from my perspective, is the planned IPO of the Saudi Arabian Oil Company, a.k.a. Saudi Aramco, the world’s largest oil and natural gas company by revenue. The IPO, representing perhaps 5% of the state-owned company’s value, is expected to raise between $50 and $100 billion, which would make it the biggest initial offering ever. Historically, in emerging and frontier markets, when governments open more sectors to private companies, it tends to create very good investing opportunities for global investors.

However, not all countries are selling assets because of weak commodity prices. Vietnam is facing a different, but positive, situation. As one of the three countries best positioned to gain manufacturing market share from China (Cambodia and Bangladesh being the other two), Vietnam is experiencing a significant inflow of foreign direct investment (FDI) as companies relocate factories there (see Chart 3).

Chart 3: Vietnam’s infrastructure investment (US$ billion and % of GDP)
Vietnam’s infrastructure investment (US$ billion and % of GDP)
Source: Global Infrastructure Outlook.

 

This inflow is pressuring the Vietnamese government to provide better infrastructure (roads, ports, rail) to maintain the investment trend and sustain its 6%-plus GDP growth, which is one of the best growth rates globally. To fund this infrastructure boom, the government is selling down its stakes in companies such as Vinamilk (the largest dairy company, now valued at over $10 billion) and Sabeco, the largest brewer in the southern part of the country. As in commodity-oriented countries, this change should provide more liquidity and transparency and, we hope, better returns on capital for shareholders.

Beyond this structural shift in frontier emerging markets, broader trends remain in place, which include manufacturing share gains from China and the resulting shift from traditional markets to more formal retail shopping – trends that we witnessed in the bigger emerging markets, such as China, Brazil and Korea, 25 years ago.

Political risk is almost always an issue when investing in these markets, and it can create dramatic headlines. In my experience managing the Fund, however, I have found that much of the uncertainty in these markets is reflected in the prices of their securities. That said, I still believe frontier emerging valuations remain relatively cheap overall (especially relative to developed markets such as the U.S.), and investor sentiment appears to be subdued, given the focus on Internet-related companies. As we move into 2018, this backdrop provides an attractive risk-and-reward scenario for investors seeking to diversify their portfolios with a structurally growing, low-correlated asset class.

All the best over the new year,

Adam Kutas

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