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Frontier Markets Semi-Annual Outlook

August 2022*

In the Shadow of the War

With commodity markets upended by the Russo-Ukrainian war, rising inflation and tighter monetary policy have followed. The prospect of a synchronised slowdown points to softer growth in frontier markets (FM), where the post-pandemic recovery is still in its early stages. Dwindling foreign reserves mean that some FM are particularly vulnerable to a debt crisis.

Just as the post-pandemic recovery got underway, frontier markets (FM) have been hit by a surge in commodity prices in the wake of Russia’s invasion of Ukraine in late-February. The pandemic had already left scars in many frontier markets due to their limited fiscal space to offset the economic hit. But with higher raw materials prices pushing up inflation across the world, developed markets (DM) have initiated an aggressive tightening cycle. This is likely to put pressure on central banks in other parts of the world to keep up, with higher rates dampening domestic demand.

Meanwhile, tighter global financial conditions are set to put pressure on FM reserves, which are already strained in food and energy importing nations. Additionally, due to the small and open nature of their economies, frontier markets are particularly exposed to the likely DM slowdown. All told, FM economies face significant headwinds.

While sharing many of the same challenges facing emerging markets (EM), FM are vulnerable in additional ways. For a start, low-income economies are less likely to borrow in domestic currency, which leaves them exposed to a stronger US dollar. For example, the IMF recently noted that 60% of low-income countries were in or at high risk of debt distress. Secondly, dependence on food imports and strained external balances mean that many FM are at risk of experiencing a food crisis, which could trigger social upheaval.

The flipside is that commodity exporters (Kazakhstan and Nigeria), countries with ample reserves (Morocco and Romania) and those in a strong fiscal position (Vietnam) face the best prospects.

Market Strategy

FM equities, as measured by the MSCI FM 100 Net TR Index, continued to slightly outperform EM equities (MSCI EM Net TR Index) over the past six months. Nonetheless, both trailed DM equities (MSCI World Net TR Index) over the same period.

Some valuation metrics for FM equities have improved. The discount of the 12M forward P/E of FM to EM has widened from 5% at the end of January to 11%, higher than its five-year average of 6%. On balance, considering that EPS for FM is expected to grow by 4.7% this year, much higher than the 4% contraction projected in EM, there is upside potential.

Bearing in mind each country’s exposure to the various global headwinds, as well as equity valuations, we make only one change to our allocation:

*The publication reflects asset performance up to 29 July, 2022, and macro events and data releases up to 11 August, 2022, unless indicated otherwise.

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The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.

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© 2022 City of London Investment Management Company Limited.
All rights reserved.

City of London Investment Management Company Limited (“CLIM”) is authorised and regulated for the conduct of investment business within the UK by the Financial Conduct Authority (FCA) and is registered as an Investment Advisor with the United States Securities and Exchange Commission (SEC). Registered in England and Wales No. 2851236. Registered Office: 77 Gracechurch Street, London, EC3V 0AS, England.

© 2022 City of London Investment Management Company Limited. All rights reserved.