Frontier Markets Semi-Annual Outlook

August 2023*

Cautious Optimism but Challenges Abound

Resilient global growth and the approaching pause in the Fed’s tightening cycle suggest a more supportive outlook for frontier markets (FM). Nonetheless, downside risks, such as an El Niño event or a global slowdown, leave us cautious. Our allocations seek exposure to the nearshoring trend and constructive commodity outlook.

Following a challenging backdrop of rising commodity prices and tighter monetary policy, the outlook appears to be improving. Global growth has been better than initially feared, with the global composite PMI index above the 50-mark in July. Economic activity has proven most resilient in the US, where forecasters have pushed back or softened recession projections. While China’s post-lockdown recovery has disappointed, policymakers acknowledged this when unveiling support measures at the July Politburo meeting. The announced stimulus measures should support steady but softer growth in China, which has positive spillover effects on FM. Meanwhile, with disinflation firmly underway in the US, the Fed is widely expected to reach peak rates this year. As such, the USD should soften, providing some respite for emerging markets (EM) and FM. 

There are still a few challenges clouding the horizon. Aggressive monetary tightening suggests a slowdown in developed markets (DM) seems likely. The eurozone has narrowly avoided a recession, and a continued downturn seems likely. In the US, leading indicators point to a softening in activity, albeit milder than expected six months ago. More specifically for FM, the US Climate Prediction Center indicates a greater than 95% chance of an El Niño weather event over the coming months. El Niño tends to lead to drought and dry conditions in parts of Asia and more rainfall in parts of South America. On the former, Vietnam has already started to feel the impact of reduced hydropower generation, and its rice and coffee output is at risk. Conversely, Argentina’s agricultural production could receive a boost from greater precipitation following droughts at the start of the year. More generally, lower agricultural output and higher food prices would hit countries that are net food importers and have a large weight to food in their CPI basket. Nigeria, Bangladesh and Morocco appear vulnerable on this front. 

Market Strategy

FM equities, as measured by the MSCI FM 100 Net TR Index, outperformed EM equities (MSCI EM Net TR Index) by 3.8% points over February-July. It underperformed DM equities (MSCI World Net TR Index) by 4.0%pts, but this reflects the AI-driven technology stock rally in DM. Valuations for the MSCI FM100 Index have become more attractive, as its 12M forward P/E is at a near 40% discount to EM, much wider than its five-year average. 

For our country allocation, we favour markets that benefit from nearshoring trends (Vietnam) and our constructive near-term commodity view (Kazakhstan). We stay underweight in Argentina and Nigeria due to election uncertainty and volatile swings in the naira, respectively. 

We only make one change to our allocation:

  • Downgrade Romania to neutral. Neutral valuations, a twin deficit problem and proximity to the eurozone slowdown mean that we take profit from our outperformance and close our overweight allocation.

Chart 1: S&P Extended Frontier 150 Net Total Return USD, Feb 23-Jul 23

Source: S&P

*The publication reflects asset performance up to 31 July, 2023, and macro events and data releases up to 8 August, 2023, unless indicated otherwise.

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.