Frontier Markets Semi-Annual Outlook

February 2023*

Not Out of the Woods

With peak rates in sight and a China reopening, the backdrop for frontier markets (FM) is more positive. Nonetheless, challenges remain, from slowdowns in the US and eurozone, to tight monetary policy. As such, FM with unfavourable external balances will likely remain under pressure.

The outlook has improved over the past six months. First, China has abandoned its zero-Covid policy much faster than anticipated, suggesting a strong economic rebound in China. Second, the tentative decline in global inflation heralds a peak in rates, with financial conditions easing over the past few months in anticipation. This has helped weaken the US dollar, giving emerging (EM) and FM some breathing space. Third, unseasonably warm weather and high gas storage levels have reduced the likelihood of an energy crisis in Europe.

Still, headwinds abound. Slowdowns in developed markets (DM) imply softer external demand, weighing on export and tourism sectors in FM. In addition, DM policy is expected to remain tight, putting pressure on FM currencies and foreign reserves. In this environment, we favour markets well positioned to benefit from the China reopening, either through direct trade links (Vietnam) or through the positive feedthrough to commodity prices (Kazakhstan).

Meanwhile, the economic damage wrought by recent droughts in Argentina, Morocco and Kenya lays bare the fact that climate change already poses a risk to FM. Without significant and timely investment, FM will continue to face macroeconomic instability as weather patterns become unpredictable, increasing the likelihood of social unrest. The IMF’s recent climate change-focused Resilience and Sustainability Facility, which has disbursed funds to Bangladesh, is a step in the right direction.

Market Strategy

FM equities, as measured by the MSCI FM 100 Net TR Index, underperformed both EM equities (MSCI EM Net TR Index) and DM equities (MSCI World Net TR Index) by 10.4%pts and 7.6% pts, respectively, over the past six months.

Valuations for the MSCI FM100 Index are still attractive. FM’s 12M forward P/E is at an 18% discount to EM, wider than its five-year average discount of 5%. Moreover, FM earnings are projected to grow by 14% this year, outpacing the 7.5% decline expected in EM. This suggests the potential for re-rating of FM assets.

  • Downgrade Slovenia to neutral. Valuations are cheap on a forward P/E basis, but forward earnings for the largest constituent of MSCI Slovenia, Krka, are weak. In addition, Slovenia is still exposed to energy risks.

*The publication reflects asset performance up to 31 January, 2023, and macro events and data releases up to 10 February, 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.