One of the key themes of recent months in world investment has been the surprising retreat of emerging markets in the face of the repatriation of international liquidity, and the relative outperformance of the frontier class of generally lesser-developed nations.
Until the aggravated situation arose in Ukraine (relegating tensions in the Middle East in the table of global risks), both that country and others such as Argentina and Kazakhstan had been rather sheltered from the rush of knee-jerk investor reactions.
Now there are signs that these and similarly classified countries will come under increased scrutiny — their underlying economic fundamentals inspected — and that funds flows will become more discriminating between stronger and weaker names, in key variables like foreign reserves cover and debt ratios. Indeed, much attention has been paid to exchange-rate susceptibility already.
They have not been dismissed, however, as merely marginal plays in the investable universe. Indeed, given the hunger for yield that will persist as long as key interest rates remain at rock-bottom levels, those considered to be the healthier frontier markets may continue to be favoured, perhaps even benefiting from rotation within the class itself.
Global market trends across the board may be vulnerable if the collective security scenario over Ukraine stays tense and potentially volatile, but in fact both stocks and bonds have in recent weeks otherwise responded well to the muddling-through nature (no better, no worse) of the world economy.
Into this asset allocation mix comes research recently by Bank of America Merrill Lynch (BofA ML), which addresses the frontier category in an in-depth manner, and advises that the wheat should be separated from the chaff; differentiation is due.
“Frontier markets are in fashion,” the study remarks. Compared to mature emerging markets (EM), “they tend to have lower levels of leverage, and are working harder on reforming their economies. They are also further away from the middle-income trap [when it is] increasingly hard to squeeze the marginal drop of productivity growth. And while investors deplore the lack of liquidity in EM, they appear to applaud it in Frontier, as it is so low that it actually reduces volatility — at least as long as all goes well.”
As to the Gulf, a number of points can be made, bearing in mind that two of its constituent members are due to upgrade from frontier to emerging market status this May.
First, along with Central and Eastern European countries, the GCC tends to score well in having low political risk, aided in Qatar and the UAE notably by institutional and income factors.
Second, as mentioned here last week reflecting on the IMF’s assessment, there are greater signs of “realistic and prudent budgeting practices [and] the need to manage expenditures carefully”, notably in Saudi Arabia and the UAE.
Third, even so, like other producers, the Gulf states have had the tailwind of high commodity prices, a so-called supercycle, that economists know as an improvement in the terms of trade. A potential unwinding, again as the IMF observed, is a “key risk”.
BofA ML deduces that ideally one would be positioned in countries that have achieved high growth without a “major boost” of that sort. To the extent that certain cases, including in the Gulf, rely on that uplift, there is implicitly a concern.
Fourth, Saudi Arabia gets special mention as a country that offers among the best risk/reward profiles, as “we are most optimistic about reforms” in the labour market (workforce nationalisation) and residential market (mortgages and affordable housing). Indeed, Saudi Arabia “scores best according to nine drivers of growth”.
Across the frontier segment, “looking at the data, the GCC countries come out on top in terms of macro resilience and fiscal/debt dynamics,” Jean-Michel Saliba, Mena economist at BofA ML told me last week. “They are benefiting from sovereign wealth [backing] and still accommodative monetary and fiscal policy settings, which contribute to momentum.”
Asked whether momentum isn’t itself potentially hazardous, Saliba drew a distinction this time. That degree of impetus is not so much a concern as it was before the global financial crisis, he argued, because “the big problem then was leverage, whereas now credit growth figures are quite subdued; the level of vulnerability is no longer the same”. As for the UAE specifically, the emirate “is not completely out of the woods yet, but still the factors that led previously to boom and bust are not as present as they were.”
On the growing issue of rising financial breakeven rates in the Gulf, Mr Saliba perceives “some adaptation” in terms of fiscal consolidation. “A decent financial cushion has been built up,” he remarks. If there were a paradigm shift to lower oil prices, though, then [the GCC states] would need to adapt to a new reality.”
With that critical proviso, it seems a certain, measured confidence towards the region is once again in order.
