We use three criteria to classify frontier economies—investment credit rating status (high yield), income status, and issuance size. Our definition of the EMD Frontier universe currently includes 36 economies.

Emerging Markets have confronted a number of shocks since 2020. This includes the pandemic, the increase in food/energy prices, along with a move higher in global interest rates. For frontiers, which are smaller economies, this has resulted in higher yields and more limited access to dollar-denominated funding.

Recent global challenges raise the question: What is the case for investing in frontier economies? Three are salient. First, among the 36 countries in the space, there is diversification potential. Second, there is plenty of differentiation among the sovereigns. Last and most importantly, since inception, frontiers have significantly outperformed the broader dollar-pay EM bond indices (proxied by the JP Morgan EMB-Global).

A comparison between the JP Morgan EMB-Global Index and the NEXGEM Index substantiates this point. The NEXGEM Index proxies frontier sovereign performance; it currently includes 33 of the 36 countries in our frontier universe. During 2023 the NEXGEM Index rose by 21 per cent, nearly 1,000 basis points better than the EMB-Global. This outperformance continued through the first half of 2024, with the NEXGEM returning +4.8 per cent vs +1.8 per cent for EMB-Global.

In terms of the macro trends in frontier economies, growth is higher for the group, which would be expected as they are starting from a smaller base. Turning to monetary policy, the news on inflation is less encouraging; it is higher, and food has a larger weight in the CPI baskets.

For investors, the willingness and ability of a sovereign to pay is the foremost concern. It is important to analyse the fiscal and external balance sheets across frontier economies and examine factors that determine payment capacity.

Our investment process entails evaluating whether country fundamentals are improving or deteriorating. In frontier markets, this has translated into an overweight position in the countries where we have a positive outlook on the countries’ fundamentals.

Too Risky?

The concern among investors is whether it is too risky to invest in frontier markets. Reflecting this concern, in December 2023, nine frontiers were trading at spreads 900 basis points above US Treasuries (we remove Lebanon from our market calculations). Excluding the sovereigns already in default, that left five countries in “distressed” territory.

Most of the economies that have defaulted are smaller and therefore have not had a systemic impact on the asset class. Together, the seven frontier markets that defaulted since 2020 account for just 1.4 per cent of EM GDP (using the EMBI ex-China as our universe). Second, after the shocks of the last four years, the weakest countries have already experienced payment difficulty. Colloquially, many of the weakest hands have folded.

With defaults tapering off, there was a strong rally in frontier sovereign debt in 2023. For context, while the NEXGEM Index returned 21 per cent last year, countries that were rated CCC or in default returned 50 per cent. Dividing this performance into two different categories, there are frontiers that many investors, going into 2023, expected to face payment stress. When this did not occur, these countries rallied strongly (El Salvador and Pakistan). The other group of countries was those that already defaulted. The investment thesis was that these sovereigns were prepared to settle with their creditors on terms better than initially feared.  This has borne out in Suriname, Zambia, and most recently Sri Lanka.

This highlights another relevant point. For most countries, the relationship with their creditors does not end after a restructuring. Countries typically renegotiate the terms of their debt and continue to engage with creditors as they restructure. Unlike some of the examples in the corporate universe, the net present value (NPV) on restructured sovereign debt has averaged about 50 cents on the dollar during the 1998-2022 period. Friendly restructurings can have an NPV over 75 cents on the dollar.

Diversification

Frontier debt investing allows for exposures to countries that can’t easily be found in other asset classes. This is not limited to dollar-denominated debt, as investing in frontier local markets also presents dynamic opportunities. Because frontier markets are smaller, they tend to be driven more by internal market dynamics.

This has two implications. First, local currencies in these economies are less correlated with other EM currency markets. Second, because these markets are not as saturated by international investors, macro considerations can be more important than global drivers. To be sure, in such markets, the potential for higher returns can come at the cost of less liquidity.

Differentiation

Looking at frontier economies as a group presents a unique set of challenges because this group of countries is so disparate. All are high-yield rated, though, we argue that not all can be painted with the same brush.

Some of the frontiers are ‘BB’ rated economies; within our universe of 36 countries, 14 are rated ‘BB-’ or higher by at least one rating agency. These countries are less vulnerable to event risk and have solid credit metrics. Examples of countries in this category include the Ivory Coast, Morocco, Paraguay, and Costa Rica.

On the other end of the spectrum, there are ‘B’ and ‘CCC’ rated credits, which could, in an adverse case, suffer from creditworthiness concerns. We saw some of these countries fall into distress post-pandemic. There are many countries between these two extremes—in some, credit fundamentals may not be rock solid, but there is not currently a high risk of default; examples would be Jordan, Nigeria, and Angola.

Our active positioning in frontiers has typically been above their share of the NEXGEM benchmark, but where we see a challenging outlook, we will take zero exposure. For context, within the NEXGEM universe described earlier, accounts that we manage only have exposure in 19 of the 33 countries. In short, we believe this market sector presents significant investment opportunities to those prepared to undertake in depth analysis of individual countries.

Geopolitical tensions were cited by 83 per cent of respondents as a major risk to global growth over the next year, up from 72 per cent in 2023, reflecting concerns over competition between the major powers and the potential for trade disruption. Sovereign wealth funds (SWFs) regard emerging markets as potential beneficiaries, pointing to the opportunities presented by trends such as near-shoring. As a result, 67 per cent of SWFs expect emerging markets to match or beat the performance of developed markets over the next three years.

SWFs also saw an average return of 7.2 per cent a significant improvement from the -3.5 per cent reported last year. Which was the first time, since the survey started in 2013, that SWFs had experienced negative returns.

Invesco’s study is based on the views of 140 chief investment officers, heads of asset classes and senior portfolio strategists at 83 SWFs and 57 central banks, who together manage USD22 trillion in assets.

Emerging markets primed to benefit from multipolar world

SWFs view strategic competition between the US and China as likely to create opportunities for emerging markets to attract investment, forge new partnerships, and assert their economic and political influence on the global stage.

The majority (54 per cent) expect this competitive dynamic to work to the advantage of emerging markets – versus just 12 per cent that disagree – as they benefit from trends such as ‘near-shoring’ whereby major economies strengthen their global supply chains and manufacturing and procurement strategies across multiple locations. SWFs expressed interest in exposure to these opportunities, either through direct investment in companies based in these markets or via multinational companies expanding their presences within them.

However, SWFs are increasingly adopting a nuanced approach to investing in these markets, considering their unique risks and opportunities and reflective of each country’s positioning in an increasingly complex and interconnected geopolitical landscape. Within emerging markets, Asia (ex-China) is seen as the most attractive region overall, with a particular interest in India, with its large domestic market, growing middle class and increasing global competitiveness. Latin America is also in the spotlight, particularly for Middle Eastern and Asian Funds with Mexico and Brazil seen as well placed for US near-shoring. China remains a large and important market for SWFs, whilst they navigate regulatory shifts and geopolitical tensions.

Within Emerging markets, EM debt is viewed as an attractive asset class for SWFs to diversify their portfolios. It is seen as offering attractive spreads over developed market bonds, providing a potential boost to portfolio income. Meanwhile, the improving economic fundamentals and policy reforms in many important emerging markets have enhanced their creditworthiness, reducing the perceived risks associated with investing in these markets. SWFs identified India as the most attractive destination for investing in emerging market debt. 88 per cent are interested in increasing their exposure to Indian debt, up from 66 per cent in 2022, reflecting improved confidence in the country’s economic prospects.

“Cautious optimism about the global economic outlook has been tempered by growing concern over competition between global powers”, says Rod Ringrow, Head of Official Institutions at Invesco. “The long-standing rivalries between the major powers have escalated, and the picture is complicated further by the sequence of important elections taking place this year, particularly in the US, which could have profound implications for markets.”  

The allure of gold in an uncertain world

The impact of geopolitics has also been felt by central banks, which are increasingly turning to gold to diversify their reserves and hedge against various risks.

The majority (56 per cent) of central banks agree that the potential weaponisation of central bank reserves makes gold more attractive, while 48 per cent believe that rising US debt levels have increased its appeal. “Gold’s status as a tangible, apolitical asset gives confidence to central banks”, continues Ringrow. “Especially given the challenge of finding viable alternatives to the US dollar as a reserve currency.”

Central banks are also looking to bolster their reserves over the next two years, motivated not only by long-standing geopolitical tensions but by upcoming elections in key markets. Central banks are mindful of the potential for election outcomes to trigger market volatility, currency fluctuations and changes in investor sentiment, leading 53 per cent to indicate their intention to increase the size of their reserves over the next two years, with only 6 per cent looking to reduce them.

‘Higher for longer’ outlook prompts caution on leveraged asset classes

Invesco’s study also revealed a widespread view that inflation and interest rates are set to stay higher than previously expected (43 per cent) of SWFs and central banks expect inflation to settle above central bank targets, with just over half (55 per cent) expecting targets to be met.

In total, 71 per cent of SWFs and central banks anticipate interest rates and bond yields to remain in the mid-single digits in the long term, which is having a significant impact on SWFs’ long-term asset allocation plans by prompting greater caution on highly leveraged and growth-oriented investments due to uncertain borrowing costs.

Infrastructure leads the way as the most popular asset class over the next 12 months, with a net asset allocation intention of 21 per cent, followed by listed equities (19 per cent) and absolute return funds/hedge funds (12 per cent). By contrast, SWFs’ sentiment towards cash (-11 per cent), real estate (-6 per cent) and private equity (-3 per cent) has diminished.

This outlook has also boosted the appeal of private credit, which has emerged as a compelling alternative to traditional fixed income, offering attractive yields and access to opportunities that do not exist in public markets. More than one-third (36 per cent) of SWFs have reported better than expected returns from their private credit investments, with just 5 per cent indicating that the asset class had performed worse than expected.

Private credit is also seen as offering attractive diversification from traditional fixed income, highlighted by 63 per cent of investors, and good value when compared to conventional debt (53 per cent).

Energy transition a priority theme for long-term investors

The energy transition continues to present challenges and opportunities for SWFs and central banks.

This year’s study revealed that the energy transition is viewed as an increasingly attractive investment opportunity, with 30 per cent of SWFs and central banks considering it a high priority allocation theme and a further 27 per cent holding some form of renewable and cleantech investments. “Development sovereigns and liability sovereigns in particular often have strong mandates for societal good alongside long-term steady returns that make these investments appealing”, says Ringrow. “The stable, predictable cash flows over extended time horizons are attractive to sovereign wealth funds, which are among the longest-term investors of all.”

The firm writes that given China’s significant market size, its current dominance in emerging markets (EM) portfolios, and specific factors such as geopolitics and regulatory policy that could affect performance, it has chosen this setup, designed to offer investors a more balanced exposure to the EM opportunity. The EM ex- China strategy builds on Robeco’s 30-year track record in fundamental EM investing.

The new actively managed strategy enables investors to carve out China from their EM allocation and gain more exposure to smaller EM economies under-represented in the main index, such as Korea, Taiwan and Brazil. It invests in over 1,100 companies, in high-growth sectors like fintech and semiconductors. The fund consists of a diversified portfolio of 60 to 80 stocks, selected with a value tilt, targeting attractive valuations with potential earnings upside. It offers a unique blend of fundamental and quantitative research for stock selection, with the objective of achieving a better return than the index.

The dominance of China in portfolios has increased over the years. In 2000, Chinese stocks comprised only about 5 per cent of the index, which at the time was dominated by the likes of South Korea, South Africa, Brazil, Mexico and Taiwan. But much has changed since then. China’s economy has grown by a factor of 15, becoming the world’s second largest economy. By comparison, South Korea’s economy roughly tripled over the same period, while South Africa’s and Taiwan’s barely doubled.

As investor interest in China’s remarkable growth story has surged, so too have Chinese equities’ share of the MSCI EM Index. At the peak of the market in 2020, Chinese stocks accounted for nearly 40 per cent of the index. Today, even after their recent downturn, they comprise roughly 25 per cent of it by weight – one and a half times the proportion of Taiwanese stocks in the MSCI EM (17 per cent), and nearly twice that of South Korean equities (13 per cent).

Wim-Hein Pals, Head of Emerging Markets Equities at Robeco, says: “We are launching this fund to offer clients and prospects a more balanced exposure to the EM opportunity given China’s dominance in the EM index. Given that emerging economies are growing faster than developed countries and have stronger balance sheets for governments, companies and households, we believe rebalancing may be overdue as investors globally are underexposed to EM ex-China.”

The key to a possible renaissance lies in the US and how policymakers resolve the ongoing fiscal uncertainty. If the country manages to deliver a soft-landing, taking inflation back to more palatable levels and avoiding recession in 2024, the stage is set for a major boost for manufacturing, with emerging markets being the obvious beneficiaries. 

Charles Jillings, Portfolio Manager of Utilico Emerging Markets Trust, says: “We are becoming increasingly excited by the prospects for emerging markets in 2024. Whilst some emerging market countries have already marginally reduced interest rates, further cuts are likely to come in 2024 as real rates in the majority of emerging markets are now typically positive, inflationary pressures are under control and these markets are becoming more robust to external shocks.”

Jillings adds: “With falling inflation and a weaker US dollar, emerging markets should be in a position to take full advantage of the global upswing in manufacturing activity that is anticipated to happen later in 2024 and into 2025.”

Political change is also on the horizon with 40 per cent of the world’s population taking part in elections this year.

Significant emerging markets set to hit the ballot boxes this year include Taiwan; Pakistan; Indonesia; India; Mexico; and South Africa, while in the developed world, citizens of the US and UK are set to cast their votes in 2024.

According to Andrew Ness, Portfolio Manager of Templeton Emerging Markets, it is these latter elections that will likely have the biggest impact.

“Overall, we don’t expect a major impact on the portfolio as most incumbents are expected to prevail, leading to policy continuity. Taiwan looks like the closest race with the incumbent DPP lead narrowing in recent polls. A DPP defeat, however, may lead to a softening in the rhetoric with China leading to, potentially, positive market consequences.”

Ness continues: “Overall, little noise is expected from the emerging market electoral cycle. There is probably a bigger scope for volatility in key developed market elections this year.”

Lindsay James, investment strategist at Quilter Investors, agrees that the US elections will be significant for global markets, noting the possibility of a return to Republican administration led by Donald Trump, which has obvious ramifications for the United States’ nearest emerging market, Mexico. 

“There has perhaps never been a more consequential and important US presidential election than this one and it tops the list of the events to watch in 2024. The spectre of Donald Trump looms large in this one, and if, as he is expected to do, he runs again the divisiveness in the US will be ratcheted up another level. Given the events that surrounded his departure in early 2021, it is not hyperbolic to say that US democracy could be put under severe pressure, and markets may not like that outcome.”

Further words of caution come from Charles Ferraz, Chief Executive Officer at the New York-based investment boutique Itaú USA Asset Management, who warns investors that nothing can be easily predicted in 2024.

“The only certainty we have about the outlook is that surprises are inevitable. Hence, the crucial focus on diversification, resilience, and seizing opportunities persists. Investors must meticulously construct portfolios and allocate resources wisely, prioritizing professionals showcasing expertise in navigating the complexities of dynamic and volatile markets.”

Bfinance writes that today, China faces fundamental challenges, including a troubled property sector, high local government debt, a growing unemployment rate, a shrinking labour force and state interventions. At the same time, China represents 30 per cent of the MSCI Emerging Markets index – by far the largest country constituent – and so comprises a substantial part of the asset class.

The emergence and maturation of GEM ex-China strategies provide a good opportunity for investors to reconsider their long-term portfolio strategy, Bfinance says. GEM ex-China strategies provide a lever with which to express positive, negative or neutral views on China. These strategies can complement a standalone China equity allocation – allowing for greater specialism – or provide an option for investors who wish to remove, actively manage or structurally reduce their exposure to China.

GEM ex-China equity strategies are proliferating in number, with 45 managers now running GEM ex-China equity portfolios and close to 100 others considering doing so. Investors should exercise caution during manager selection: live track records are short, with only three strategies in existence for more than five years, and managers need appropriately deep research capabilities to build robust portfolios without China, the firm writes.

While quoted fees are broadly similar to active GEM equity, ‘early bird’ and seed investor discounts provide significant opportunities for highly competitive fees. Allocators casting a broad net can identify a large number of managers who are looking to enter the space and/or build assets, creating good scope for negotiating attractive terms.

Robert Doyle, Senior Director at Bfinance, says: “The emergence of credible GEM ex-China strategies provides investors with a new way to approach emerging markets investing, and these strategies are relevant to investors irrespective of their sentiment towards China. We see demand growing among our institutional client base and ‘supply’ is expected to develop quickly, with 45 firms already operating in this space and close to 100 others actively considering a new product launch.”

Mirroring the firm’s strategies available to US investors, they are the Matthews Emerging Markets Equity Fund (ISIN LU2651608080), Emerging Markets ex China Equity Fund (ISIN LU2651608247), Emerging Markets Discovery Fund (ISIN LU2651608676). All three funds are categorised as Article 8 under SFDR. 

Managed by Lead Portfolio Managers John Paul Lech and Alex Zarechnak, with support from co-managers Andrew Mattock and Peeyush Mittal, the Matthews Emerging Markets Equity Fund uses a fundamental, bottom-up investment approach to build a core, quality-growth all-cap portfolio of 30 to 70 companies.  The investment team typically looks for companies that have higher growth metrics, as well as higher quality metrics, than the broader market with a focus on firms that can serve the growing needs of domestic consumers within their market.  

The Matthews Emerging Markets ex China Equity Fund is a concentrated all-cap portfolio of 30 to 70 stocks that provides investors with the ability to separate China from their core emerging markets allocation, either to avoid exposure or have more control using a dedicated China strategy. The fund employs the same bottom-up stock-picking strategy as the Matthews Emerging Markets Fund and is also managed by the same lead portfolio managers with support from co-manager Peeyush Mittal. 

The Matthews Emerging Markets Discovery Fund provides investors with the ability to complement their current emerging market allocation with a portfolio that invests in small companies that often have more innovative and entrepreneurial business models. The Fund invests in 40 to 80 small companies across the Emerging Markets, typically early in their lifecycle, holding them as they capitalize on structural growth trends in large addressable markets. The fund is managed by Lead Portfolio Manager Vivek Tanneeru with support from co-managers Jeremy Sutch and Alex Zarechnak. 

Cooper Abbott, CEO of Matthews Asia, says: “In our discussions with institutions and wealth managers, a growing number are looking to build customised exposures to Emerging Markets and have greater control over a core allocation. Matthews’ launch of these Emerging Market Funds gives the power of choice to sophisticated investors, allowing us to deepen partnerships with clients in Europe and Asia and for them to leverage our firm’s capabilities to construct highly distinct, actively-managed portfolios.” 

Neil Steedman, Head of International Distribution, says: “Emerging markets can offer investors the biggest potential for long-term growth over many other assets classes. With a combination of large populations, higher economic growth, rising wages and productivity, a shift toward sophisticated services and consumption and deepening capital markets, they will continue to create new and attractive investment opportunities for investors. We are pleased to offer our proven approach to stock-picking and portfolio construction to investors who seek more distinct emerging markets exposures.” 

Despite marginal falls in inflation in December for the UK and the US of 0.2 per cent and 0.6 per cent respectively, relative high rates prevail which Rob Brewis, investment manager at Aubrey Capital Management, says is not true of emerging markets.

“It is worth clarifying the emerging market [inflationary] experience. Most emerging markets did not have near zero inflation, nor zero rates going into this period. So, while inflation and subsequently interest rates have risen, the magnitude of these rises has been much less dramatic than in the US and Europe.”

Brewis cites India, Mexico and frontier market Vietnam where inflation has been “on a long and downward trend”.

“This may have been temporarily interrupted, but the downtrend remains largely intact. Long term structural downtrends in inflation are usually good for equities,” Brewis says.

John Wyn-Evans, head of investment strategy at Investec Wealth & Investment, also likes the outlook for emerging market equities thanks to “sensible monetary and fiscal policy which he says saw many EM countries fend off the worst effects of global inflation in the last year”.

“There is plenty of ammunition to provide renewed stimulus to growth. Valuations are relatively attractive, too,” he says.

Research from Managing Partners Group covering 100 professional investors across Switzerland, Germany, Italy, and the UK published this month, demonstrates a growing appetite for emerging markets, with 46 per cent expecting to increase their allocations in the next two years. 

Jeremy Leach, chief executive officer of Managing Partners Group, says: “In the face of rising inflation and an economic downturn, investors are doing everything they can in the search for yield including increasing their appetite for risk through investing in equities.”

Emerging market performance from the start of this year will likely attract yet more investor attention, with equity returns easily exceeding those from their US counterparts. 

The MSCI Emerging Markets index has returned 7.79 per cent in the month to 17 January, while the US returned 4.09 per cent. 

The Chinese markets have fared even better with returns of 11.17 per cent over the same period.

The prospects for the Chinese stock market look promising this year after the lockdown measures which Brewis says “sucked the life out of the Chinese economy” are abandoned in favour of a more relaxed approach.

“We invest in the Chinese consumer: will he/she be released to spend the massive savings hoarded up in the past few years? We believe so, and this will be a much more favourable backdrop for our consumer companies who are now very cheaply valued,” Brewis says.