The Year of the Frontier

Investors started 2011 in an upbeat mood. In retrospect, it can be said that the doom thinkers have been proven wrong last year. In 2010, Silk Invest’s main investment theme of “moving to a new normal” has materialized. The past 12 months can best be described as a combination of strengthening fundamentals, shifting economic relations and high volatility. Our main theme for this year is about a positive market consolidation where frontier markets equities and fixed income are expected to outperform other markets.

With expected returns at 30%, Africa and the MENA region and frontier Asia are the place to be

During this year, while the emerging markets will continue to be attractive, with expected equity returns of 14%, they are likely to offer a performance that lies closer to that of the developed world. In contrast, frontier markets are expected to generate returns of around 30% in 2011, with Africa, the Middle East and North Africa (MENA) as the best performing regions. The main drivers of this forecast result from the bottom-up analysis of the underlying universe combined with a positive macro outlook.

In this space, Silk Invest expects average dividend yields of 4-6%, earnings, growth levels of 10-15%, local currency appreciation of 1-3% and valuation multiples of around 10-15%. With regards to Africa, Silk Invest is most bullish on Ghana and Kenya. Both markets are expected to generate returns in excess of 40%. In the MENA region, Silk Invest expects UAE, Saudi Arabia and Qatar to be the best performers with the potential of 35-40% returns for 2011.

The benign macro environment is shaping up

During 2010, the sum of the world economies made up for a relatively healthy recovery with global GDP growth reaching 4.8%. However, the ride was anything but steady. Investors had to perform amidst extreme conditions such as a wave of sovereign debt crises, an ongoing debate about a double dip recession, the effects of austerity measures and the monetary experiments of the world’s major central banks. At Silk Invest, We believe the world economy will further stabilize in 2011 and Silk Invest expects global GDP to again grow by around 4%.

The Africa and MENA regions will be the fastest growing regions outside developing Asia. More importantly they will be the only regions which will see an acceleration of growth in 2011. The MENA economies will be growing by just over 5.1%, up from 4.1% in 2010. Qatar will expand by 18% and Egypt is set to grow by as much as 7%. In Sub-Saharan Africa, we will also see robust growth levels in Ghana and Nigeria, which are expected to increase their GDP by 10% and 8%, respectively.

Differentiation is key

The developed equity markets are not doomed and not all emerging markets are equally attractive. After shooting upwards by 90% in 2009, it wasn’t much of a surprise that the BRIC markets failed to be the best performing markets in 2010. In fact, with the exception of Russia, most developed markets did much better.

During 2010, we have noticed that markets have started to trade more in line with fundamentals. As a result, the markets with strong growth prospects and attractive valuations outperformed. This especially proved to be true for the developed markets where markets such as Sweden and Germany delivered high returns while the more troubled economies such as Greece, Spain and Portugal suffered considerable losses.

A similar pattern can be found in the developing world where the frontier markets with more solid fundamentals have started to catch up with their peers in the larger emerging markets. The trend of frontier markets moving higher to fully reflect their future potential will continue to be one of the most important developments in global financial markets during 2011.

This trend is set to further accelerate thanks to a combination of a healthy appetite from local investors and an increase in foreign investment flows. The result will be that the frontier markets of Africa, Asian and the Arab world, should be able to deliver the forecasted 10-20% outperformance. The categorization of markets as being developed, emerging or frontier is gradually losing relevance in a world that is increasingly about fundamentals. Therefore, differentiation is the key to success.

The return of inflation

Inflation returned in 2010 and it is expected to remain with us in 2011. Last year’s strong increase in commodity prices will be followed by a year of consolidation. However, fuel prices will go up by around 10% and food prices are likely to continue edge higher in 2011.

In this perspective, it is very interesting to observe that in there are many emerging market economies where it will be possible to lower inflation levels in 2011. This is especially the case for much of Sub-Saharan Africa where inflation levels are expected to drop towards an average level of 7% in 2011, even below the levels we observe in much of Latin America. This trend comes as a direct result from the improving institutional strength of African countries. They have proven to be able to successfully manage their government budgets and to implement effective monetary policies. It comes as no surprise that Nigeria’s Lamido Sanusi, has recently been named as the world’s Central Bank Governor of the Year by The Banker magazine.

Sovereign risk now is part of the of game

Total debt levels have continued to swell in 2010 and sovereign debt will continue to be closely followed as an investment theme in 2011. While Emerging markets generally have stronger balance sheets, they face other challenges such as the need to effectively manage increased political instability.

It is a fact that many of the countries across Africa and the Middle East currently enjoy the lowest levels of debt in the world but they are facing a year of major transitions. Regional heavyweights such as Egypt and Nigeria will hold presidential elections and the global media will carefully watch how the events in Sudan and Ivory Coast will develop.

Given a few exceptions, political stability in frontier markets has dramatically improved over the past few years. Growing economies with high levels of solvency have further consolidated this trend. On the ground, the outlook is optimistic and the risk premiums associated with these markets are expected to further come down when the above-mentioned political transitions unfold in a smooth fashion.

It may seem a daunting task, but investors will need to weigh the risks posed by potential defaulting governments against young countries which are managing a transition to more democracy. The signs in the capital markets are pointing that investors are getting more assertive.

It may seem a daunting task, but investors will have to outweigh the risk of mature countries defaulting versus the prospects of younger nations that are rapidly modernizing towards democracy and are playing an increasingly assertive role in the world economy. The rapid growth of these new capital markets merely confirm that a new economic world order is taking hold.

The bond party is over…or not yet

The long term cycle towards lower interest rates which began in the eighties seems to have finally broken down. In a fairly short period of time, 10-year US yields have increased from levels of around 2.5% to the levels of today which seem to be edging closers to the 4% mark. Continued quantitative easing will not help as a combination of increased investor awareness about sovereign risks and higher inflation rates are only putting further upward pressure on yields.

Governments will need to learn that there is a cost involved when borrowing money while investors will need to put their money to work instead of riding a low yield cycle. Silk Invest believes that emerging markets debt is the better option for investors who remain keen on fixed income. However, the reality is that interest rate spreads are trading at unprecedented low levels in the major emerging markets. Fixed income investors in search of yield will increasingly be attracted to the frontier markets as they offer the return potential they are looking for.

The Silk Road Income fund is positioned to give investors an average yield to maturity in excess of 10%. This is highly driven by the rich yields that many frontier markets still offer today. Silk Invest expects these yields to further converge towards the levels of the major emerging markets in 2011.

Currency volatility is here to stay

Emerging market currencies generally had a good year in 2010 but 2011 may prove to be more challenging. Central banks across the globe will continue to experiment with new measures to deal with their specific challenges. They will need to navigate through a market environment dominated by wide currency fluctuations. The unfolding of carry trades and the trend of large emerging markets taking measures to protect their interests will undoubtedly further add to volatility.

Investors seeking local currency exposure should consider frontier markets in 2011 as these currencies are typically less volatile than those of the larger emerging marker nations. In addition, they are underpinned by strong fundamentals, offer higher yields and are trading below their historical exchange levels.

No bubble…investors are still underweight EM

Overall, the allocation of investors to emerging markets still hasn’t reached its full potential and investors need to re-assess the weighting of these markets in their portfolios. For most investors, emerging markets currently only account for only 10-20% of their portfolios. Silk Invest firmly believes that investors should move their weights to a level more in line with the share of the emerging markets in total global market capitalization, which currently stands at 32%. Another benchmark for allocation could be the weight of emerging markets in the global GDP at 38%, adjusted for purchasing power parity (PPP).

It is clear that investing in emerging markets has become one of the favorite conversation topics amongst institutional investors. Until now, most of this has only been talk and most of the intention still needs to materialize. A dramatic rise in allocations could trigger even higher valuations but the risk of this happening on the short term seems rather small. The flows that went into emerging markets in 2010 were not much higher than what we saw back in 2006 and they still considerably below the levels seen in 2007. Measured as a percentage of GDP, during 2010, capital inflows into emerging markets were around 4%, in comparison, these levels stood at 9% in 2007. Moreover, emerging markets are currently still trading at a discount when compared to the developed markets.

Keep an eye on valuations

2010 has proven that valuations are important and 2011 will probably further focus investor’s attention on this reality. Investors need to quantify the opportunity that lays in fundamentally sound long term investment cases, but they also need to take into consideration the individual valuation multiples for each investment.

This not only holds true for developed countries where the US looks cheap and Japan looks expensive, but it is equally the case for the emerging markets. In this sense, Silk Invest believes that emerging markets present a much brighter outlook than developed markets. Today, within the emerging markets universe, valuations in India and China are currently somewhat stretched while frontier markets appear to offer much to better value.

Silk Invest’s equity funds have average forward price earnings (PE) multiples of around 11x which puts them at a discount of around 30% in comparison with the overall EM universe. This valuation discount comes into eve sharper contrast when comparing the expected dividend yields of the Silk Invest funds of 4-5% with global averages of around 2%.

In conclusion, we believe that in 2011, we will see a consolidation in global markets where capital inflows into emerging markets are set to further increase. The frontier markets, as a result of their attractive valuations, are likely to outperform all other markets. The quest for yield will also further support frontier market bonds and will further push a convergence of their interest rates towards those of emerging markets. 2011 is set to be ‘The Year of the Frontier’

Source of data: Silk Invest, IMF, JPM, DB, CS and various regional research houses

The Year of the Frontier – Silk Investment ...