Inflation is a global phenomenon, but there can be little doubt that it hits the poorest the hardest. Energy and food are often a greater share of household spending for lower income households. Against this backdrop, frontier markets would appear to be vulnerable. However, the picture is more nuanced than it first appears.
There is no doubt smaller emerging markets such as Egypt that import significant amounts of their energy and food, or have high debt as global interest rates rise, or are embroiled in mounting geopolitical crises have some challenges ahead at this time of crisis.
However, frontier markets are richly diverse and there are those that are surviving and even thriving in the current environment. For investors, it’s just a question of looking in the right place.
The developed world is seeing levels of inflation that are the highest since the 1970s. German wholesale energy prices are up 23% year-on-year, the biggest move since the data series began in 1968. The gloomiest predictions put UK inflation at over 20%. It is a grim picture and a difficult backdrop for companies.
While some frontier markets, such as Egypt, have been equally hard hit, we find a number of frontier markets where inflation remains within a standard historic range, allowing interest rates to rise only moderately - Indonesia, or Vietnam, for example.
At the same time, many frontier markets, such as Hungary and Chile – through prudence or necessity – have shown significant fiscal and monetary discipline, which contrasts starkly with the largesse seen in developed countries.
Of course, there are exceptions: Turkey has seen inflation top 80%, while in Argentina, inflation soared to nearly 80% from a year earlier.
It is also worth noting that some countries in our universe are beneficiaries of higher commodities prices. There are frontier countries that are significant exporters of oil in the Middle East or of soft commodities in Association of Southeast Asian Nations (ASEAN) and Latin America. In 2022, the Gulf Cooperation Council region is currently on track to report the highest current account and fiscal account surpluses for eight years.
Equally, we see other forces at work in frontier markets. Post-Covid, Dubai has emerged as a truly global financial centre, and the workplace of choice for those in creative industries, crypto enthusiasts, and finance professionals alike. This has supported asset prices.
Vietnam is also benefiting from a post-Covid bounce. With the majority of food produced domestically, Vietnam has been relatively insulated from soft commodity price rises to date. In Asia, we see encouraging signs of economic growth rebounding in Indonesia and Malaysia. The latter, in particular, is a beneficiary of tech outsourcing away from China.
The portfolio does not have to invest in all countries in the universe. We choose to be selective - swerving the portfolio away from the weakest frontier markets – those prone to severe inflation shocks from commodity market tightness – and steering towards the strongest and more resilient markets.
Company strength
In developed markets, company fortunes have often transcended those of the wider economy. Companies in frontier markets generally have much less ability to determine their own destiny. However, we have used recent trips to find frontier market companies that have emerged from the pandemic period with strengthened market positions, improved product portfolios and in some cases, even refined their environmental, social and governance (ESG) credentials.
Another key difference with developed markets is that valuations are far cheaper. Developed markets have fallen somewhat since the start of the year, but valuations in most of the frontier end of emerging markets remain attractive relative to their own history and also relative to more developed markets.
Nevertheless, we currently maintain a defensive tilt in the portfolio, which means avoiding vulnerable areas and being realistic about the prospects for individual companies. In Thailand, we are concerned that the gap between interest rates and inflation is at unprecedented levels, and we expect significant further rate hikes. In many pockets of the Middle East we think that valuations start to look up.
It is our view that the outlook for many frontier markets may be brighter than many imagine. Certainly, there are vulnerable areas, but there are countries and companies in the world’s smaller economies that continue to thrive in spite of the global economic outlook.
Emily Fletcher is co-manager of the BlackRock Frontiers investment trust. The views expressed above should not be taken as investment advice.