Call of the frontier: The search for a new generation of emerging markets

Citi recently launched a new thought leadership initiative, Citi Global Perspectives & Solutions (Citi GPS), through which we will deliver insights and viewpoints on compelling issues and structural thematic trends in the global economy. Below, Andrew Howell, Citi's equity strategist for Central Europe, The Middle East and Africa, summarizes the latest Citi GPS report - Call of the Frontier: The search for a new generation of emerging markets - which discusses how investors may now need to look to new geographies to replicate the higher returns of emerging markets past.

Nothing ventured, nothing gained. This maxim reflects one of the basic tenets of financial markets: investors demand a higher expected return for investing in projects of greater uncertainty. Over the past 24 years -- and especially over the past decade -- investing in emerging markets has certainly delivered those higher returns. A $1,000 investment in the MSCI Emerging Markets index on the day it was launched in 1988 would be worth $17,553 today, including reinvested dividends, a compound annual return of 12.7%. This compares with the same investment in the MSCI World index, which today would be worth just $4,940 (an annual return of 6.9%).

While the group of markets we call emerging are expected to continue to do well in the coming years, we believe that replicating their outperformance of the past quarter century will be difficult. The emerging market (EMs) have evolved, both in terms of their size and the pace of their growth. Greater political stability, improvements in infrastructure, financial deepening and a rapid expansion in trade have driven dramatic changes in the fabric of emerging market countries. As EMs have matured and become less risky places, the expected return from investing in them has almost certainly converged downward.

Replicating the higher returns of EMs past may require investors to look to new geographies: the Frontier Markets. Frontier markets have relatively small/illiquid equity markets compared with EM, and tend to be less economically developed. An essential element of our argument is that frontier markets are smaller than they should be, given the size of the population and potential economic output of the countries in which they are based.

In this report, we focus on 15 countries in particular -- our "Frontier-15" -- which have the potential to generate the kind of returns for equity investors over the coming decades that the emerging markets themselves have produced over the past quarter-century. These are Argentina, Bangladesh, Egypt, Ghana, Iraq, Kazakhstan, Kenya, Mongolia, Nigeria, Pakistan, Romania, Sri Lanka, Ukraine, Venezuela, and Vietnam.

We also look in more detail at the economic outlook for two economies that rank among the fastest long-term growers within Citi's Global Growth Generators (3G) growth framework: Nigeria and Vietnam. Despite headwinds for both countries, the economic opportunity for each is undeniable given the presence of key ingredients to growth: large, young populations; low per capita incomes; greater openness to trade; in the case of Nigeria, a large natural resource base, in the case of Vietnam, fast-growing, industrializing neighbors.

There are plenty of near-term challenges to both economic and financial market success in these countries. Developing economies benefit from global trade and capital flows, and as such will not be immune to economic instability stemming from the Eurozone's troubles. Frontier markets tend to have weaker institutions, and less political stability, than more mature economies. Looking into the future, however, we are confident that frontier markets will achieve some degree of convergence with both emerging and developed markets. A range of economic and financial factors, as well as features of the business environment should support this. Over time, the frontier markets are likely to adopt many of the changes implemented by their more successful peers, the emerging markets, while doing their best to avoid their own more egregious mistakes of the past. Given their starting point, even modest improvements can yield significant results. Such has been the story with emerging markets, and indeed the developed markets before them. The frontier beckons.