The cowboy and the frontier

Frontier markets prosper through offering uncertainty. But as Mr. Uncertainty prepares to occupy the White House, that might have less value.

In 2011, a senior economist at the International Monetary Fund wrote a paper examining the role frontier markets should play in equity investors’ portfolios.

Jorge Chan-Lau used a risk parity model, which attempts to spread exposure in a portfolio according to volatility estimates rather than, say, market capitalisation. After weighing up the data, Chan-Lau concluded that frontier markets should get a much higher allocation in investors’ portfolios.

Chan-Lau repeated one usual argument made in favour of frontier investing: the benefits of diversification these markets offer. But he also said a strategy of “overweighting frontier markets could help portfolios outperform when global equity prices are rising”.

There is little evidence the diversification appeal of frontier markets has eroded. But what happens when these markets don’t help your portfolio outperform? What happens when, instead, the real action is to be found elsewhere?

We may be about to find out.

Since the election of Donald Trump as the next president of the United States, US equity markets have rallied strongly. The Nasdaq and the S&P 500 have both jumped since the election, and — perhaps thanks to Trump’s focus on manufacturing— the Dow Jones Industrial Average is up more than 5%.

Faced with a choice between stressing Trump’s belligerent anti-trade rhetoric and his hazy fiscal stimulus plans, equity investors appear to have opted for the latter. Trump has, so far, received a surprising vote of confidence from the market.

But even if you believe Trump’s election will be good news for the US markets, it is unlikely to be so welcome in Asia’s frontier economies. This is especially true for those that rely on trade and foreign investment.

Bangladesh’s growth story, although fuelled by domestic consumption, has benefited from rising exports. Real estate and power projects in Myanmar have received a boost from Barack Obama’s decision to lift sanctions in October. And Vietnam, more than any other Asian frontier, has relied on trade to make itself richer.

Vietnam has achieved eye-catching growth thanks in large part to its cheap labour force, which has boosted foreign direct investment, in particular into the manufacturing sector. It is a signatory to the Trans-Pacific Partnership, and would reap huge benefits in the now unlikely event that the pact is signed.

But HSBC equity analysts downgraded the country to ‘negative’ in the middle of November, pointing to the impact of Trump’s election at a time of already-slowing global trade. The bank also drew attention to bloated price-to-earnings multiples in the country, a sign of how much the market has rallied over the last five years.

A different time

Chan-Lau used stock market data from between 2002 and 2011, covering part of the administrations of George W. Bush and Barack Obama. The two men had many, many differences but one thing that united them was a default stance on free trade — the more, the better.

Trump has challenged the old order, and as a result he has challenged the hopes of frontier markets that were hoping to copy the example of China, which transitioned from a manufacturing hub to a global behemoth.

That is going to particularly hurt Vietnam, but Trump could unleash a torrent of selling on stocks in other, less trade-reliant countries. His unpredictability will raise tensions in Asia. Indeed, it already has. (His recent call with the president of Taiwan is one thing; his Twitter rant afterwards is quite another.)

Perhaps more importantly, frontier markets will also be hurt by the faster rise in interest rates that is likely to follow any major fiscal stimulus by the Trump administration. That will push up borrowing costs for these countries and wreak havoc on their currencies. It will also make them a less attractive destination for investors who will no longer be so desperate for yield.

None of this means frontier equity markets are doomed. In the long-run, the performance of their stock markets will depend more on domestic growth and political reform than it does on Donald Trump.

But for a group of markets that thrives on offering foreign investors uncertainty, things are about to get tougher. After all, the election of Donald Trump offers more than enough uncertainty for most.



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