Frontier markets to be hidden treasure of 2010

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Frontier markets could become the sweet reward of 2010 if investors are willing to take risks in underdeveloped, illiquid and potentially unstable markets.

Large emerging market economies have been a major linchpin of the global recovery this year as they have reduced and diversified their exposure to the global credit crisis by cutting interest rates and selling reserves without sacrificing growth.

Investors have poured cash into emerging markets, pushing up the MSCI emerging market index 72% so far this year.

But some investors see the developing markets of Brazil, Russia, India and China, a grouping known as BRIC, as oversaturated and overpriced. Instead, they are looking for other markets in which to put their money to work.

So for investors with a higher tolerance for risk, frontier markets are diamonds in the rough.

"There is tremendous amount of interest in investing in the second-tier markets that come after the BRICs because of the growth opportunity that has presented itself as a result of the economic downturn," said Steven Bailey, chief operating officer at Frontier Strategy Group, a Washington-based information services and advisory firm focused on emerging markets.

According to the International Monetary Fund, Group of Seven rich world countries is expected to show a 1.3% rise in gross domestic product in 2010, compared to 5.1% economic growth in emerging economies.

China leads the pack with GDP expected to grow by 9% next year, but other smaller and less developed countries have seen their markets soar.

Sweet returns at a risk

Markets such as Sri Lanka, which has seen its stock index surge almost 94% this year and its currency rise to a seven-month high as a result of the end of a 25-year civil war in May, are attractive for frontier market investors.

Sri Lanka's local government debt market is also strong, with a 5-year bond yielding close to 11%.

"What we are beginning to see as this crisis has unfolded and the recovery is underway, is the returns that investors get on Eurobonds have dwindled away," said Stuart Culverhouse, chief economist at frontier markets brokerage Exotix, London.

"Instead, people are beginning to look at the local debt market as a way of getting more superior returns," he said.

Frontier markets generate higher returns but the risks are high. Positions may be difficult to exit quickly, and corruption, dismal accounting practices, and the expropriation of assets are all real threats.

Nevertheless, investors are being enticed by frontier markets because they have lagged behind the more advanced emerging markets.

"Some frontier markets were fairly well insulated from the economic downturn because of abundant natural resources, as well as the fact that a lot of those markets didn't have access to western financing so they weren't as exposed to the downturn," Bailey said.

According to fund tracker EPFR Global, emerging market equity funds have attracted $56.8 billion this year, putting them on track to eclipse the record $50 billion in 2007. A year ago funds saw cumulative outflows of $40 billion.

However, late last month's Dubai's debt delay proposal caused investors to slow their move into emerging market equity and riskier bond fund groups.

Ripe for growth

Nevertheless, telecom sector funds last week had their best week since the second quarter of 2007 -- an industry that is ripe for growth in frontier markets.

Frontier countries are witnessing greater spending power by their middle classes for the first time, which is driving growth in consumer consumption and financial services.

Sub-Saharan Africa is a leading example where sectors such as telecoms, financials and commodities have seen high growth.

Nigeria, with the biggest equity market in the sub-Sahara after South Africa, and with the continent's largest population at 140 million people, has the right mix to create strong

returns in these sectors, analysts said.

"The number of telecom subscribers is rising 25% per year in Nigeria," said Christopher Hartland-Peel, head of Africa equity research at Exotix.

Commodity-based economies such as Ghana and Angola are also "diamonds in the rough", with Ghana the world's second-largest cocoa producer and Angola surpassing Nigeria to become the continent's biggest oil producer.

Argentina, downgraded to "frontier" status from "emerging" earlier this year by MSCI because of ongoing controls on capital flows, has returned 58.7% year-to-date and its economy is likely to recover further as the country is expected to settle its 2002 defaulted debt with creditors.

"We are seeing a huge amount of flows into all sorts of emerging markets. For the first time in the history of the Depositary Receipts product there is a true interest in

frontier markets," said Anthony Moro, managing director and head of Emerging Markets for BNY Mellon Depositary Receipts.

The only concern, Moro said, is the relative small size of the market, which could limit portfolio flows. "They are not ready for prime time but these frontier markets are certainly on the radar screen."