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David Coombs: A new frontier

David Coombs MM blog

It is now well documented that by as early as 2020, emerging markets will supersede developed economies as the new engines of global economic growth, with the BRIC economies of Brazil, Russia, India and China driving the majority of this growth.

Over the last ten years alone, the BRIC economies have contributed 65 per cent of global growth. With these economies moving ever-closer to developed status, investors are beginning to ask where the next great emerging market opportunities lie. We believe focusing on demographics can help answer this question.

Demographics are a key contributor of economic growth, with the potential to drive powerful domestic consumption trends.

Estimates suggest that household spending starts to accelerate after $3,500 GDP per capita and the BRICs surpassed this years ago.

This renders Frontier markets fertile ground for nascent consumer trends, such as mobile phone penetration.

By filtering through the list of developing countries that currently represent a small share of global economic growth but enjoy large and young populations, have the potential for rising productivity, low but rapidly increasing levels of income and underpenetrated markets, we believe it is possible to unearth the next gems of the emerging world.

Countries such as Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey and Vietnam – currently labelled as frontier markets – meet these criteria.

In our most aggressive strategy – the Rathbone Enhanced Growth Fund – we have invested 4.38 per cent in the Goldman Sachs Next 11 fund, to which the aforementioned countries belong. We believe this is a way of gaining exposure to the non-BRIC emerging markets, without being over-exposed to the Middle East and North Africa. MENA constitutes some 50 per cent of the frontiers’ benchmark.

Aside from offering investors the potential for higher long–term returns, these markets also hold appeal in being less–correlated to global equity markets – a benefit for portfolio diversification purposes.

Indeed, a correlation of frontier to global equities is 0.6, whereas a correlation of emerging markets to global equities is >0.9.

It is, however, important for investors to remember that these markets also carry higher risk – political and liquidity risk being the two most notable.

Frontier markets have lower market capitalisations and less liquidity than more developed emerging markets, thus benefitting when global liquidity flows are abundant, but remaining highly vulnerable to seizures in liquidity, for example during crisis periods.

Political risk also has a huge bearing on the performance of these markets, demonstrated by history, and is something of which investors must be fully cognisant.

Over time, we believe these countries could rival the G7 in terms of new growth, hence allocating to them whilst they are in their infancy makes sense for growth mandates.

Furthermore, these markets are far from being homogenous – engendering different drivers at difference stages of development – making broad–based exposure more appealing than single country exposure.

We do, however, urge investors to understand the higher levels of risk attached to these markets, versus more developed and more familiar emerging markets such as the BRICs.

David Coombs is head of multi-asset investments at Rathbone Unit Trust Management

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