Nick: Hello everybody, this is Nick Robinson from abrdn and you're listening to the Emerging Markets Equity podcast, the show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions from key individuals to evolving trends, all with the goal to identify and profit from opportunities in the region. So, a few weeks ago on this podcast, I was joined by Hasnain Malik from Tellimer and we talked about China, nearshoring and many of the other current themes in emerging markets. But as well as EM, we veered into discussing those countries, which aren't even developed enough to be classified as emerging, the so-called frontier markets. We talked about how some of them are particularly well placed to benefit from a nearshoring trend, a weaker dollar and rallying commodity prices. So today, we're going to build on that discussion and focus in on frontier markets, both in terms of how to think of them for investing, but also which ones might be winners of the future. So, joining me today to discuss this is my colleague, Kevin Daly. Kevin is an investment director on our fixed income team and he's been successfully running a frontier markets bond fund for the last decade. So, he's an expert in this field of investing. Kevin, thanks for joining me today. It's great to have you on.

Kevin: Yep. Pleasure to be here. Thank you.

Nick: Great, well, let's get started. So, I guess I'm an equity fund manager, you're a fixed income fund manager. So typically, we'll look at investments from different angles in that you guys tend to be a bit more top-down and focus on economies, whilst we focus on companies and the so-called bottom-up investing. But our experience in frontier markets has been a bit different in that we tend to be, or we need to be a bit more focused on the top down just given how volatile some of the countries can be in terms of things like capital controls, and for particular government instability that you get. You know, how do you see frontier market investing in terms of how it differs from conventional emerging market or even developed market investing?

Kevin: Yeah, I guess, if I start at the top, probably one of the biggest differences that we have when it comes to investing in frontier bonds versus equities, is we, you know, I think the universe of investments is, in some ways larger, because we're looking at hard currency sovereign bonds, we're looking at local currency government bonds, which you know, as an asset class is two times the size of the hard currency sovereign. And then there's also hard currency corporate, so we have quite a bit of investment opportunities out there in the investment universe is probably 40 to 45 countries as well, as you know, doesn't mean we're investing in that many at one given time. But, you know, we'll continue to follow them on a regular basis in terms of the macro analysis and the investment opportunities. So, the limited part I know about frontier equities is it tends to be, you know, larger capitalizations in a handful of countries or a handful of stocks. And I think when it comes to bonds, I think there's more opportunities to diversify across, you know, again, hard currency, local currency markets.

Nick: Yeah, certainly thinking about investing in frontier markets from a stock perspective, liquidity was always a bit of a challenge and then just finding those companies which we felt had good governance, where we trust the owners and the management team. And actually, a lot of that, where we felt most comfortable in many examples was investing in locally listed subsidiaries of big multinationals. So, things like the Unilever subsidiary, in Nigeria, for instance, where at least you could be fairly confident that there was a good controlling shareholder keeping an eye on things. In terms of your frontier markets bond fund that you've been running for the last 10 years. Yeah, what have been the big learning experiences you've had over the last decade?

Kevin: Well, when we started this out, you know, 10 years ago, I guess, at that point, you know, there was some concerns internally, about the liquidity of the asset class, I think, over time, that's been largely dispelled. Meaning, you know, we've generally found opportunities to not just enter markets, but more importantly, exit markets or reduce our holdings if necessary. And you know, a good example, that was during the pandemic, the peak of the pandemic, where we had quite a bit of, you know, in terms of our percentage holding around 35% in local currency bonds at that point. Now, intuitively, one would think local markets would have seized up and would have been less liquid in hard currency markets, but it was actually the other way around. And why is that because you had a lot of mutual funds, which invest in the hard currency frontier names, and they were getting hit with large redemptions. Now, there is no local currency index or market generally local EM, local currency funds don't invest in these frontier local markets, so you didn't have that sort of technical aspect, which, you know, you had outflows, which then in turn weighed on these local markets. The domestic bid was also an important part at that point, too. So, you know, again looking back, we were able to raise a lot of liquidity to meet the expected outflows by reducing sharply reducing our local currency positions, and at the same time getting ourselves in position to invest in the hard currency volumes, because these were the ones that were hit by far the hardest. And, you know, when we look back over the last three quarters of 2020, we actually saw a very strong performance from hard currency bonds as they recovered during that period. So, it just shows you that, again, liquidity at times, it can work, you know, in your favour, it can work against you. And fortunately, at that point in time, we weren't forced to sell any hard currency bonds to raise cash, you know, we were able to do it all through the local markets that we have been investing at the time.

Nick: Yeah, so I suppose when you think about local currency versus hard currency, and particularly the environment we're in at the moment where you know the dollar has been weakening a bit of late after quite a long period of strength. Yeah, how do you think about that going forward, you know, given dollar weakness, and also governments ability to repay those hard currency debt?

Kevin: Yeah, I mean, I guess, you know, we put less emphasis on the dollar, per se, because a lot of these local markets, you know, actually trade like credit markets. So, you know, if you have a crisis, or you have, you know, a country running a large current account deficit, or, you know, you have rising inflation. So, all these factors, which, you know, we've seen over the last couple of years, have weighed on some of these local markets. When I look at the three largest local markets that we've invested in the past, Egypt, Nigeria, and Pakistan, they're really uninvestable at this stage. And why is that. Well, you have a combination of factors, you have misaligned currencies, in the case of Egypt rates, you know, still well below inflation. In the case of Nigeria, the currency is adjusting, but again, it's all dependent on where you get in. And then of course, rates have yet to adjust, in line with the rising inflation. And Pakistan, similar situation where you know you have had a huge currency devaluation in the last few years, given the deterioration in the country fundamentals as well. And on top of that rising inflation as well. And you know, when you look back at these markets, these were markets which were very investable, very liquid and we had pretty large positions in the past, at this stage, we have zero exposure to those countries. So, these are markets, which again, are trading more like credit markets, as opposed to, you know, the currencies, as opposed to trading off the dollar. But, you know, if we do enter a period where dollar weakness does occur, and there is some thought to that, given that the Fed is pretty much done, and at some stage they marched cutting rates in 2024, that should usher in some dollar weakness, and that generally will help some of these frontier currencies, but I still think, you know, what's going to drive these currencies is less to do with the dollar and more to do with the country fundamentals.

Nick: Right, and then I suppose you've started drilling down into specific markets there. So, beyond Egypt, Nigeria, Pakistan, which frontier markets would you have particular concerns about today? Are there anywhere there's been political change that might make you nervous or anywhere, further capital controls could come on the horizon. And I suppose you know, it's probably worth touching on Argentina, just given some of the political change there that's happened recently, and the new President's desire to dollarize the economy.

Kevin: Yeah, I guess, let me start with the biggest challenge I see for frontier markets today, and really, you know, into 2024 is the lack of access to the external bond market to the international bond market. And that, you know, in many ways, has been a theme of the last year and a half or so where countries have had no access to the international bond market. Why is that because it's a real taboo in our markets, if you're looking to borrow double digit yields. And at this stage, you know, countries, you know, most countries out there have yields in the region of 11+%, I mean there’s a couple in West Africa which are inside of 10% now, but these countries, you know, have chosen not to come to the bond market. And instead what, you know, what they've done and what some of their frontier peers have done have been more reliance on the IMF for cheaper financing, which I think is not just from a debt management standpoint, important, but also from a fiscal standpoint, there's anchors in place which these countries have to continue to meet these targets. And that from an investor standpoint is a positive thing too. But I would say that is the single biggest challenge facing these countries. Now, on a positive note, most of these countries are not facing any large bond maturities next year. There are two large majorities which the market is going to be closely on. One is Kenya, which has a $2 billion maturity in June, and then Pakistan, which is $1 billion in April. The base case if this stage is these countries are going to meet these maturities. But you know, through drawing down other resources, whether it be loans or FX reserves, so that in itself means that you have, you know, less capacity to continue to service your debt going forward. So, it's important that these countries, do regain market access over the next several years, but our base case for next year is the is that frontier countries largely will have zero access to the external bond market. So, I would say that by far is the biggest challenge these countries are facing.

Nick: And what’s driving that lack of access? Is that just the fact that investors just don’t have much desire for this exposure given risk aversion?

Kevin: Well, it's, first of all, it starts with, you know, what we've seen with where treasuries are right, you know, 10 year treasuries, you know, let's call it 430. Few weeks back, we were touching 5% or going through 5%. And the reality is these countries that issued euro bonds, you know, going back six, 7, 10 years ago, were doing it when Fed funds were at, you know, at zero, right. And when 10-year treasury yields were sub 2%. So, you know, they had access to the market, because there was a search for yield. And you know, you had very low treasury yields, and very low corporate bond yields. So, this helped them get access to the bond market. But today, you know, again, when you look at where spreads are, you know, the country risk premiums, most of these countries are looking at country risk premiums of 600 to 900 basis points, let's call it, right. So if you tack that on to where treasury yields are, that immediately puts you into double digit yield territory, and as I said, you know, there will be a lot of raised eyebrows if countries start trying to come to the market with double digit coupons, you know, 10%, 11% ,12%, I think there would be limited demand for those names, and in some ways might set off the alarm bells going. So that is the main reason but I think also you have to look at the deterioration in credit risks. The last couple of years, we've seen an increase in defaults in frontier markets. And over the next two, three years, I would expect to read more credit events as well. So, you know, that's another reason why investors are reluctant to lend money to these frontier countries at this point.

Nick: Yeah, it's interesting. I mean, I'm sure risk aversion is certainly a factor as well, because when we look at it from an equity side, I mean, 10 years ago, this was an asset class that a lot of clients had an awful lot of interest in. And today, there's virtually zero interest in the asset class as a, as a broad theme. I think you were, perhaps I interrupted you before you were about to talk about Argentina. So I'll let you carry on that.

Kevin: Yeah, we can't avoid talking about Argentina, can we. Yeah, I guess. If you look at the election result, it's a pretty strong mandate that Milei got. And, you know, he has some pretty, you know, radical policies, which he discussed at length on the campaign trail, and some of those were, in many ways, scaring the market scaring the domestic audience, and the big one is dollarization. And, you know, what Argentina desperately needs is, well, first of all, this is a country with 140, 150% inflation rates, which is crazy, right, and in order to address this issue, and to bring inflation down, and to introduce dollarization, Argentina needs a significant boost in its FX reserves, and, you know, net reserves are negative in Argentina right now. So, dollarization is off the menu for now. It might be something that Milei tries to bring back in several years time, but that’s a big issue, right. And on top of that he's also talked about fiscal consolidation you know, Argentina is running fiscal deficits you know, 5% or higher and you know, this is another part which is also weighing on inflation. So you've got a number of big challenges that he's facing. And you know, what Argentina has also is an electorate, which can really turn on its politicians very quickly. And this is through the midterm elections two years out, so you know, the window to get things done to introduce some of these significant changes is a fairly small one when it comes to not just emerging markets, but frontier markets. So, you know, I would say, you know, so far the market likes the result, the strong mandate that he has, you know, you see the nice little rally in Argentine bonds this week. But, you know, you still have some significant challenges ahead, it won’t be easy, and we'll have to wait and see how things play out. But from an investor standpoint, Argentine dollar bonds are trading in the high 20s, low 30 buying those bonds today, you know, you are prospects for recovery value are still relatively attractive, should things go well, but, you know, that's another challenge as well as whether or not there will be another restructuring over the next several years. And again, you can't rule that out as well.

Nick: Yeah, and then I suppose thinking about the other side of the coin, in terms of frontier markets, are there any that are doing so well, at the moment, there's a possibility they may be upgraded at some point to the coveted status of emerging?

Kevin: Well, you know, I would say the one country which has been promising, the early stages of the new administration is Nigeria. So, we had an election in February, Tinubu, from the ruling APC party won the election. You know, when he was sworn into office, at the end of May, the immediate announcement to remove fuel subsidies was greeted very positive by the market. And then several weeks later, they announced they were going to start to align the exchange rates, right, the official rate with the parallel and it's been a slow, long, slow, painful process since then, the parallel rate has been weakening further, the official rate was 462 before the announcement, and now it's called at 750, 800 and sort of bounces there and about, but you know, what they need is they need to find liquidity in order to get investors comfortable bringing dollars back on shore to invest in the local market. And, you know, one of the negative surprises, shall we say, with Nigeria that came out, again, after Tinubu took office was an audit of the Central Bank, which showed their net reserves were extremely low. And this is a country with gross reserves at 33 billion. So, it's clear they don't have the reserves to provide liquidity for the market. So, but you know, again, so far, so good, this administration is coming in with, with an agenda for structural reform, and that's something which previous administrations in Nigeria have been either reluctant or unwilling to do. So, I give them credit for that. And on top of that, you know, another key initiative is to boost the revenues to GDP, which is one of the lowest in the world, it's around 10% right now, their goal is to increase it to 18% over the next three years, so ambitious that that is, using the term structure reform and Nigeria in the same sentence is something which hasn't really happened in many, many years. So, I give these guys credit for, for the reform agenda. And, you know, so far the early signs are positive, but again, you know, there's still a lot of work ahead that they need to they need to do.

Nick: And presumably, with a place like Nigeria, a bit like the Middle East, some healthier revenues from a higher oil price should help that reform agenda and give the government bit more breathing space? Or is that a bit too simplistic way of thinking about it?

Kevin: Well, that will help in that you have with a weaker exchange rate, official rate, that means you have more fiscal revenues for spending for the government, which is important, but the revenues, and then again, that will be a non-tax revenue, right. Tax revenues is something which are paltry, right. And it's, you know, a lot of people in Nigeria don't pay taxes. And companies that have tax exemptions or loopholes are, again, ports, which are getting away with avoiding taxes. So, there's a lot of crackdown that needs to occur to boost the revenue intake. And in the past, this is something that previous governments have been unwilling to do so. So, there are several factors which could help to boost tax revenue. Oil is obviously one of them, which is again, a non-tax revenue item, but on the tax revenue side, there's a lot of work that they need to and hopefully they can deliver if they canI think investors will start to rerate Nigeria, as you know, as a country, which looks investable again, and as we've seen over the last six, seven years, you've had several episodes there were investors have come on shore and added stuff on shore through capital controls. So, they're least sending the right signals to the market. But as I said, there's a lot of work still to be done.

Nick: Thanks. Yeah, I suppose sticking on commodities. And that theme. I remember from an investment trip I did to Rwanda some years ago that country is particularly well positioned in terms of some of the rare metals like Niobium, and Tantalum, which are used in EV batteries. So, thinking about that, as the world navigates this energy transition, are there any frontier markets that standout in terms of positioning in some of those transition commodities, or broader commodities, like copper, and the like?

Kevin: I mean, you know, Zambia is one that stands out as a big copper producer. And, you know, Zambia has been in the news a lot lately, because of the debt restructuring, which, you know, looked like it was on track until China kind of threw a spanner in the works by pushing back on the agreement that was reached between the government and bondholders. But nonetheless, when you look at the story, copper is a important export item for, for Zambia, I mean, this year, unfortunately, copper production has been lower than expected, below 800,000 tonnes, but this government has said, you know, this is the government, a pro marketed government, which was elected back in 2021, you know, they've said, their target, you know, is to get copper production to 3 billion tonnes. So, now, that is extremely ambitious. But even if you get, you know, halfway there, if you can double copper production, that will be very positive. And so, there's been a lot of emphasis on trying to address that issue in the country. And, you know, I think when you look at the, the importance of copper in in EVs and other items, as well, it's an extremely important input into EVs, batteries, etc. So, I would say, they could be well place to benefit from this green transition that we're seeing around the world. So, that would be one for me, that really stands out.

Nick: Okay, yeah, that's interesting I do remember there's a couple of investable companies in Zambia, which you can invest in from an equity perspective. So, it's not a market that's entirely impossible to invest in. I suppose one of the other trends we've talked about a lot on this podcast in the past has been nearshoring. So, have you seen the impact of that within your frontier market universe?

Kevin: Not really, I think, you know, a lot of these countries unfortunately, don't have the manufacturing capacity to offer nearshoring opportunities to companies. You know, we've heard this in the past, Nigeria, for example, that they're going to focus on manufacturing, but again, they just don't have the, the infrastructure, the capability at this stage to do that, right. So, I would say, at this stage, it's not really a market driver, it's not something you hear very much in terms of, a frontier country attracting major companies. But, as an investor, you always do think about this, and if there is an opportunity out there for a country to increase its capacity and boost its infrastructure to offer these opportunities. And yeah, I think it would be obviously an extremely important development for these countries going forward.

Nick: Yeah, that's fair. I mean, having visited Nigeria a few times, I can't really imagine the state of a roads there or a port there is, is really in the state that you would imagine it being a real manufacturing hub anytime in the future. So, perhaps final question, you know, over this last decade, which is, which frontier market has been your favourite to visit on investment trips? Where have you found your, where would you like to go back to for perhaps a family holiday?

Kevin: Wow, that's, that's a that's a tough one, family holiday. Let me start with my favourite, favourite trips. I mean, I've, I largely have enjoyed most, you know, of the trips that I've gone on in the past to Sub-Saharan Africa. I was intrigued by recent, in the last five years, you know, for example, going to Gabon, and you know, Gabon has been in the news with the military coup that occurred back in August and when I was there it just struck me as a very calm and quiet country and a very small country as well too. That was an interesting one, because, you know, 85% or 80% of the country is forest, forestry, right. I remember hearing a lot about the opportunities there, in terms of the benefits they could derive, because, you know, generally has been very reliant on oil exports. You know, that, was an interesting trip, I think, you know, I went to Egypt about four years ago, three, four years ago, and that had been my first trip to Cairo. And I was just amazed by the hustle and bustle, the potential there. And, you know, what you see with Egypt, unfortunately, has been a situation where government has been very reluctant to, to disengage the military, from the private sector, and at the same time, to sell up government owned entities, which, you know, is going to be necessary in order to unlock IMF financing. I would say, you know, there are parts of Egypt, which I haven't been to, which I know are very, you know, I guess if you're talking about family holidays, that's where you want to go. Sharm El Sheikh, things like that. I'd say the last place that was really intriguing for me was Ethiopia. I've been there a number of times in the past. The last trip I went, there was again about four years ago to Addis Ababa. And again, I was amazed by the improvements in the infrastructure in that country. And, you know, it's a very industrious country as well, too. So, there's a, you know, I guess, I'm always amaze when you go back to these capitals. These are urban centres in Africa and Sub-Saharan Africa, just to see the development that's going on. And there's, as we know, lots of opportunities is upside potential these countries if they could get their policies, right, and if they get, attract foreign investment, and that's always a challenge, especially in the last two, three years, we've had a number of crises which have had a big impact on investment into these countries. So yeah, I would say there has been generally a very good experience in travelling around the region.

Nick: Okay, great. Well, with that, triplet of holiday recommendations for the more adventurous traveller, I think that's probably a good place to draw the podcast to a close. So, the only thing left for me to do now is thank my guest, Kevin. Thank you, Kevin.

Kevin: Yeah, thank you, Nick.

Nick: And thanks so much, everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for our next episode and tune in.

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