Investment Insights Podcast: Frontier Markets Still Attractive

Stuart Quint, Investment Insights PodcastStuart P. Quint, CFA, Senior Investment Manager & International Strategist

On this week’s podcast (recorded June 2, 2016), Stuart weighs in on frontier markets and how this space is still an attractive area for investors.

Quick take:

  • Today’s frontier markets closer to yesterday’s higher-growth emerging markets.
  • Frontier markets are different and may offer potentially higher growth prospects relative to re-emerging markets.
  • Frontier markets can offer potential positive benefits in portfolio diversification.
Source: MSCI, Blackrock

Source: MSCI, Blackrock

Source: MSCI, Blackrock

Source: MSCI, Blackrock

Frontier markets still offer investors the potential for higher returns and lower correlation within broadly diversified portfolios. Although emerging and frontier markets both offer younger populations and higher economic growth potential relative to developed markets, there are also key differences that currently favor frontier markets.

Frontier markets include a variety of countries that, in many cases, are more tied to domestic factors as opposed to global growth. Countries in Sub-Saharan Africa, such as Kenya and Nigeria, and in South Asia, such as Vietnam and Bangladesh, offer potential investment opportunities. Several of these markets are enacting structural reform and attracting foreign direct investment to improve economic growth prospects. While depressed oil prices have an impact on growth in Middle East economies, such as Oman and Qatar, these countries also boast higher incomes and strong population growth rates.

Source: MSCI, Blackrock

Source: MSCI, Blackrock

Source: MSCI, Blackrock

Source: MSCI, Blackrock

In contrast, emerging markets are more of a mixed bag. The larger BRICK economies (Brazil, Russia, India, China, South Korea) within emerging markets contain a spectrum of moderate growth to stagnation along with banking sectors hobbled by large and rising bad credit. Depressed commodity prices directly hurt Brazil and Russia, while a capacity glut in basic materials impacts bank loans in China and India. The question of “whither the BRICKs” is vital to the direction of emerging markets given they comprise over half of the index.[1]

Investing in frontier markets provides more exposure to domestic growth sectors whereas emerging markets are more geared toward industries influenced by global commodity exports. Domestic sectors account for three out of every four dollars in frontier markets, while they comprise only one out of every two dollars in emerging markets. Industry sectors related to global trends (in many cases commodities) comprise nearly half of emerging market companies but only a quarter of frontier markets.[2]

Frontier markets only comprise less than 3% of the world’s total market capitalization.[3]  Coupled with potentially faster growth relative to the developed world, further structural reform could propel further growth in capital markets.

Superior population growth is one supportive factor. Median population growth of 1.5% in Frontier markets exceeds growth in both developed and emerging markets.

2014 Median Compound Annual Population Growth
Frontier Markets 1.5%
Developed Markets 0.7%
Emerging Markets 0.9%

Source: World Bank and Brinker Capital

A growing variety of funds and ETFs have come to market and allowed greater access to investing in frontier markets in recent years. Nonetheless, frontier markets continue to offer potential benefits to diversifying investment portfolios. Even over the last five years, frontier markets still show lower correlation to broad equity indices (and even lower relative to emerging markets).

Please click here to listen to the full recording.

[1] BRICK comprises 54% of the MSCI Emerging Markets Free Index.  Source: MSCI and Blackrock.
[2] MSCI, Blackrock, and Brinker Capital
[3] Bloomberg and Brinker Capital

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change. Brinker Capital, a Registered Investment Advisor.

May 2016 Monthly Market And Economic Outlook

Amy MagnottaAmy Magnotta, CFASenior Investment Manager, Brinker Capital

Continuing the rally that began in mid-February, risk assets posted modest gains in April, helped by more dovish comments from the Federal Reserve and further gains in oil prices. Expectations regarding the pace of additional rate hikes by the Fed have been tempered from where they started the year. Economic data releases were mixed, and while a majority of companies beat earnings expectations, earnings growth has been negative year over year.

The S&P 500 Index gained 0.4% for the month. Energy and materials were by far the strongest performing sectors, returning 8.7% and 5.0% respectively. On the negative side was technology and the more defensive sectors like consumer staples, telecom and utilities. U.S. small and micro-cap companies outpaced large caps during the month, and value continued to outpace growth.

International equity markets outperformed U.S. equity markets in April, helped by further weakness in the U.S. dollar. Developed international markets, led by solid returns from Japan and the Eurozone, outpaced emerging markets. Within emerging markets, strong performance from Brazil was offset by weaker performance in emerging Asia.

The Barclays Aggregate Index return was in line with that of the S&P 500 Index in April. Treasury yields were relatively unchanged, but solid returns from investment grade credit helped the index. High-yield credit spreads continued to contract throughout the month, leading to another month of strong gains for the asset class.

We remain positive on risk assets over the intermediate-term; however, we acknowledge that we are in the later innings of the bull market that began in 2009 and the second half of the business cycle. The worst equity market declines are typically associated with recessions, which are preceded by aggressive central bank tightening or accelerating inflation, factors which are not present today.  While our macro outlook is biased in favor of the positives and a near-term end to the business cycle is not our base case, the risks must not be ignored.

A number of factors we find supportive of the economy and markets over the near term.

Global monetary policy remains accommodative: The Fed’s approach to tightening monetary policy is patient and data dependent.  The Bank of Japan and the ECB have been more aggressive with easing measures in an attempt to support their economies, while China may require additional support.

Stable U.S. growth and tame inflation: U.S. economic growth has been modest but steady. While first quarter growth was muted at an annualized rate of +0.5%, we expect to see a bounce in the second quarter as has been the pattern. Payroll employment growth has been solid and the unemployment rate has fallen to 5.0%. Wage growth has been tepid at best despite the tightening labor market, and reported inflation measures and inflation expectations, while off the lows, remain below the Fed’s target.

U.S. fiscal policy more accommodative: With the new budget, fiscal policy is poised to become modestly accommodative in 2016, helping offset more restrictive monetary policy.

Constructive backdrop for U.S. consumer: The U.S. consumer should see benefits from lower energy prices and a stronger labor market.

However, risks facing the economy and markets remain, including:

Risk of policy mistake: The potential for a policy mistake by the Fed or another major central bank is a concern, and central bank communication will be key. In the U.S. the subsequent path of rates is uncertain and may not be in line with market expectations, which could lead to increased volatility. Negative interest rates are already prevalent in other developed market economies. An event that brings into question central bank credibility could weigh on markets.

Slower global growth: Economic growth outside the U.S. is decidedly weaker, and while China looks to be improving, a significant slowdown remains a concern.

Another downturn in commodity prices: Oil prices have rebounded off of the recent lows and lower energy prices on the whole benefit the consumer; however, another significant leg down in prices could become destabilizing. This could also trigger further weakness in the high yield credit markets, which have recovered since oil bottomed in February.

Presidential Election Uncertainty: The lack of clarity will likely weigh on investors leading up to November’s election. Depending on the rhetoric, certain sectors could be more impacted.

The technical backdrop of the market has improved, as have credit conditions, while the macroeconomic environment leans favorable. Investor sentiment moved from extreme pessimism levels in early 2016 back into more neutral territory. Valuations are at or slightly above historical averages, but we need to see earnings growth reaccelerate. We expect a higher level of volatility as markets assess the impact of slower global growth and actions of policymakers; but our view on risk assets still tilts positive over the near term. Higher volatility has led to attractive pockets of opportunity we can take advantage of as active managers.

Source: Brinker Capital. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Brinker Capital Inc., a Registered Investment Advisor.

An Update on Oil

Ryan DresselRyan Dressel, Investment Analyst, Brinker Capital

As of January 29, 2015, the price per barrel of West Texas Intermediate crude oil stands at $44, down just about 60% since its 52-week high in June 2014 (See chart below). For each 10% drop in oil, forecasters seemed to gawk at the possibility of further price decline, citing global demand projections, U.S. energy independence from The Organization of Petroleum Exporting Countries (OPEC), and increased consumption from emerging markets. What they omitted from their projections, however, was the impact that U.S. and Canadian production had on OPEC from a political standpoint.

Crude Oil WTI (NYM $/bbl) Continuous (CL00-USA)

Source: FactSet

OEPC has not adhered to an individual country production quota since 2011, but with oil prices around $100 per barrel in recent years, it was relatively insignificant news. These high prices actually worked against OPEC by encouraging too much competition from North America. During that time, North American energy companies were in the midst of ramping up production from shale, oil sands and other sources that were previously expensive to produce (refer to graphic below). In fact, United States domestic production has nearly doubled over the past six years[1]. Eventually in mid-2014, global demand for oil began to lag supply, caused by weak economic growth in Asia and Europe, which sent the price of oil plummeting.

Source: BofA Merrill Lynch Global Commodity Research

Source: BofA Merrill Lynch Global Commodity Research

Facing pressure from these new low prices, OPEC met on November 27, 2014 to discuss curbing production in an effort to support higher price levels. Since OPEC’s production quota was abandoned, each member country was unwilling to reduce its output.

The indecisiveness at this meeting signaled some very profound conclusions to the market. First, it re-confirmed that OPEC continues to become a disorganized collection of countries, rather than an organized cartel. This is important because it implies that OPEC is no longer acting as a balancing agent in global markets, which can significantly increase volatility. The second conclusion made by the market was that Saudi Arabia is unwilling to cede its crude oil market share (12.2% of global production as of September 2014[2]). In a bold statement made last December, Saudi Arabia’s oil minister, Ali Al-Naimi, confirmed these assumptions:

“If I reduce, what happens to my market share? The price will go up, and the Russians, the Brazilians, U.S. shale oil producers will take my share,” Al-Naimi told the Middle East Economic Survey last month. “Whether it goes down to $20 a barrel, $40 a barrel, $50 a barrel, $60 a barrel, it is irrelevant.”

The final conclusion from the November meeting was that smaller countries who depend on oil as a large part of their government revenue, cannot afford to cut production. These countries include Iran, Iraq, UAE, Venezuela and Nigeria among others. Due to the fact that Saudi Arabia’s reserves far exceed other OPEC members (See graphic below), they can afford to wait out low oil prices while others cannot.

Source: IEA, BofA Merrill Lynch Global Commodity Research

Source: IEA, BofA Merrill Lynch Global Commodity Research

What to Watch For:

There are many factors to watch as it relates to oil and its impact on various asset classes, interest rates, credit quality, and foreign exchange rates. The two most important factors are U.S. producer inventories and the Saudi production rate.

As of January 23, 2015, U.S. oil inventories reached their highest December levels since 1930 (383.5 million barrels)[3]. According to Bank of America Merrill Lynch, it takes U.S. shale producers 6 -12 months to react to rising or falling prices. If aggregate inventory levels remain near max capacity while the U.S. production rate falls, it would indicate that drilling projects are being cancelled and would likely have a large impact on small, highly-levered shale players. In turn, this could increase the number of defaults on energy company debt, which would have a negative impact on fixed income markets. The timing of these potential defaults could be accelerated as the foreign exchange rate of the U.S. dollar continues to rise. A stronger U.S. dollar makes it more expensive to finance debt levels[4]. As previously mentioned, it is clear that the Saudis want to retain their market share and continue to drive out production from their competitors.

Internationally, it will be important to monitor global economic growth (especially in China and India), which affects demand. If demand stays relatively low, it will put additional pressure on smaller OPEC members to plead with the Saudis to cut production or take unprecedented actions to support their economies. Those countries may have their patience tested, as the International Energy Agency forecast an annual demand increase of just 900,000 barrels per day in their January report (unchanged from December)[5].

Geopolitical risk is also an important factor to watch. The instability in neighboring Yemen could threaten Saudi Arabia’s production. Elsewhere, ISIS and the conflict between Ukraine and Russia add uncertainty to the global crude oil supply.

As the price of oil continues to decline, investors are attempting to take advantage. The four biggest oil exchange-traded products listed in the U.S. received a combined $1.23 billion in December, the most since May 2010, according to Bloomberg[6]. Regardless, the market may require patience as the Saudis’ political chess game plays itself out while crude oil prices continue to decline.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

[1] International Energy Agency, 2014

[2] U.S. Energy Information Administration, 2014.

[3] American Petroleum Institute, January 23, 2015

[4] Drilling, producing, and transporting oil is a very expensive process. As such, many U.S. energy producers require debt financing to fund capital investment. The total debt level of energy companies is approximately 16% of the U.S. High Yield Debt Market, which is almost four times higher than in 2004. Tudor, Pickering, Holt & Co. (TPH) has determined that at least 40 publicly held North American-focused E&Ps have reduced their 2015 capital expenditure guidance since December 8th by an average 31% from 2014 spending levels.

[5] Oil Market Report, International Energy Agency. January 16, 2015.