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Frontier Markets Semi-Annual Outlook

August 2021*

Uneven Distribution

Frontier markets (FM) face a number of challenges to their economic recovery, with renewed COVID-19 waves and low vaccination rates chief among them. While the pandemic remains a concern for some policymakers, a number of FM countries are moving on from it and are set to rebound strongly.

Frontier markets have a number of headwinds to contend with in the coming months including: 1) rising COVID-19 cases amid the presence of the Delta variant; 2) low levels of vaccinations in some countries, making restrictions and lockdowns the main policy prescriptions and 3) rising inflationary pressures. This is likely to hamper growth prospects in the short-term, particularly for domestically-oriented economies. At the same time, countries with exposure to external demand and commodity producers are set to receive a boost from favourable global demand conditions.

Central banks in FMs face a policy dilemma as the economic recovery encounters obstacles on the one hand, but food and other prices accelerate on the other. Some price pressures are due to supply chain problems which may persist in the short-term amid ongoing COVID-19 disruptions. Moreover, falling output gaps in FM are putting upward pressure on inflation. Many central banks are nevertheless likely to keep policy unchanged in the coming months as economies navigate COVID-19 restrictions. However, as the vaccination rollout improves and FM economies begin to lift mobility restrictions over the next year monetary policy may become less accommodative. Fiscal policy is set to follow a similar path, but could be eased further in the short-term to support households and businesses. At the same time, should financial conditions tighten globally, more restrictive policy settings would be required to support some FM currencies.

Overall, the economic recovery within FM is likely to be unevenly distributed. As developed and some emerging economies reopen, demand for services is likely to outpace that for manufactured goods, limiting the marginal benefit for FMs. The delayed reopening of FM economies also impedes the tourism sector in certain countries. By contrast, commodity producers like Kazakhstan are benefiting from the improvement in global demand and prices.

Market Strategy

FM equities have become more expensive at a time of increased economic challenges. The 12M forward P/E of MSCI FM has narrowed from a 17.5% discount to emerging markets (EM) six months ago to 1.4% currently, close to the five-year average. EPS are expected to be 14% above pre-pandemic (2019) levels this year and 27% higher in 2022. By comparison, EPS for EM are projected to be 36% higher in 2021 and 47% in 2022. Hence, lower expectations are somewhat factored into FM such that if some countries manage COVID-19 better-then-expected (e.g. Vietnam, which has accelerated its vaccination rollout significantly) this could support equity prices.

At the same time, the 12M forward dividend yield remains healthy at 3.6% compared to 2.8% for EM and 1.9% for developed markets. This could prove supportive for FM equities in what is likely to remain a low rate environment in the developed world.

In our view, the varied economic backdrop presents several opportunities. For example, Kazakhstan appears attractively valued and offers a high dividend yield (7.2%). Vietnam faces near-term challenges from COVID-19, but its fundamentals remain sound, it is set to benefit from external demand tailwinds and valuations are still attractive in this context. By contrast, Argentina is rolling out vaccinations at an impressive pace but faces political uncertainty from the November mid-term elections and valuations are still frothy.

Overall, we only make few changes to our country allocation. We reduce Kenya to neutral, taking profit on outperformance since valuations now better reflect the good news and the latest outbreak of COVID-19 presents downside risks. We also raise Bangladesh to overweight on the back of strong support from external demand and remittances, as well as more attractive valuations than six months ago.

*The publication reflects asset performance up to 30 July, 2021, and macro events and data releases up to 6 August, 2021, unless indicated otherwise.

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The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.

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City of London Investment Management Company Limited (“CLIM”) is authorised and regulated for the conduct of investment business within the UK by the Financial Conduct Authority (FCA) and is registered as an Investment Advisor with the United States Securities and Exchange Commission (SEC). Registered in England and Wales No. 2851236. Registered Office: 77 Gracechurch Street, London, EC3V 0AS, England.

© 2022 City of London Investment Management Company Limited. All rights reserved.