Outperforming Frontier Markets in Asia

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By Ruchir Desai, Fund Manager, Asia Frontier Capital

ABOUTOver the past 12 to 18 months, there has been a marked divergence in the performance of different Asian stock markets. Many of the larger emerging markets in Asia have underperformed for a variety of reasons, but one reason that stands out has been the strong outperformance of emerging Asian stock markets.

Countries such as Iraq, Kazakhstan, Mongolia, Pakistan and Sri Lanka are among the world’s most prosperous markets, far outperforming larger Asian emerging markets.

There are several important reasons why emerging Asian markets have performed so well.

Easing monetary policy

Taking a step back, 2022 has not been the easiest year for many Asian frontier countries due to the actions of an aggressive US Federal Reserve (Fed), the war in Ukraine, and rising food and fuel costs, which have led to high inflation in Asian frontier countries. As in most of the rest of the world, macroeconomic imbalances have been clearly felt in Asian frontier countries during this time of many global macroeconomic headwinds.

To counteract these macroeconomic imbalances, many Asian border countries have taken harsh measures, such as aggressively raising interest rates and allowing their currencies to weaken. In addition to these measures, some countries, such as Bangladesh, Pakistan, and Sri Lanka, have turned to IMF (International Monetary Fund) programs.

To further strengthen and balance their economies, many Asian border countries have also taken other tough decisions, such as eliminating fuel subsidies, raising electricity tariffs and embarking on reforms that include making state-owned enterprises more efficient.

While such policies have proven burdensome for residents of many Asian border states, we believe they were necessary and necessary to restore economic stability and create the foundation for future economic growth.

Decisions made by various central banks and governments in Asia’s frontier countries began to have an impact in early 2023, when inflation began to decline and other indicators, such as current account deficits, began to stabilize. Inflation fell dramatically in countries like Georgia, Kazakhstan, and Sri Lanka last year due to decisions made in 2022. Pakistan also saw inflation fall from its peak a year ago.

As inflation has fallen and relative macroeconomic stability has been achieved, many central banks in Asian frontier countries have created space to begin easing cycles in the second half of 2023. Last year, we witnessed central banks in Georgia, Kazakhstan, Mongolia, Pakistan, Sri Lanka, and Vietnam cutting interest rates. This is in contrast to what we see from other central banks in Asia, which have either maintained or continued to raise interest rates. Moreover, monetary easing is taking place in Asian frontier countries, even though the Fed has not begun its own easing cycle.

The main reason for this is that EM Asian central banks had to be overly aggressive in 2022 compared to other central banks as their economies faced greater pressure from global macroeconomic headwinds, but the results of these decisions are now bearing fruit. This rate easing cycle was one of the main reasons for the rally in many EM Asian stock markets over the last 12 to 18 months, and we expect this tailwind to drive returns for our universe in the second half of 2024.

Macroeconomics and Profit Recovery

The return of economic stability to Asian frontier countries has led to improved growth. For example, Sri Lanka reported a better-than-expected 5.3 percent gross domestic product (GDP) growth in the first quarter of 2024, which should allow it to fare much better than the consensus estimate of 2-3 percent for 2024.

Sri Lanka’s economic growth recovery is partly due to a strong recovery in the tourism industry. The country welcomed one million tourists in the first half of the year and is on track to return to pre-pandemic levels by the end of 2024. More importantly, the recovery in Sri Lanka’s tourism industry will contribute around US$3.5 billion in foreign currency earnings, supporting the country’s ongoing macroeconomic recovery.

Vietnam, which also saw relatively weak economic growth in 2023 compared to previous years, posted a much better performance in the first half of 2024, with GDP growth in the second quarter of 2024 coming in above estimates at 6.9 percent.

The dynamics of GDP growth in Vietnam are largely due to the recovery in exports. Exports play an important role in the country not only in terms of obtaining foreign exchange, but also in generating jobs and income, which has an impact on other sectors of the economy, such as domestic consumption.

Moreover, the economic dynamism of emerging Asia is gaining momentum not only in 2024 but also in the longer term, with our universe expected to record the highest GDP growth compared to other key regions of the world over the next five years.

Countries like Bangladesh and Vietnam are expected to drive economic growth, as they should be able to expand their economies by 6 percent or more over the next five years. This sustained economic growth has been fueled by rising disposable incomes of a large young population, infrastructure investment, and changes in global supply chains.

Given the overall economic recovery and lower interest rates in emerging markets in Asia, we expect a solid rebound in earnings in 2024 and 2025, especially for companies in Pakistan, Sri Lanka and Vietnam.

Continued momentum in economic growth and earnings will be another key driver of earnings generation in emerging markets in Asia.

Discounted valuations relative to history

One of the other important factors leading to the strong performance of Asian equity markets is that valuations bottomed out in early 2023. Moreover, despite the rally in equity markets, valuations of Asian markets continue to trade at a discount in the region. For example, both Pakistan and Sri Lanka trade at low single-digit P/E (price to earnings) ratios, despite their equity markets performing very well.

Our AFC (Asia Frontier Capital) Asia Frontier Fund reflects these attractive valuations and currently trades at a P/E of just 7.0x, which is a significant discount to history. We believe that with further easing of monetary policy not only in our universe but also globally, sentiment towards Asian frontier markets should improve dramatically, leaving room for valuations to be re-priced much higher for the fund, leading to prospects for consistent returns from Asian frontier markets.

Application

After a difficult few years, we strongly believe that Asian frontier markets have entered a positive economic cycle due to the important steps they have taken towards reform. We also believe that countries such as Bangladesh, Pakistan and Sri Lanka have no choice but to continue their reforms, just as many Southeast Asian countries had to do after the Asian financial crisis in 1997.

We believe that the ongoing economic recovery in emerging Asia, supported by attractive valuations and favorable macroeconomic factors, will continue to deliver stable returns.

Moreover, companies listed in Asian emerging markets are still significantly under-researched compared to their peers in the region. This presents an opportunity to generate high returns as more investors start to focus on Asian emerging markets in the next three to five years, given that they are less correlated with global markets and have delivered solid performance.

Asian frontier markets offer sophisticated investors a strong diversification vehicle, and our AFC Asia Frontier Fund provides a suitable platform to gain exposure to the ongoing reassessment of Asian frontier markets, which is reflected in its performance. The fund’s one-year return is 30.1 percent as of June 30, 2024, a significant outperformance over all global benchmarks.