By Ruchir Desai, Fund Manager, Asia Frontier Capital
Over the past 12 to 18 months, there have been marked divergences in the performances of various Asian stock markets. Many larger emerging markets in Asia have underperformed for various reasons, but one standout has been the strong outperformance of stock markets in Asian frontier countries.
Countries such as Iraq, Kazakhstan, Mongolia, Pakistan and Sri Lanka have been among the top-performing markets globally while also outperforming their larger Asian emerging-market peers by a wide margin.
Some important reasons explain why Asian frontier markets have had such strong performances.
Monetary easing
Taking a step back, 2022 was not the easiest year for many Asian frontier countries due to the actions of an aggressive U.S. Federal Reserve (the Fed), the war in Ukraine and rising food and fuel costs, which led to high inflation rates for Asian frontier countries. Like much of the rest of the world, macroeconomic imbalances were pronouncedly felt in Asian frontier countries during this time of multiple global macroeconomic headwinds.
To counter these macroeconomic imbalances, many Asian frontier countries took tough measures, such as raising interest rates aggressively and allowing their currencies to weaken. In addition to these measures, some countries, such as Bangladesh, Pakistan, and Sri Lanka, requested IMF (International Monetary Fund) programmes.
To further strengthen and rebalance their economies, many Asian frontier countries also took other difficult decisions, such as removing fuel subsidies, increasing electricity tariffs and kickstarting reforms, including making state-owned enterprises more efficient.
Although such policies were difficult for the populations in many Asian frontier countries, we believe they were overdue and much needed to bring back economic stability and provide a platform for future economic growth.
The decisive decision-making by various central banks and governments in Asian frontier countries began to have an impact by the start of 2023, when inflation started to decline, and other metrics, such as current account deficits, began to stabilise. In the past year, inflation has fallen drastically in countries such as Georgia, Kazakhstan and Sri Lanka because of the decisions taken in 2022. Pakistan has also now seen inflation begin to recede from its highs one year ago.
With inflation declining and relative macroeconomic stability being achieved, many central banks in Asian frontier countries created room to begin interest-rate-easing cycles towards the second half of 2023. In the past year, we have seen interest-rate cuts from central banks in Georgia, Kazakhstan, Mongolia, Pakistan, Sri Lanka and Vietnam. This is contrary to what we see with other central banks in Asia, which are either holding or still raising interest rates. Furthermore, monetary easing is taking place in Asian frontier countries despite the Fed not having begun its own interest-rate-easing cycle.
The key reason for this is that Asian frontier central banks had to be overly aggressive in 2022 relative to other central banks as their economies faced greater pressures from global macroeconomic headwinds, but the results of these decisions are now bearing fruit. This interest-rate-easing cycle has been one of the key reasons for the stock-market rallies in many Asian frontier countries over the past 12 to 18 months, and we expect this tailwind to drive returns for our universe into the second half of 2024.
Macroeconomic and earnings recoveries
The return of economic stability to Asian frontier countries has led to improvements in economic growth. For example, Sri Lanka reported better-than-expected gross domestic product (GDP) growth of 5.3 percent in the first quarter of 2024, and this should allow it to do much better than the consensus estimates of 2-3 percent for 2024.
The recovery in Sri Lanka’s economic growth is partly due to the strong revival in its tourism industry. The country received 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 of Sri Lanka’s tourism industry will bring in approximately US$3.5 billion in foreign-currency earnings, which will support the ongoing macroeconomic recovery occurring in the country.
Vietnam, which also had relatively soft economic growth by its standards in 2023, has posted a much better performance in the first half of 2024, with GDP growth in the second quarter of 2024 coming in higher than estimates at 6.9 percent.
This momentum in GDP growth in Vietnam is in no small part due to the recovery in exports, since they play such an important role in the country, not only in earning foreign exchange but also in generating employment and income, which impacts other parts of the economy, such as domestic consumption.
Furthermore, economic momentum is picking up for Asian frontier countries not only in 2024 but also over the long term, with our universe expected to post the highest GDP growth over the next five years compared to other key regions globally.
Countries such as Bangladesh and Vietnam are expected to drive economic growth, as they should be able to grow their economies by 6 percent or more over the next five years. This sustained economic growth has been led by the rising disposable incomes of a large young population, infrastructure investments and shifts in global supply chains.
With overall economic growth recovering and interest rates easing in Asian frontier markets, we expect to see robust rebounds in earnings in 2024 and 2025, especially for companies in Pakistan, Sri Lanka and Vietnam.
This ongoing momentum in both economic and earnings growth will be another key driver for delivering returns in Asian frontier markets.
Discounted valuations relative to history
One of the other important factors leading to the strong outperformances of Asian frontier stock markets is that valuations bottomed out at the beginning of 2023. Furthermore, despite the equity-market rally, valuations for Asian frontier markets are still trading at discounts within the region. For example, both Pakistan and Sri Lanka are trading at low single-digit P/E (price-to-earnings) ratios, even though their stock markets have done very well.
Our AFC (Asia Frontier Capital) Asia Frontier Fund reflects these attractive valuations and is currently trading at a P/E ratio of only 7.0x, which is a large discount compared to its history. We believe that as further monetary easing takes place not only in our universe but also globally, sentiment towards Asian frontier markets should dramatically improve, which will leave room for valuations for the fund to re-rate significantly higher, leading to the prospects of consistent gains from Asian frontier markets.
Conclusion
After a challenging few years, we strongly believe Asian frontier markets have entered a positive economic cycle because of the important steps they have taken towards reforms. Furthermore, we believe that countries such as Bangladesh, Pakistan and Sri Lanka have no choice but to follow through on their reforms, similar to how many Southeast Asian countries had to follow through after the 1997 Asian financial crisis.
We are convinced that the ongoing economic recoveries in Asian frontier countries, backed by attractive valuations and macroeconomic tailwinds, will continue to drive consistent returns.
Furthermore, listed companies in Asian frontier markets are still significantly under-researched compared to their peers in the region. This is an opportunity to generate strong returns as more investors start focussing on Asian frontier markets over the next three to five years, given that they are less correlated with global markets and are delivering robust performances.
Asian frontier markets offer sophisticated investors a sound diversification tool, and our AFC Asia Frontier Fund provides the right platform to gain exposure to the ongoing re-rating in Asian frontier markets, as reflected in its performance. The one-year return for the fund stands at 30.1 percent as of June 30, 2024, a strong outperformance against all global benchmarks.