By Ruchir Desai, Fund Manager, Asia Frontier Capital
The last three years have seen events that have profoundly impacted the global economy. The COVID pandemic, the war in Ukraine and geopolitical tensions have led to fundamental shifts in how people, companies and countries operate. The significant increase in global interest rates over the past year has also added to the headwinds that companies and countries face.
No country or region has been unscathed by the events of the past few years, and within the Asian frontier-market universe, there have been both positive and negative impacts. One of the most significant shifts over the past few years has been the reconfiguration of global supply chains, which began with rising United States-China trade tensions that only accelerated after the pandemic.
Asian frontier countries are benefiting from the global supply-chain shift
Although several countries have benefited from this supply-chain shift, the prime Asian beneficiary of this trend has been Vietnam. Even before trade tensions between the US and China began in 2018 or the pandemic struck in 2020, Vietnam was already attracting much manufacturing-related foreign direct investment (FDI), as it boasts a large, young and disciplined labour pool; offers lower wages; and is geographically well situated within Asian supply chains. The government has actively promoted manufacturing-led exports to achieve greater prosperity, similar to its East Asian neighbours, such as China, Japan, South Korea and Taiwan.
Furthermore, Vietnam further strengthened its credentials as a manufacturing hub by signing free trade agreements with the European Union (EU), South Korea and Japan while also being part of the CPTPP (Comprehensive and Progressive Agreement for Trans-Pacific Partnership) and RCEP (Regional Comprehensive Economic Partnership).
In the decade before trade tensions between the US and China began in 2018, Vietnam’s exports grew at a compound annual growth rate (CAGR) of 16 percent. As trade tensions rose and the pandemic struck, many companies had to re-examine their supply chains. Vietnam stood out as a key beneficiary, positioning itself as a dependable manufacturing hub over the prior decade. Years of sound policymaking to attract global manufacturing activity and a stable political environment had prepared Vietnam to capture this opportunity. In other words, Vietnam is now in the “sweet spot”.
Putting in perspective the emergence of Vietnam as an important supply-chain partner in the past few years, its exports to the US have almost tripled from US$42 billion in 2017 to US$109 billion in 2022, as companies have sought to base manufacturing operations in Vietnam to diversify and protect their supply chains from geopolitical headwinds.
Over the past few years, it has not been only Japanese, South Korean or other countries’ multinational companies shifting manufacturing activities to Vietnam. Chinese companies across various industries, such as electronics, footwear, mobile phones and textiles, have also set up large operations in Vietnam. For example, critical China-based suppliers of Apple products, such as Goertek and Luxshare-ICT, now have sprawling manufacturing activities in Vietnam.
With Vietnam becoming a hub for manufacturing activity in Asia, foreign direct investment has consistently been around $20 billion annually over the past five years, totalling close to 6 percent of gross domestic product (GDP), amongst Asia’s highest.
However, Vietnam is not the only beneficiary of supply-chain diversification. Bangladesh has also been a key beneficiary of this trend, transforming into the second-largest garment exporter globally after China. Bangladesh has become a key sourcing partner for apparel companies from both the US and Europe and saw its garment exports more than double in 10 years to $43 billion in 2022.
The war in Ukraine has also led to shifting supply chains in Central Asia, as the uncertainty of conducting trade with or via Russia has led to supply lines being routed through Central Asia, benefiting countries such as Georgia, Kazakhstan and Uzbekistan.
However, the country that has gained the most since February 2022 is Georgia. Over the past year, Georgia has seen significant increases in tourism revenues, remittances and exports, as the country received long-term visitors from Belarus, Russia and Ukraine while goods were routed via its Black Sea Poti Sea Port, now operating at full capacity.
The result of this dramatic shift in Georgia’s economy has been tremendous: GDP growth in 2022 came in at an exceptional 10.1 percent, and the momentum has continued into 2023, with GDP growth of 7.5 percent so far this year. This significant thrust for Georgia’s economy means that its currency is one of the few globally that has appreciated against the US dollar in the past year at a time when a hawkish US Federal Reserve (the Fed) has been raising interest rates and emerging-market currencies have been facing severe depreciation pressures.
Favourable demographics, long-term consumption and improving infrastructure
The movement of manufacturing and trading activities into Asian frontier countries has positively impacted job creation and disposable incomes, playing well into the favourable and attractive demographics of Asian frontier markets. Countries such as Bangladesh, Pakistan and Vietnam have sizeable populations of 169 million, 227 million and 100 million, respectively, while the median age of our universe of Asian frontier countries is only 27. This large and young population, with rising disposable-income levels, provides a solid consumer base for companies, also giving rise to the many fast-growing consumption-related companies listed on various Asian frontier stock exchanges.
The growth of the manufacturing and services sectors in Asian frontier economies is also leading to higher urbanisation rates, which are not only tailwinds for consumption but also motivating governments to invest more in infrastructure projects, such as highways, metros and airports. The combination of the growth of the manufacturing and service sectors, higher consumption and greater infrastructure investments is generating sustainable GDP growth in Asian frontier markets.
Asian frontier markets are growing faster than most others
Despite downgrades to global GDP growth by the International Monetary Fund (IMF) for 2023, Asian frontier economies are still expected to show among the highest economic growth rates relative to other geographic regions, with countries such as Bangladesh, Georgia, Mongolia, Uzbekistan and Vietnam all expected to post GDP growth rates of between 5 percent and 7 percent in the next five years.
Asian frontier markets are ripe for re-rating as valuations have bottomed out
So, how does all this tie into the investment case for Asian frontier markets? The last 12 months have been challenging for frontier and emerging markets due to the economic volatility created by geopolitical events, but more importantly, significantly higher inflation and interest rates have led to headwinds for both economic and investor sentiments.
Certain countries, such as Pakistan and Sri Lanka, have felt more severe impacts from recent events, with the former recently winning approval for an IMF programme, while the latter is slowly but surely coming out of the crisis, with tourism witnessing a strong rebound in Sri Lanka, reforms taking place and, more importantly, the IMF programme pushing the country to follow through on its reforms.
An uncertain global macroeconomic environment has led to contractions in valuation multiples for Asian frontier markets, with our AFC Asia Frontier Fund trading at its all-time low P/E (price-to-earnings) ratio of 6.6 times (x). We strongly believe that at these current low valuations, Asian frontier markets are ripe for a strong re-rating, which should be led by an expansion in valuation multiples.
The key reason for this conviction is the reversal in the global interest-rate hiking cycle. With the Fed reaching the end of its interest-rate hiking cycle, central banks in our universe are gaining more confidence in managing their monetary policies. Three Asian frontier central banks have already cut interest rates in the past few months, with Georgia, Sri Lanka and Vietnam reducing their benchmark interest rates by 50, 450 and 150 basis points, respectively. Our AFC Funds are already capturing the start of this re-rating cycle, with all four AFC Funds having generated strong positive returns so far in 2023, including our AFC Iraq Fund, which is up 38.6 percent.
Higher inflation and interest rates were the key headwinds for Asian frontier markets in 2022. But in 2023 and beyond, these headwinds will most likely turn into tailwinds, supporting the more important growth drivers for Asian frontier markets—namely, the substantial economic benefits of global supply-chain shifts, attractive demographics, improving infrastructure and superior economic-growth rates.
Hence, this is an opportune time to invest in Asian frontier markets—when they are at the bottom of the valuation cycle, making them ripe for a re-rating as both macro and structural factors begin to work in their favours.