Frontier markets returned 6.8 per cent in 2014, having been more than 20 per cent to the good as late as early October.
The sector’s continued outperformance of emerging markets (EMs) was helped by superior growth, continued inflows from international investors and the promotion of two of the major constituents in the index to EM status – United Arab Emirates and Qatar.
Geopolitics was an ever-present issue, particularly in the Middle East, while several countries devalued their currencies, including Argentina, Kazakhstan, Ghana, Nigeria and Vietnam.
The underperformance of cyclical sectors was a common theme across both EMs and frontier markets, with mining and energy stocks moving to multi-year lows – a result of weak demand and falling commodity prices.
The sudden collapse in the price of oil served to focus investor attention on the beneficiaries of such a decline, with Asian markets the clear winners and Russia, the Middle East and Nigeria among the most obvious losers.
EMs have underperformed developed markets by an unprecedented 53.3 per cent across the past five years. This extends a frustrating period for investors in EMs with the index essentially range-bound, while developed markets have delivered solid gains.
The issues that hindered EMs included continued earnings disappointments, lacklustre GDP growth, expectations of early US Federal Reserve monetary tightening, widespread weakness in EM currencies against the US dollar, continued selling pressure from foreign investors and deteriorating sovereign (Russia, Brazil) or corporate governance (South Korea).
Those markets that outperformed did so following positive political change (India, Indonesia and Thailand) or in anticipation of market reform (China).
The question many investors are asking is whether the good times will continue for frontier markets. Returns during the next year are likely to be driven by a small number of key considerations.
In the short term, investor attention will remain focused on the path of energy prices. It seems reasonable to assume that these will remain volatile and prudent to assume that they may stay lower for longer as strong, sustainable growth still eludes many parts of the world.
In such a scenario, the recent beneficiaries will continue to benefit while exporters suffer.
The poor performance of EMs in 2014 was exacerbated by currency losses. Many EM and frontier market currencies now stand at levels only previously seen in times of crisis.
Recent weakness clearly reflects expectations surrounding the future path of US monetary policy, which still seems far from certain. Taken in aggregate, EM currencies are at their lowest level in 15 years. This belies the improved balance sheets and flexibility that the sector enjoys now relative to where it was 15-20 years ago.
A relief rally in EM and frontier market currencies is a distinct possibility if the benefits of greater currency competitiveness start to show in fundamentals or if expectations surrounding the upward path of US interest rates are delayed.
China will continue to take centre stage in the global economy this year. In spite of slower growth now being a reality, it is noticeable that some of the pessimism that surrounded the Chinese economy has dissipated over the past year.
