Frontier emerging markets stocks soar as investors cheer reforms

Former pariahs in emerging markets have been among the world’s best-performing stock markets this year as investors bet reforms in troubled economies such as Argentina and Pakistan will help them leave the worst of their currency woes behind them.

Argentina’s Merval index has led Latin American bourses, rising 53 per cent in US dollar terms, while Pakistan’s stock gauge is one of the best performing in Asia, as markets that until recently were seen as very troubled have outperformed larger and more expensive peers.

These so-called frontier markets have been attractive because of their cheap valuations, say investors. In contrast, indices in more established markets such as Mexico and Brazil have declined in dollar terms as capital has been pulled towards surging artificial intelligence stocks in the US.

“You’ve got a big sucking sound out of the US, called [chipmaker] Nvidia,” which has pulled money away from larger emerging markets, said James Johnstone, co-head of the emerging and frontier markets team at Redwheel, an investment manager.

“But what is performing well are markets that have gone through almost existential crises and carried out the requisite reforms,” he added. 

A group of developing economies including Sri Lanka and Turkey “have been through a really difficult period” but are now primed for recovery as expensive foreign currency debts and double-digit rates of inflation are brought under control, Johnstone said.

In Pakistan, the Karachi stock market has risen 30 per cent since the start of 2024, more than Taiwan and India’s benchmark share indices. It has nearly doubled in dollar terms since June last year when the country avoided a default by securing a $3bn loan from the IMF.

“The recent rally is due to investors’ confidence that Pakistan will get a long-term IMF deal after the successful completion of the standby agreement last year,” said Mohammed Sohail, chief executive of Pakistani brokerage Topline Securities.

Even after the recent bull run, Pakistani stocks still trade about 3.7 times their earnings, roughly half the historical average of seven, Sohail added.

The biggest contribution to the rally has come from the banking sector, which has enjoyed bumper profits as the central bank raised the policy rate to above 20 per cent to bring down runaway inflation, according to a research note from Arif Habib Limited, a Pakistani brokerage.

Even so, foreign flows into Pakistan’s stocks remain minimal and the turnaround is instead a reaction to a drop in food and fuel inflation, which spiked after Russia’s invasion of Ukraine, said Dominic Bokor-Ingram, a senior portfolio manager in emerging and frontier markets at Fiera Capital. “We don’t see it as a reform story but as a bounce back from very low levels,” he said.

Some frontier stock markets remained in the doldrums in the first half of the year in dollar terms because currency devaluations have taken place recently. Egypt’s stock market, for instance, is down 27 per cent this year, hit by the Egyptian pound’s devaluation in March.

Even in the group of countries that have experienced stock market rallies, economic conditions largely remain miserable for ordinary people. Inflation is often still high compared with other emerging markets, despite sharp rises in interest rates — in Turkey, for instance, inflation cooled for the first time in eight months in June, but is still 71.6 per cent. A number of governments are facing resistance to plans to raise taxes to pay off their debts.

The Nairobi all-share index has jumped 44 per cent in dollar terms this year as Kenya averted default on looming bond payments and the shilling rallied more than one-fifth against the dollar.

But last month President William Ruto withdraw a finance bill, which was part of a plan to comply with an IMF bailout, after a deadly crackdown on protests against what were seen as onerous tax measures backfired.

Pakistan’s finance ministry unveiled a tax-heavy budget last month, which is aimed at increasing revenues and assuaging IMF concerns, as the nation’s wobbly governing coalition seeks a path out of anaemic growth, double-digit inflation and soaring public debts.

Argentina’s President Javier Milei has been steering economic measures into law, moving quickly compared with past reform attempts that got bogged down in political opposition, Bokor-Ingram said. “The difference between this time and all the previous times is the speed with which Milei has done it.”

Frontier markets and more idiosyncratic larger markets such as Argentina have also come on to investors’ radars as they try to control exposure to larger emerging markets such as China.

However, despite the promise of reform in some countries, many investors are conscious that returns on EM stocks have generally been poor over the past decade compared with US markets, one emerging market equity manager said. At the end of the day, the manager added, “you’re just operating in a highly cyclical asset class”.