October 20, 2020

Why to Invest in 2 Frontier Markets: One Stable, One Not

Panama is solid, but ever-troubled Argentina does offer spot opportunities.

Reported by Amy Guthrie

Art by Andrea Chronopoulos

In March, as countries around the globe enacted lockdowns and quarantines to prevent the spread of COVID-19, investors hungrily snapped up $2.5 billion in sovereign bonds from investment-grade Panama, while Argentina lurched toward its ninth sovereign default. The two Latin American frontier markets could hardly be more different.

To invest in frontier markets is to wager that those countries are on the path to a better future. While investors agree that Argentina, Latin America’s third-largest economy, is in many ways headed backward, some see promising returns in both countries.

“The two are on opposite ends of the spectrum: Panama is very stable with a long track record, and Argentina is just restarting after its debt restructuring, with higher yielding bonds,” said Oren Barack, managing director of fixed income at New York-based AGP / Alliance Global Partners.

Overall, Panama offers strong institutions and a long-standing allure as a crossroads for commerce due to its famous canal connecting the Atlantic and Pacific oceans. Argentina, by contrast, has a lengthy slog ahead to regain the confidence of investors, but is larger and offers a broader range of investing opportunities.

Barack, who specializes in global high yield and distressed debt, has bought sovereign, quasi-sovereign, and corporate debt in both Argentina and Panama during the pandemic.

The basic premise of frontier investing is to identify opportunities in countries that are further behind on the development curve than their emerging or developed counterparts, but that are on the right track for strong economic growth. Frontier markets with large, young populations stand to possibly benefit from a demographic dividend as their economies grow, putting more cash into pockets for consumer goods.

“There’s a lot of potential for catch-up,” said Babatunde Ojo, co-lead portfolio manager on Harding Loevner’s $210 million frontier emerging markets equity strategy.

The Harding Loevner frontier team holds just one stock in Argentina: global software solutions provider Globant, a company that derives 83% of its revenue from North America and Europe. That exposure comes via American depositary receipts (ADRs) traded on the New York Stock Exchange, which guarantee that the fund’s money won’t get stuck in Argentina—though there’s still risk of price dislocation. Globant’s stock has appreciated more than five-fold since Harding Loevner bought it in 2016.

Ojo sees even fewer options in Panama. One company in Panama—Copa Airlines—has been approved for investment through Harding Loevner’s research process, but the portfolio manager isn’t keen to buy an airline amid the public’s pandemic-fueled aversion to travel.

Frontier markets are generally seen as “pre-emerging” markets. This classification has much to do with the shallowness of their local capital markets: Frontier market securities tend to be more thinly traded than their more developed counterparts. Inadequate liquidity may result in wider bid-ask spreads, and difficulty exiting an investment, especially in turbulent times.

Neither Argentina nor Panama fits neatly into the frontier category. Argentina has a highly educated population of 45 million people that lives mostly in cities, while the country itself is a leading exporter of grains and beef. Panama—a country of just over 4 million inhabitants on the narrow isthmus that links North and South America—has strong institutions, but its US dollar-based economy could use a bit more diversity and depth, since much of it is tied to revenue from Panama Canal shipping.

As investors weigh what countries to put money into, they find that categories such as “frontier” are sometimes fluid. Fixed-income investors view both Panama and Argentina as mainstream emerging markets that are included in JPMorgan’s widely followed Emerging Markets Bond Index (EMBI). That hasn’t meant Argentina is safe for bond investors. Those who were left holding pre-default Argentine sovereign bonds took a huge haircut in the August restructuring deal, recovering just 54.5 cents on the dollar.

The EMBI Global Diversified index, which allocates 1.34% to Argentina and 3% to Panama, was down 0.5% year-to-date through September but had returned a positive 6.1% annualized over the prior five years.

While the MSCI considers Argentina an emerging market, its index policy committee warned in June that the nation’s imposition last year of capital controls could force a reclassification to either frontier or something lower. Fellow equity index providers FTSE and S&P have already downgraded Argentina for the same reason. Panama’s local stock market is so illiquid it doesn’t even factor into the MSCI’s frontier indexes.

Taken as a whole, frontier stocks have had a rough ride during the pandemic. Year-to-date through September, the MSCI Frontier Markets Index, which tracks companies from 28 countries, was down 8.6% versus a five-year positive return of 4% annually. The MSCI Frontier Emerging Markets Index, which includes Argentina and smaller emerging markets such as Peru, had lost 16.8% this year but gained 1.2% annualized over five years.

For comparison, the MSCI All Country World Index —which covers 23 developed and 26 emerging markets, including Argentina—was up 1.7% this year and had returned 10.9% over five years through September on an annual basis The MSCI EAFE Index (it represents 21 developed markets, excluding the U.S. and Canada) was down 7% this year and up 5.2% annually over five years.

Latin America has been hard hit by the coronavirus, with a quarter of new infections globally reported there during the northern hemisphere’s summer months. Most of those cases occurred in the region’s two biggest economies, Brazil and Mexico, neither of which embraced strict quarantines.

Both Argentina and Panama adopted tough lockdowns to prevent the spread of COVID-19, barring international flights and closing many local businesses for months. The economic cost of shutting down has been high. The International Monetary Fund (IMF) projects that the Argentine economy—which was struggling before the pandemic—will shrink by 11.8% in 2020, while gross domestic product (GDP) in Panama is forecast to contract by 9%.

During the five years prior to the pandemic, the World Bank notes that Panama was one of the fastest growing economies in the world, with an average annual growth rate of 4.6%. That growth has been unevenly distributed within the country, with a large rural population of mostly Black and indigenous people living in poverty. Employment is heavily skewed toward services such as finance, construction, and trade due to its status as a logistics hub anchored by the Panama Canal shipping route.

“With global trade activity picking up, Panama is in a solid position to rally,” said Benito Berber, chief economist for Latin America at Natixis, the French investment bank and asset manager.

Outside of sovereign bonds and instruments for the country’s airport, there are limited ways to tap into Panama’s growth potential. The country only has two listed ADRs: those of Copa, the air carrier, and financial institution Banco Latinoamericano de Exportaciones e Importaciones (Bladex).

The case for investing in Argentina, for many, is one of short-term opportunism because plenty of its assets remain depressed in the wake of the country’s September swap of $65 billion in sovereign bonds.

However, Argentina faces entrenched political and social obstacles that analysts fear will prevent the country from resuming the sort of growth trajectory it needs to get back on solid footing. It must also tame inflation, which has run over 40% year-over-year since 2018, and renegotiate its $44 billion loan from the IMF.

A turnaround won’t be easy. Bruno Rovai, Latin America sovereign analyst at Macquarie Investment Management, noted that Argentina’s sovereign hard-currency bonds are trading at low prices, implying that another default is on the horizon.

“While we think there’s some probability of another restructuring in the next five years, we also think current bond levels offer an attractive entry-point for a tactical, short-term investment opportunity,” Rovai said.

Hasnain Malik, head of strategy and equity research at Tellimer, agrees that Argentina stands little chance of clinching the reforms it needs to avoid yet another sovereign default. He views the investment case for Argentine equities as largely subject to the sovereign debt situation.

Malik, who covers 35 emerging and frontier markets globally from a base in the United Arab Emirates, lists several other emerging and frontier economies that aren’t as cheap or liquid as Argentina, but that have better long-term growth and lower risk: Pakistan, the Philippines, and Vietnam.

Yet he can see why equity investors might be tempted to dabble in Argentina. For starters, the country has nearly two dozen ADRs listed in New York, some of which have revenue streams that are largely from beyond its borders. Example: Shares of MercadoLibre, an e-commerce player that operates throughout Latin America and relies on Brazil for the majority of its revenue, have doubled in value this year on the Nasdaq, although Malik says those valuations no longer present an attractive entry point for investors.

In buying ADRs, Malik says investors can mitigate much of the risk of capital being trapped in locally listed stocks for extended periods due to foreign exchange crises, as was the case at different points over the past decade in countries such as Egypt and Nigeria.

Stocks from domestic-oriented sectors such as banks, consumer goods, telecom, and utilities still present steep discounts, but they also carry the downside risk of a painful and slow recovery for the Argentine economy.

Nonetheless, opportunities do exist there. At least one fund boasts that stock picking in Argentina has helped its returns this year. In September, the BlackRock Latin American Investment Trust reported that its equity portfolio was overweight on the South American country. By placing 4.8% of its assets in Argentine securities—mostly in multinational steel giant Ternium—the $197.3 million fund outperformed versus its benchmark, the MSCI Emerging Markets Latin America Index, which only allocates 1.7% to Argentina. A whopping 64.2% of the equity index is allocated to Brazil, followed by Mexico with 21.4%, Chile with 7%, Peru with 3.3% and Colombia with 2.4%.

At the same time, the BlackRock fund, managed by Ed Kuczma and Sam Vecht, reduced exposure in August to YPF, an Argentine energy company, taking advantage of outperformance following a deal with private bondholders. The BlackRock managers see the outlook for YPF as not supportive for earnings or cash flow generation, since gas prices have been suppressed locally due to oversupply and an ongoing residential tariff freeze, coupled with a decline in demand because of COVID-19 lockdown restrictions and a weak economy.

Often, investments in frontier markets such as Argentina and Panama are bets for the long term, maybe for more years than some might like. Harding Loevner, though, aims to hold frontier stocks for five years or more. “People have this notion of frontier as the poor, the wretched, the less educated—but that’s not the truth,” said Harding Loevner’s Ojo, who grew up in Nigeria. “They’re just not as rich yet.”