Argentina, Nigeria and Pakistan are three of the worst under-performers on a one-year view in frontier-emerging markets. They have underperformed MSCI FEM by 26% to 43%, are valued at 23% to 41% discounts to five-year median price/book and, in the case of Nigeria and Pakistan, are seeing liquidity (daily traded value in equities) 44% to 77% below five-year averages.
Equities in these countries are so cheap because there is a perceived lack of policy credibility in the eyes of market consensus. In the case of Argentina, this is the credibility to control inflation and fiscal deficit and meet external debt obligations. In Nigeria, the credibility to implement public project spending and enact structural reform. In Pakistan, the credibility to address security, fiscal and export weaknesses.
It is in Pakistan that this consensus view looks the most unfair and therefore, this is our favourite of these three distressed markets. Argentina is second; the next government may not be as market-unfriendly as feared but external vulnerability remains very high and resident capital outflows historically spike in the run-up to elections. Nigeria is our least favourite: it is cheap, no doubt, but so are the others, and it shows the least sign of a significant change in policy framework and has not made the progress (either in terms of raw growth or structural change) that we would have hoped for during the period since mid-2016, during which oil output and price recovered.
In Argentina, the lack of credibility stems from the risk that policy takes a market-unfriendly turn under an Alberto Fernandez government, which makes the refinancing of high, short-term external debt too difficult. This builds on top of the existing inability of the Macri government to credibly anchor inflation expectations. The market consensus expectation has swung to a default on external debt – the question is will it be orderly or disorderly.
Perhaps the best one can hope for is that Alberto Fernandez follows a strategy similar to Lula in Brazil in 2002; engages the IMF, communicates to his political base the need for fiscal consolidation and to market sceptics that a return to undiluted Kirchnerism is not in the offing.
In Nigeria, the lack of credibility stems from the federal government and central bank policy, which prioritises official FX rate stability to such an extent that growth has been crushed. A further potential factor is ongoing leakages from oil revenues that have prevented FX reserves being rebuilt to the extent they should have been given high output and price for the last year or so. President Muhammadu Buhari’s re-election (with his supporters leading both houses of parliament, unlike in his first term) appears to have reinforced this policy environment rather than emboldened a change.
The recent action to restrict FX made available for food-related imports is an echo of the Nigerian playbook from 2015, which ultimately led to a very large parallel market FX rate discount and capital controls. Our central case does not assume a significant further drop in oil price or any disruption to oil output, but if either of these were to take place, we are not confident that Nigeria would weather such shocks any better than in 2015.
In Pakistan, the lack of credibility stems from concerns over persistently low FX reserves. In turn, this reflects fears over the government’s ability to stay the course in the IMF programme, enact serious structural reform (eg, on loss-making state-owned enterprises, chronically low tax collection or value-add exports) and to avoid sanctions (eg, related to FATF), or avoid being derailed and distracted by insecurity (related to India, Afghanistan or domestic militants) or dysfunction between the military and civilian sides of government.
Essentially, the market consensus view is that Pakistan has not changed. We fundamentally disagree. The combination of orthodox economic policy (which pre-dates the IMF loan) and an FX rate which is close to fair value, in addition to structural changes in domestic politics (vastly improved security, the break-up of quasi-mafia political parties, cooperative military-civilian relations), geopolitics (better relations with the US and China) and infrastructure (China Pakistan Economic Corridor), makes the Pakistan of today very different from the Pakistan of the past four decades.