Frontier, Index, Nordics

Iceland – a fish out of water in Frontier

Iceland is about to make its splash into Frontier. The country is going into the FTSE FM index in September 2019 and MSCI is consulting over whether to include Iceland in its FM and FM100 indices with 3.5% and 9.0% weights, respectively, in May 2020.

But Iceland does not resemble frontier peers at all. Its population is much smaller (350,000), more aged (15% over 65 years old versus 5% in most frontiers) and much richer (US$74k per capita GDP versus below US$10k in most frontiers). Its larger stocks are much more transparently communicative and liquidly traded than most of the larger stocks in frontier. For example, the two potential constituents of MSCI FM – Marel in food processing equipment and Arion Bank – both have average daily traded value of cUS$5m per day.

Iceland’s economy has been repaired after the crisis of 2008, when its banking system was too reliant on short-term international funding and too big relative to the domestic economy for the central bank to bail out.  The economy now depends on aluminium exports (21% of GDP), fish exports (16%) and tourism (13%). Europe accounts for 80% of exports and about 50% of tourists, with the UK alone accounting for 9% and 13%, respectively.

From an investment perspective, however, this does not look like the right timing for Iceland. Its economy is slowing after a decade of successful post-crisis repair. Weakening demand, a poor season for capelin fishing (the second most important fish export after cod), the bankruptcy of low-cost airline WOW and the grounding of Icelandair’s Boeing 737 MAX fleet are all contributing factors to the slowdown. Iceland’s central bank expects a 10% decline in tourist arrivals in 2019.

And after strong total returns year to date for the local index, equity valuations do not appear compelling. From a relative perspective within FM, anaemic growth in Europe and a benign US rate outlook should tilt portfolios towards higher growth markets.

A key reason to look at Frontier markets in the first place is to find faster growth in per capita GDP than that seen in developed countries, alongside economic “convergence” as property rights are better protected, human and financial capital is more efficiently mobilised and new technology spreads across borders. Another attraction is that these markets are generally less sophisticated and liquid, which creates the opportunity to invest in very good companies at prices that insufficiently reflect their outlook.

But Iceland does not have these characteristics. It is a fish out of water in FM and its inclusion simply reinforces how unfit for purpose these indices now are.

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