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Magazine Issues » October 2014

FRONTIER MARKETS: Africa’s pre-industrial revolution

FogChange is sweeping across Africa, from a reduction in conflicts, to the creation of 'Silicon Savannah'. Fiona Rintoul looks at factors that stir interest in this frontier market.

Africa is the world’s last big undeveloped market. Therefore, the question of whether it is time to invest in Africa has cropped up intermittently over the past decade, as the continent’s fortunes – seen through the sometimes distorting prism of investor returns – have seesawed. For Africa investment specialists, there is, of course, no such question. To them the numbers are too compelling to ignore – especially the demographics. 

One in seven of the global population is African. By 2050 that number will be one in four, says David McIlroy, head of African investments at Alquity. Fifty per cent of the population is under 20, and 77% of African children now benefit from some kind of schooling, according to the African Development Bank. 

“It has been time for Africa for the last 20 years,” says Stephen Bailey-Smith, head of African research at Standard Bank. For the rest of the world, the answer to the Africa question always seems to be a mishmash of positives and negatives. Yes, the growth and the returns are there. But so is the political risk.  However, the past couple of years have brought some real changes in Africa, one of the most important being the introduction of African eurobonds. Since 2007, there has been a whole raft of mainly sovereign issuance, which has meant that many mainstream international investors now have holdings in Africa. 

‘The majority of [African eurobond] holders are international,’ says Malick Badjie, head of investment solutions at Silk Invest. ‘US pension funds and US endowments have picked up a large percentage of them.’

And so, mindful as investors are that waiting for perfection is not the best way to make returns in developing markets, and that mainstream emerging markets are increasingly correlated with developed markets, the question arises again: Is now the time to invest in the world’s second most populous continent?

Certainly, there can be little doubt that Africa is now on corporate radars in a way that it just wasn’t ten years ago. 

“Most major companies in the world now have to have an Africa strategy,” says Bailey-Smith. “Ten years ago the strategy was to ignore Africa.” 

The past decade has been a game changer for Africa. Six of the fastest growing economies in the world were African. Over the next five years, seven of the world’s fastest-growing economies will be African. However, that message doesn’t always come across to the more casual observer.

“Inevitably, there’s a gap between perception and reality,” says McIlroy. “Any time Africa appears in the news it’s for some negative reason. That masks the tremendous progress it’s made as a continent.” 

The next ten years could be equally crucial for the continent. Fortune favours the brave, especially in developing markets, and those who fail to take the plunge in a timely manner may miss the most exciting period of growth, some Africa-focussed managers believe. 

“Africa today is where emerging markets were in the 1990s,” says Kanwal Masood, portfolio specialist at T. Rowe Price, which has been running an Africa and Middle East fund since 2007. 

She emphasises the structural changes that have taken place in the continent. 

Democracy has increased with 50 countries having some form of election. In the 1970s, two-thirds of the continent was conflicted, whereas today only a handful of countries are. Debt levels are coming down and economic management is improving. At the same time the investor base has been changing in ways that help to promote stability. 

‘We launched our Africa and Middle East fund in 2007 when the MSCI Frontier Markets index launched,” says Masood. “Initially, it attracted a lot of retail money. Then after the financial crisis and the Arab spring that money went out. Now flows are coming more from pension funds.”

Africa has also become less of a destination for hedge funds since the financial crisis. “[2004 to 2008] was a bit of a halcyon period for African markets on the local debt and equity side,” says Bailey-Smith. “That has given way as the hedge fund industry in general has given way.”

Silk Invest’s Badjie agrees that the “hot money flows before 2008” have turned to something more stable, as Africa ceases to be an “emerging-markets add-on”. This coincides with Masood’s experience at T. Rowe Price that pension funds are now looking for a dedicated frontier-markets manager. “We see more and more pension funds making a dedicated allocation,” she says. “Typically they will allocate 1-5%,” she adds.

Sometimes, though by no means always, socially responsible investment (SRI) considerations provide an additional motivation for institutional investors. “We had an SRI mandate from a Catholic organisation,” says Badjie. “It’s a fantastic story for people looking for ESG [environment, social and governance] investments.”

Crucially, domestic underpinning of the African markets has also strengthened, prompted in part by the liberalisation of pension fund guidelines. In Nigeria, for example, the threshold for investment in the capital markets by pension funds has been raised from 25% to 50%. 

Although buy-and-hold state pension funds can act as a drag in some markets, the expansion of pension funds in Africa is broadly positive. The Nigerian reforms also allowed investment by pension funds in infrastructure funds and private equity. Access to private equity is an important development, as listed markets often do not reflect the breadth of African economies, even if Nigerian pension funds may have been slow to take advantage of their new freedoms. 

“A lot of private equity groups are potentially interested in the African story,” notes Bailey-Smith. “There’s very little issuance on the equity side.”

Domestic underpinning is increasingly complemented by investment in the capital markets from the African diaspora. “Historically, the diaspora invested in real estate, but they have become more sophisticated and long-term,” says Badjie. “Now they are investing in the equity markets.”

This goes hand-in-hand with a returning diaspora. “Ten years ago, Africa suffered from a brain drain,” says McIlroy. “Since 2008 the diaspora has been returning.” None of this is to say that Africa is risk-free – or even that the African markets (outside South Africa) are on their way from frontier to emerging.

“Some of the smaller markets are not even in the MSCI Frontier Markets index,” says Masood. “That’s the first step for them. Nigeria is the one country that could reach emerging status, but even in Nigeria’s case it would take at least 10 years.”

Political risk and volatility are part of the landscape, and the continent has a long way to go before it can compete with the likes of China or India.

“Africa should be viewed as predominantly pre-industrial,” says Bailey-Smith. ‘Pre-industrial economies struggle to develop macro stability and to compete with industrial economies. The infrastructure needs are so great, and it’s a big race to overcome that hurdle.’ 

But in many ways the factors that make Africa risky are also the ones that make it attractive. One of the big draws of Africa – and frontier markets more generally – is a lack of correlation with developed markets at a time when emerging markets have become increasingly correlated. 

“Frontier markets tend to be idiosyncratic,’ says Bailey-Smith. 

“It’s almost a definition of frontier markets that they are pre-industrial and, therefore, more volatile and less prone to the drivers of other emerging markets,” Bailey-Smith adds.

These idiosyncracies are one reason why diversification is important. Egypt is a prime example of why, having gone from basket case a couple of years ago to what has become one of the best performing markets in Africa this year.

At the same time, there are some broad themes, one of which is the emerging consumer. According to the African Development Bank, Africa’s middle class has grown to 350 million (34% of the population), up from 126 million in 1980 (27%). The middle class is projected to continue to grow, reaching 1.1 billion (42% of the population) by 2060. 

“The real growth is going to come from the consumer sector,” says Badjie. “We see interesting opportunities in telecoms, banks and materials.” 

And in many cases, progress can be made more quickly in Africa by learning the lessons from what has happened in other areas of the world. 

“Advancing in the midst of 21st century technology can close the gap,” says McIlroy. “For example, internet access in Africa is through mobiles. There’s an area in the west of Kenya called ‘Silicon Savannah’ where they are developing African solutions to African problems.” 

Africa is interesting precisely because it is different. There are now almost 50 European funds with an investment focus of Africa, the majority of which were launched in the past years. So, is it time for Africa?

“For us Africa is in the sweet spot right now,” says McIlroy. “People are bored with Bric [Brazil, Russia, India, China]. They are looking for the next big thing. Africa is the last undiscovered area.” 

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