Investors flock to Africa amid uncertainty in the U.S.

Buying stocks from companies located in Ghana or Kenya or bonds issued by Zambia or Nigeria might not sound like a good bet to the average investor, but institutional fund managers are moving into these assets at a historic pace.

During 2017, stocks and bonds issued from so-called frontier markets — countries too small or with capital markets too underdeveloped to be labeled emerging — saw capital flows to rise to around $141 billion. That was the highest level since 2007, according to the Institute of International Finance.

One part of the frontier market asset class that has caught fire of late is Africa.

“Overall, we are positive on Africa and have incrementally added to our positions there as the outlook has kept improving through the last year or so,” said Pradipta Chakrabortty, portfolio manager of Harding Loevner’s frontier emerging markets strategy.

Cliff Quisenberry, co-founder and portfolio manager at Caravan Capital Management, said that over the past year he has seen a major influx of cash that has tripled the holdings of his frontier-dedicated strategies. Having previously offered only private funds, after receiving the largest contribution in the firm’s history last year Caravan launched a frontier markets mutual fund in November.

Currently with under $25 million of assets under management, Quisenberry said he’s expecting the strategy to attract $300-$400 million in the next three years.

“I think there’s an expectation that the U.S. market has topped out, and there could be further downturn beyond this 10% drop [in U.S. stock markets since their peak], so where do you go and where can you get positive returns?” Quisenberry said. “I think that’s one of the things people are looking at from frontier markets.”

While U.S. stocks have gone cold in 2018 after a run-up last year, frontier market equities have continued their strong performance. MSCI’s frontier markets index (FM) has risen 6% year to date, while the U.S. S&P 500 has fallen 1.2%. In 2017, the index gained 31.5% compared to the S&P’s 18.4% rise.

Guggeinheim’s widely popular frontier market ETF (FRN) has gained 9.5% so far in 2018 after rising 26.9% last year.

Investors say they like African stocks because in addition to the opportunity for home-run gains, they offer diversification. Companies located in sub-Saharan are less impacted by political risk emanating from headlines on U.S. President Donald Trump or a possible trade war between the United States and China.

Africa is hot as the U.S. goes cold

Led by economic turnaround stories and currency deregulation in countries such as Nigeria and Egypt, data from eVestment shows African stocks have become popular among individual investors as well as institutional fund managers. Combined, they poured almost $2.5 billion into African equities in just the fourth quarter of 2017, eVestment’s data showed.

In contrast, eVestment found that institutional fund flows to U.S. stocks decreased by more than $106 billion during that time period.

If investors like African stocks, they are in love with African bonds. The eVestment data shows retail and institutional investors holding more than $37 billion in African bonds in the fourth quarter of 2017, almost three times the level of investment in the first quarter of 2013. Institutional fund managers alone held over $29 billion in African debt in the fourth quarter of 2017, nearly five times the level of assets under management they held five years earlier.

Fund flows to African bonds have increased in every quarter of 2017 and in 15 of the last 20 quarters – or three out of every four quarters for the last five years, according to eVestment.

“This is the year for sub-saharan Africa,” said Josephine Shea, emerging markets debt senior portfolio manager at Standish Mellon, a subsidiary of BNY Mellon. Shea said she is positive on African and frontier market debt broadly, but has been selective in her allocation.

Bond issuance has picked up significantly over the past two years. In 2017, frontier markets issued $67 billion of local currency bonds, the Institute of International Finance reported. That brought the total debt issued by frontier markets to some $800 billion at the end of 2017, between corporate entities and governments. That amount of debt has nearly tripled over the past decade.

Bonds issued in hard currency – typically U.S. dollars or euros – have also risen to the highest levels on record, IIF data shows.

Risk

In their thirst for high-yielding investment vehicles investors may be looking past some serious risk. About half of the 25 largest frontier countries are projected by the International Monetary Fund to reach gross debt to GDP ratios of over 60% this year. Seven of the 25 have been downgraded by credit ratings agencies. Lower credit ratings typically mean the countries will have to pay more in interest on debt issued in the future as they are seen as having a higher risk of defaulting.

“It’s not absolute level of debt that is concerning in frontier markets, it’s the pace at which it’s being accumulated and the fact that we’re moving into sort of uncharted territory,” IIF Managing Director Sonja Gibbs told Yahoo Finance. “You have a lot of borrowers who are fairly new to the market so managing debt that they’ve taken on may become challenging for some more vulnerable countries.”

Investors say they are well aware of the risks and overall they feel they are being compensated sufficiently by the high bond coupons and stock outperformance African and frontier market securities offer. They’re so comfortable, in fact, that some fund managers have recently begun conversations about investments in Zimbabwe. The country is considering opening up to investors after long-time leader Robert Mugabe left office in November (ending a 30-year rule). Zimbabwe was notorious for its runaway inflation under Mugabe that hit such high levels the country had to start issuing 100 trillion dollar bills.

Andrew Brudenell, portfolio manager and head of frontier equities strategy for Ashmore Investment Management, said that it’s early days in Zimbabwe but there have been discussions about investing there in the future.

“It used to be the largest economy in Africa and when you go there you can see that basic infrastructure does exist, it just needs updating a lot,” Brundenell said. “It is capable and that’s quite important. So we shall watch and see as the elections unfold what the people say and what authorities begin to do.”

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Dion Rabouin is a financial markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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