Cautiously Optimistic for 2023 - AFC Asia Frontier Fund 2022 Review and Outlook for 2023

Dear Investors and Newsletter Readers,

2022 has been a challenging year for global stock markets, including those in the Asian frontier universe. Though we did expect inflation and interest rates to rise this year, the conflict in Ukraine led to a higher than anticipated increase in global inflation and central bank hawkishness.

However, as we enter the new year, we are cautiously optimistic for the 2023 outlook for Asian frontier markets as we believe global central banks, and more importantly the U.S. Fed, are through with the aggressive part of their interest rate tightening cycle.

Asian frontier markets are therefore well positioned for a re-rating since valuations for our fund are back to where they were at the start of the pandemic in March 2020. Moreover, we believe the triggers for a re-rating in valuations are in place as investors globally begin to factor in fewer macro headwinds in the form of lower inflation and a peak in interest rates.

2022 was all about higher inflation and higher interest rates, and we believe 2023 could be the opposite, which can provide a tailwind for upward re-ratings in Asian frontier valuations.

 
2022 Review – a Challenging Year for Global Stock Markets

This year was tougher than we anticipated. After a great run for the fund and for Asian frontier markets in 2021, we expected it to be a challenging 2022 (as we discussed in our 2022 outlook) with inflation and interest rates picking up as a headwind for global markets.

However, with a combination of higher than expected global inflation due to the war in Ukraine and the U.S. Fed being behind the curve in its interest rate cycle, the resulting impact on global and Asian frontier stock markets was more negative than we anticipated at the start of the year.

In this volatile year, there were still positive contributors to fund performance on a country level, with Georgia, Jordan, and the fund’s Asian frontier focussed beverage holding in Turkey adding to performance, while the major negative contributors were Mongolia, Bangladesh, Sri Lanka, and Pakistan. However, we must add that both Mongolia and Sri Lanka had very strong performances in 2021 and they were among the world’s top performing markets last year.

Though it has not been the best of years, fund performance was more negatively impacted in the first seven months of the year as the fund lost -19.4% till July 2022. Since then, Asian frontier markets have been less volatile with fund performance between July 2022 and December 2022 being approximately -4.4%. Hence, we see green shoots appearing in fund performance and also across our markets over the last three to four months as countries in our universe have adjusted to the changing global macro environment.

For example, with our holdings in Georgia and Kazakhstan there was a lot of concern when the war in Ukraine broke out since both Georgia and Kazakhstan have close links to Russia. These stocks reached a bottom in March 2022 but since then have had an overall positive impact on fund performance. In Georgia, TBC Bank has gained 2.4x since its low in March 2022, while Kaspi and Halyk Bank have gained 101% and 64% respectively since their lows in March 2022.

These stock price appreciations have made these three companies a part of the fund’s Top 10 holdings with Kaspi being the fund’s largest stock position.

In Vietnam, our stock selection has helped with relative performance as well. The fund’s holdings in Vietnam have returned -3% so far in 2022 compared with the VN-Index decline of -32% in USD terms. This is a significant deviation from the VN-Index as the fund does not hold any real estate companies and none of the banks that are exposed to the real estate sector’s corporate bonds.

The point we are making here is that we have stuck to our benchmark-agnostic approach and focussed on stock selection with a very heavy focus on sticking and holding onto our quality names. This is a key reason why the fund has been able to outperform its benchmark, the MSCI Frontier Markets Asia Index, by a large margin in 2022. As of writing, the fund’s return of approximately -23% in 2022 is well ahead of the benchmark which has returned -40.7% this year.

From a portfolio turnover perspective, we did not make any significant changes to the fund’s holdings since we prefer to hold onto quality names for the long run. Our portfolio turnover has historically been low, and we continued with our philosophy in 2022.

Our strategy is very simple: to buy quality names for the long term and not trade in and out of names every month or every quarter. The portfolio fundamentals below reflect this fact.

From existing positions, we added mainly to TBC Bank in Georgia and Halyk Bank and Kaspi in Kazakhstan. Our key purchases and sales in 2022 are discussed below:

Key Purchases in 2022

Jordan

The fund initiated its first country exposure to Jordan in March 2022. The fund purchased Arab Potash (APOT) and Jordan Phosphate Mines (JOPH), as both these companies benefitted from the conflict in Ukraine as Belarusian and Russian potash and phosphate supplies were cut off from international markets by sanctions. The lack of supply and the resulting higher prices were very positive for both companies, especially in the first half of 2022. APOT and JOPH have returned 22% and 56% respectively since the initial purchase.

Vietnam 

We initiated a position in Vietcombank (VCB), the bank with the biggest market capitalisation in Vietnam. Despite trading at a premium valuation to other Vietnamese banks, we made this purchase as VCB has a strong history of managing its non-performing loans and overall risk profile and this has made it stand out in the current environment in Vietnam where there is a lot of uncertainty over the exposure of various banks to corporate bonds and to real estate developers.

VCB has very little exposure to corporate bonds and real estate developers. Furthermore, the bank has a lot of room to improve its net interest margins since it has among the lowest cost of funds in the industry, but the bank has not yet fully leveraged this to its advantage. VCB’s stock price has significantly outperformed the VN-Index as well as other banking tickers since the fund made this purchase.

 
Key Sales for the Fund in 2022

Mongolia

To reduce the fund’s country exposure after the strong performance of the Mongolian stock market in 2021,  the fund exited Talkh Chikher, the largest bakery and confectionary company in Mongolia, and Bayangol Hotel, which owns and operates a hotel in the centre of Ulaanbaatar and Hermes Centre which rents out shops for construction and home improvement in the outskirts of Ulaanbaatar.

Sri Lanka

We reduced our exposure to Sri Lanka in January due to the rising macro uncertainty. We exited Dialog Axiata and Hemas Holdings as both companies would be negatively impacted from a weakening Sri Lankan Rupee (LKR). Furthermore, we made these exits well before the steep devaluation of the LKR as we wanted to reduce potential currency losses on our portfolio. When we made these sales, the LKR was trading at 202 to the USD but by the end of May 2022 the LKR was trading at 360 to the USD. We were also able to repatriate the proceeds of these sales at LKR 202 versus the USD.

 
2023 Outlook – Cautiously Optimistic on Asian Frontier Markets

The key question on investors’ minds will be on the outlook for interest rates. It is quite possible that we could see interest rate hikes in the first half 2023 in the U.S. and other frontier and emerging markets, but we believe the aggressive tightening we saw from the U.S. Fed and other global central banks in 2022 has come to an end.

Inflation, though still high, appears to be peaking out especially in the U.S. Also, various supply related as well as commodity related indicators suggest weakening inflation in 2023 and with global economic growth expected to slow down in 2023, any future interest rate hikes by central banks would not be as aggressive as seen in 2022.

A peak in interest rates globally as well as in Asian frontier markets can be a trigger for positive investor sentiment. We have already seen this in the last month as global stock markets have rallied on the back of expectations that we are near the peak of interest rates.

In this environment of expectations of interest rates and inflation peaking out, we believe Asian frontier markets are well positioned for a re-rating and a more benign 2023 as valuations in our universe are at significant discount to history.

Though we may be close to the peak of interest rates, the negative impact of these higher interest rates will most likely be slower economic growth and therefore slower earnings growth. However, though earnings growth may see less momentum in 2023, we believe investors will view the peaking of interest rates and inflation as positive since both have been the major headwind to stock market performance this year.

We remain cognizant of the prospects for slower global economic growth in 2023, however, 2022 was the year when the most discussed points among investors were about higher inflation and higher interest rates. 2023 could be the opposite, with discussions on slowing inflation and peaking interest rates which should be positive for stock markets.

We therefore believe that 2023 should be a better year for Asian frontier markets with a less aggressive interest rate environment and we are cautiously optimistic. Our portfolio holdings with their solid business models are well positioned to ride any potential tailwinds from a less intense macro environment.

As usual we discuss some of the longer-term trends which we believe will be positive for Asian frontier markets:

1.    China Re-opening
2.    Supply Chain Diversification – watch Central Asia
3.    GDP Growth in Asian Frontier Countries still Stands Out

China Re-opening

We think this is a more medium to longer term trend as China has now begun removing many Covid-19 restrictions, but we are still a few quarters away from a full re-opening which allows free international travel into and out of China. Once this unrestricted free movement of people takes place in China, we believe it will be significantly positive for many of our tourism related countries, especially Cambodia and Vietnam, as Chinese tourists accounted for the majority of pre-pandemic arrivals in both these countries.

Furthermore, the potential return of Chinese tourists will provide a big boost to these economies and in the case of Sri Lanka also help with shoring up foreign exchange reserves. The fund already holds tourism-related plays in Maldives, Sri Lanka and Vietnam which can benefit from higher international tourist arrivals including from China.

Supply Chain Diversification – watch Central Asia

Despite the conflict in Ukraine and the global macro uncertainty this year, the supply chain shift into Asian frontier countries has maintained strong momentum. Bangladesh has witnessed strong export growth of 26% in 2022 even though there have been concerns of slower economic growth in its key export markets of U.S and the E.U.  Export momentum has been strong as Bangladesh has seen a steady and consistent shifting of orders for its garment exports from China.

Foreign direct investments (FDI) into Vietnam remain robust, with most of this FDI being invested in the manufacturing sector which is focussed on producing goods for the export market. Furthermore, multinationals like Apple and Samsung have also planned to produce more higher end products in Vietnam like the Apple Watch and semiconductor parts for Samsung, which shows not only how important Vietnam is becoming in the global manufacturing industry but also that is moving up the value chain.

Another area which is seeing and will see a supply chain shift is Central Asia. After the conflict in Ukraine and the economic sanctions on Russia, Central Asia has become the go-to transit route for goods moving from east to west and vice-versa. Georgia, Kazakhstan, and Uzbekistan (all of which are part of our universe) have gained from this supply chain shift as many goods now move via these three countries.

Furthermore, besides a supply chain shift, there is also a human resource shift taking place with many well-educated and experienced professionals from Belarus, Ukraine and Russia moving long term to Georgia, Kazakhstan, and Uzbekistan. Hence this inflow of human resource talent can be a longer term positive for these countries.

GDP Growth in Asian Frontier Countries still Stands Out

Even though multilateral agencies downgraded GDP growth for most countries in 2023, the Asian frontier universe still maintains steady economic momentum not only in 2023 but also in the longer term.

Bangladesh and Vietnam are expected to post GDP growth rates of 6% in 2023, which is commendable in this global macro environment, while on average over the next five years, GDP growth in the Asian frontier universe will be among the highest globally. 

Asian frontier countries are growing from a low base and there is still lot of room for consumption-backed growth led by favourable demographics. Huge investments still need to be made in infrastructure which will also be a tailwind for economic growth. Lastly but more importantly despite the talk of “de-globalisation”, many Asian frontier countries should continue to see their exports grow as they have built a strong eco-system in key product categories (i.e. garments for Bangladesh and electronics for Vietnam).

Top Country Picks are Kazakhstan, Uzbekistan, and Vietnam and we added Georgia to the List

On a relative basis, with a much stronger macro profile which is important in the current environment, we like Kazakhstan, Uzbekistan, and Vietnam over a 3–5-year horizon. These countries have a low debt to GDP ratio and more importantly low external debt.

We also favour Georgia, as it has been the key beneficiary from the conflict in Ukraine, which has resulted in significantly higher tourism revenues and remittances, leading to a strong build up in its foreign exchange reserves. Going forward, Georgia should continue to benefit from the supply chain and human resource shift taking place post the Russia-Ukraine conflict.

Besides these top country picks we believe bottom up stock selection will continue to be important across our universe since valuations for many stable and well established companies remain heavily discounted due to country specific macro headwinds as in the case of Bangladesh, Pakistan, and Sri Lanka.