South Africa is the region's sole member of the Large EM club – countries with over a 3% weight in the MSCI EM index. All the other Africa markets, ex-Egypt (a minuscule 0.06% weight in EM), are in the FM index or standalone.
Lingering disruption from Covid, imported fuel and food inflation, US dollar strength, reduced appetite from international investors for high yield, hard currency sovereign bonds, commodity demand weakness from China, slowing inward investment from China and economic weakness in the EU (the main export, tourism and remittance market for much of North and East Africa) made for a very difficult 2022 across Africa.
This year, most of these factors may improve, or, at least, not get any worse. That may be enough to prompt a revisit of Africa markets which, to differing degrees and on different measures, are cheap relative to history.
However, there is likely sufficient valuation upside, without the same risk, in the sovereign hard currency bonds of some of these countries and, with much stronger fundamentals, in other regions for global Small EM and FM equity portfolios.
Nevertheless, clearly, in geopolitical terms, Africa remains strategic for China, the EU and the US, given recently announced investment ambitions.
For more, see US charms Africa amid a scramble with China and the EU (December 2022).
South Africa is our least preferred amongst the group, mainly due to its reform impasse (ruling party split) and civil unrest risk (extreme youth unemployment).
In Africa Small EM and FM, our top-pick is Mauritius, which is cheap versus historic average and highly exposed to the global tourism recovery.
Egypt is among our less preferred markets; while its currency has appropriately devalued there is still little guarantee that necessary structural reforms to improve business conditions for the private sector are on way.
Nigeria remains untouchable for fresh foreign capital, given repatriation hurdles, and the election this year may not act as a catalyst for a policy pivot on the multi-rate currency regime).
Africa Large EM means South Africa
The captive domestic investor base, manageable external debt (short-term external debt is c10% of GDP), and net commodity exports (almost 7% of GDP) are the strengths in South Africa’s investment case.
However, political paralysis persists, driven by divisions within the ruling ANC party, and this is throttling much-needed structural reform on issues such as state-owned enterprises, particularly Eskom, where power outages are debilitating manufacturing output, fiscal deficit control (c5% of GDP) and land ownership, and is enabling a deterioration in governance and law and order, which is causing lasting social and economic damage.
South Africa equities are cheap versus the historical average but perhaps not at an attractive discount – either in absolute terms or compared with the discount on offer in its closest peer, Brazil – given the political risk from the 2024 general election and potential formal split of the ruling party, and social risk amid one of the worst levels of income inequality (the top 10% have 67% of national income) and youth unemployment (50%) globally.
For more, see South Africa: The ANC's split is core to corruption, reform and unrest risk (Dec 2022).
Africa Small EM and FM
Mauritius is a small market, even by Africa Small EM and FM standards, with under US$1mn of average daily value traded. However, it is a concentrated play on the revival of tourism (over 7% direct contribution to GDP) and the adoption of remote working by white collar professionals. And it is one of the cheapest markets relative to the historical average in the region, with one of the lowest external account risk profiles.
While 2023 IMF forecasts for fiscal and current account deficits are 6% and 8%, respectively, the very large offshore company sector, relative to the rest of the economy – a legacy of the old India double tax avoidance agreement – results in foreign reserves that cover almost a year of imports.
Kenya is one of the cheapest markets relative to its historical average in Africa Small EM and FM and new President Ruto, elected in August 2022, appeared the marginally more prudent fiscal candidate likely to operate within the conditions of the IMF programme.
However, the change in leadership may reset some of the unwritten rules of the game for local corporates given the tribal allegiances which dominate politics. Ruto is from the Kalenjin tribe and follows two decades of rule by former presidents Kibaki and Kenyatta, both from the Kikuyu tribe.
For more, see Kenya: Election implications, with Curran (August 2022) and Kenya: Supreme Court ruling reduces political risk, Curran (September 2022).
Morocco, often regarded by Africa ex-SA equity funds as the region's relative safe haven in difficult times because of its manufacturing and commodity exports and low domestic political risk, belied this reputation in 2022 and ended up one of the worst performers in the region.
The positive case for 2023 is built on macroeconomic stabilisation in the EU (the largest market for remittances, exports and tourism), a recovery of tourism (directly 8% of GDP) and market share gain off Russia in EU purchases of phosphate.
For more, see Morocco votes but the impotence of moderate Islamists may embolden the radicals (September 2021) and Morocco and Algeria friction (August 2021).
Egypt is back in an IMF programme and is devaluing its currency in line with a likely condition of that programme. Whether Egypt is willing to engage in the structural reforms – eg levelling the competitive playing field for the private sector versus military-affiliated enterprises, and switching the focus of government spend from mega projects to, for example, education – necessary to avoid a repeat of its crisis-denial-bailout cycle of the past decade or so is a different matter.
Furthermore, the policy rate hikes, depreciation and fiscal cuts underway are likely to undermine the near-term growth outlook for corporates; forward-year aggregate consensus earnings growth is still c10%.
For more, see Egypt priced for distress: Too harsh but don't expect the army to drive reform (July 2022) and Egypt: Currency devalued again to absorb external shocks, Curran (January 2023).
Nigeria was one of the region's best performers in 2022 but for the wrong reasons – because equities are viewed by local investors as a hedge to very high inflation, particularly when asset allocation by local institutional investors into local currency government securities is limited by regulation or by unattractive yields, with local currency government bond yields (12.6%) currently well below inflation (21.5%) – similar in some respects to Argentina, Iran, Turkey and Zimbabwe.
Nigeria might be regarded as an intriguing bet this year, in advance of a general election in February, where a reformist candidate, Peter Obi, who advocates exchange rate harmonisation and central bank independence, is leading opinion polls.
After two terms of sclerosis on fuel subsidy removal, oil output, tax collection, privatisation and even security improvement (less Boko Haram disruption but more herder-farmer conflict) under President Buhari, there is surely much low-hanging reform fruit.
However, three factors should restrain enthusiasm for an investment-case renaissance in Nigeria:
Obi's support (23%) was outweighed by the size of the undecided (29%) voter base in the latest NIO opinion poll in December 2022;
The Labour Party – Obi defected from the main opposition party, PDP, to Labour in May 2022 – has virtually no representation in the current parliament, state governors or state-level legislatures;
Because of the role Nigerian equities has played as an inflation hedge for local investors, valuation of the local index, on both PB and PE, is close to par with the historical averages.
For more, see Nigeria: Hawkish shift continues with another surprise rate hike, Curran (November 2022).
Ranking equity markets
Our EM Country Index ranks the investment case of 50 emerging and frontier markets and the US, as a developed comparable.
We weight c30 factors on growth, policy credibility, politics, sanctions, ESG, equity valuation and liquidity. The weights are adjustable; eg equity market liquidity (where the US and China outsize all others) can be cut to a zero weight.
Broader EM equity strategy thesis for 2023
Uneven and stuttering growth
Uneven and stuttering economic global growth suggests that no single investment theme will consistently outperform.
A single country, sector, region, or theme is unlikely to lead global equities against a backdrop of uncertainty over a number of factors such as the:
Duration of high inflation;
Depth of the recession in developed markets;
Normalisation of supply chains after the unprecedented Covid disruption;
Flare-up of domestic political and international, geopolitical flashpoints; and
Persistence of the US dollar's safe haven status.
Therefore, our overall approach to emerging markets equities is to favour active strategy over passive index-tracking, and to look for relatively cheap exposure to a number of themes:
Sovereign balance sheet resilience, rare structural reform;
Manufacturing growth winners in the marginal shift away from China;
Commodity exporters who stand to benefit from prices buttressed by capex restraint and the shift to renewable energy;
Tourism plays heading towards full post-Covid recovery; and
Technology companies with strong balance sheets and proven competitive advantage, which are best able to weather the downturn in demand growth.
Large EM versus Small EM and FM
Beyond the largest seven countries, which make up over 80% of the MSCI EM equity index, there is a very long tail in emerging markets. 17 countries make up the rump of the MSCI EM index, a further 21 'frontiers' make up the MSCI FM index and 13 countries are not classified in either index.
Small emerging and frontier equity markets ('Small EM and FM') are numerous, individually complex, fundamentally very diverse, illiquidly traded, dominated by local investors and very poorly captured, as a distinct asset class, in the most commonly used benchmark indices.
This description is not likely to change anytime soon and should make for very diverse performance within the group: bad for passive index trackers, or those with the ambition to take their fund's assets under management to great heights, but great for activist investors – at least those with funds large enough to matter (and survive the occasional redemption) and small enough to remain nimble.