Strategy Note /

Iceland: Fully valued, slowing growth, FM anomaly

    Hasnain Malik
    Hasnain Malik

    Strategy & Head of Equity Research

    Rahul Shah
    Stuart Culverhouse
    Tellimer Research
    31 July 2019
    Published byTellimer Research

    Index providers FTSE and MSCI are on track to include Iceland into their Frontier Market (FM) equity indices even though it is far wealthier and more liquidly traded than most new markets in FM. Iceland is a fish out of water in FM and its inclusion reinforces how unfit for purpose those indices are. 

    But Iceland could offer FM equity portfolios very defensive sovereign risk and exposure to a high quality global industrial in the largest stock, Marel, a food processing equipment supplier with most of its revenue base in developed markets but with a mix shift underway towards emerging ones.

    However, this is likely not the right timing for Iceland. Its economy is slowing after a decade of successful post-crisis repair. After nearly 20% total returns year to date for the local index and over 50% in Marel, equity valuations do not appear compelling. And from a relative perspective within FM, anaemic growth in Europe and a benign US rate outlook should tilt portfolios towards higher growth markets (our favourites are in Asia). 

    This report looks at macroeconomic risk, equity market valuation, FM index inclusion and profiles Marel and Arion Bank.

    FM index inclusion although Iceland is not really a frontier

    Iceland is on the radar of frontier equity investors because equity index providers, FTSE and MSCI, are on their way to including it in their FM indices. For example, it could have weights of 3.5% and 9.0% in MSCI FM and FM100, respectively. by May 2020.

    Iceland does not resemble frontier peers at all

    Its population is much smaller (350k), 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) than is typical in new (or established) frontier markets.

    Its larger stocks are much more transparently communicative and liquidly traded than most of the larger stocks in frontier. The top two stocks each have average daily traded value of cUS$5m per day.

    Iceland is not a high growth economy

    Iceland repaired itself following the banking crisis of a decade ago. Growth rebounded, government and private sector debt was reduced, and fiscal and current accounts swung from twin deficits to surpluses. After downgrades to sub investment grade (BB+) in 2010, the sovereign rating recovered to A in seven years (as per Fitch).

    Recovery was helped by a combination of banking resolution (imposing losses on creditors but protecting depositors), capital controls, currency devaluation and external assistance (including an IMF programme).

    But growth is now decelerating (indeed, the central bank expects a contraction in 2019). The drivers are weaker demand from EU and UK customers, airline capacity disruption in tourism, a poor seasonal capelin catch in fishing and lower aluminium prices.

    The central bank cut its policy rate at its last meeting in June by 25bp to 3.75%. This followed a 50bp cut in May.

    Iceland is not a cheap equity market

    The two potential constituents of MSCI FM are Marel in food processing equipment and Arion Bank; trailing PE is close to historic average for both.  The OMX Iceland All-Share is on a trailing PB of 1.5x for merely 6% ROE and on 2019f PE of 20x for merely 8% consensus EPS growth in 2020f. 

    Iceland sovereign credit not in the same realm as "frontier" or Greece 

    From a fixed income perspective, Iceland (A3/A/A) has few hard currency bonds. Its sole US$ bond is the 5.875% 05/11/22, which has a spread of just 50bp, compared to 330bp for the EMBIGD. But this comparison is rendered meaningless by the bonds’ short maturity, small size (now only US$92mn outstanding) and the country’s high rating.  Iceland’s 5-year US$ CDS is about 75bp. Iceland also has three EURdenominated international bonds. Its most recent issue was a EUR500mn five-year bond in June, with a coupon of 0.1%, and which trades at negative yields (-0.2%). Greece’s (B1/B+/BB-) 3.45% 2024 EUR GGB yields c1.0%. The yield on ISK government bonds is around 4%