Investors get mugged – and retreat from the wild frontier

In a crisis, there is nowhere to hide. Until last year, 'frontier markets' had been all the rage, with investors chasing compelling long-term stories in small, immature emerging markets ranging from the smaller Gulf nations and Kazakhstan to sub-Saharan Africa and Vietnam. These economies and markets, many hoped, could provide shelter from global turbulence. For eight years until last September, the MSCI Frontier Markets index had a low, 32% correlation with America's S&P 500 index, notes Merrill Lynch (a correlation of 100% would imply that the markets move in lockstep).

But when the credit crunch went global after Lehman's collapse, vicious contagion propelled the correlation to 90%. The same happened for the MSCI developed markets and emerging markets indices. Investors fled small, risky markets everywhere. "Illiquid and immature" stockmarkets got "mugged by enforced liquidation and panic selling", says Global Thematic Investors.

The MSCI Frontier index returned an annualised 19% between January 2000 and August 2008, but fell by more than 50% between the end of July 2008 and the end of the year. In the first quarter of 2009, it slid 17%, while emerging markets made a marginal gain. Nigerian stocks fell by 37% in the first quarter. Kazakhstan and the United Arab Emirates have fallen by 48% and 42% respectively since the autumn. But it's not just about panic selling. Eastern Europe has been hit by worries over its external debt and the slide in oil prices has battered the Gulf. Interest in Vietnam's compelling demographics and highly profitable small businesses has been eclipsed by the global slowdown, which will lower growth to just 4.2% this year, reckons Standard Chartered.

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In Africa, greater political stability and improved macroeconomic management had been in the spotlight, while buoyant commodity exports and a gradually emerging middle class were also fuelling rapid growth. But as Lex points out in the FT, the credit crunch "arrived at Africa's door" not just through a slump in demand hitting raw materials exports, but also because scarce credit has stifled capital inflows and trade finance. Meanwhile, Nigeria has highlighted a recurring problem in frontier markets (and one which is also crippling today's developed markets): poor disclosure. Regulators have allowed banks to delay taking losses on loans to speculators who placed bets on the stockmarket. Investors "will be hesitant to come back" if they can't tell which banks are healthy, says Christopher Hartland-Peel of Exotix.

So what next? The long-term story hasn't changed, but "secular bulls will have to be patient", says Merrill Lynch. An end to the frontier bear market requires higher oil prices "preferably above $60" and a sustained recovery in global risk appetite. Given the shaky macroeconomic backdrop and the fact that markets everywhere look vulnerable to renewed falls as the financial crisis continues, investors are unlikely to venture back into tiny, risky markets anytime soon.

For those who can stomach a rocky ride, one Vietnam play may be worth tucking away now. The Aim-listed Vietnam Opportunity Fund (LSE:VOF, $1.12) looks well placed to profit when markets start to turn around, as Manraaj Singh at Profit Hunter points out. It has no debt and plenty of cash, and trades on a 42% discount to its net asset value.