When the European Bank for Reconstruction and Development was set up 20 years ago, central and eastern Europe had little in the way of capital markets. Such a thing was a contradiction in terms for Communist economies.
Since then, most of the 30 countries served by the bank have succeeded in building debt and equity markets that have survived the world’s worst financial crisis since the 1930s depression.
It is a measure of the region’s progress over the last two decades that the damage from the global crisis has not been worse, says Ousmène Mandeng, head of public-sector investment advisory at Ashmore Investment Management. “It is surprising how well they have managed.”
Poland, for example, has fared so well that its sovereign debt trades at only tiny spreads over German bunds, reflecting the low risk attached to holding the instruments.
But these fledgling markets, stretching from central Europe to the Asiatic steppes, have suffered worse in the aftermath of the 2008 crisis than developing regions elsewhere. They have also taken longer to recover, according to Erik Berglöf, chief economist for the EBRD. “Now for the first time, we are seeing recovery in almost all the countries of emerging Europe,” he says.
Strong economic performance in recent months has narrowed the gap between emerging Europe and other newer markets. “Some of the most exciting performance in emerging markets has been in Latin America and Asia,” says Liesbeth Rubinstein, fund manager of the £50 million Invesco Perpetual Emerging European equity fund. But that has begun to change, she says, with emerging Europe outperforming rival markets in recent months.
The eastern Europe MSCI composite rose by 18% in dollar terms in the first four months of the year, putting it top of the class in terms of emerging market performance. In contrast, emerging Asia is up just 5.5%, while Latin America remains flat. Suffering from turbulence in Egypt, the Emerging Europe, Middle East and Africa composite index has risen by only 9% – half that of the eastern European one.
CHEAP MULTIPLES
“Eastern Europe was the ugly duckling, and performance lagged. It is starting to play catch-up,” says Rubinstein. Yet despite stronger recent performance, the region remains cheap. Price to earnings multiples for emerging Europe are just over nine, according to JP Morgan, compared to 13 for stocks in developed markets.
Even compared to other emerging markets, eastern European stocks trade on cheaper multiples. The average PE ratio for emerging markets is 11, a full two percentage points higher than in eastern Europe.
Eastern Europe offers investors advantages over other emerging markets. It boasts a highly skilled work force. According to World Bank research, Russia dwarves other members of the Bric (Brazil, Russia, India and China) quartet in its human resources.
Russia scores higher than the other markets in all three leading measures of human resource capital, according to the World Bank. It scores highest on innovation (measured by the number of patents filed by members of the population), education (numbers enrolled in tertiary education) and also in penetration of internet, computer and telephone lines.
Investors such as Rubinstein and Jerome Booth, head of research at Ashmore Investment Management, argue that stories about Russia in the mass media have distorted the country’s image for investors. “It’s still a system we are unfamiliar with and don’t tend to like as liberal western investors,” says Booth. “But it’s important to distinguish between the mass of news coming out of Russia and the particular subset you’re investing in.”
“This is the cheapest region in emerging markets,” says Rubinstein. “The region has been misunderstood and deserves investors’ attention. Russia’s strengths and unique advantages in terms of energy dominance are not being truly reflected by financial markets.”
Expecting Russian capital markets to follow the model of their western European equivalents would be unrealistic. Considering that the country progressed from serfdom to Communism at the beginning of the 20th century, with virtually no break in between, it was unlikely to adopt western-style governance, Booth says. “Other countries in central Europe had experience of western-type institutions; Russia never really had that.”
Russian sovereign debt represents an attractive investment opportunity, says Booth. The country has half a trillion US dollars in reserves, which makes it a net global creditor. “They have a very clear incentive to pay on their debt, because they need the money to sell their oil and gas,” he says. “They need foreign investors to help them get it out of the ground.”
While Russian capital markets may not always conform to what western investors are accustomed to expect in terms of corporate governance, they are underpinned by competent central authorities. “We have got to the point where Russia has become much more stable,” says Booth. “Russia is almost safer than France. In terms of risk return, it is safer than France.”
Poorer performance relative to other emerging markets is not necessarily a disadvantage. “With the Russian equity market trading at around six times earnings, it’s amazingly cheap,” says Booth. “The fact it hasn’t performed as well as other emerging markets is not necessarily bad news. If you believe in high oil prices, Russia will do well.”
Income-hungry investors may find emerging Europe more attractive than other parts of the developing world, and certainly more so than developed markets. The region’s equities have an average dividend yield of 3.2%, according to JP Morgan data, higher than the 2.9% emerging market average and the 2.6% available in developed markets.
MIDDLE-CLASS BOUNCE
Invesco Perpetual believes the region’s emerging middle class make consumer and mid-cap stocks attractive investments. “As elsewhere in emerging markets, domestic demand is a strong driver of growth for this region,” says Rubinstein. “We continue to see some very encouraging economic data releases, for example retail sales in Poland for February rose by 13% year-on-year.”
During the second half of 2010, external and domestic economic conditions improved faster than expected. Commodity prices increased and, with the exception of Hungary, unemployment levelled off.
“The effects of the benign external environment on the recovery were particularly marked in central Europe and the Baltics and central Asia,” according to the EBRD. The IMF expects the central and eastern European economies to grow at 4.5% this year and next, and the EBRD has said its own projections are the same.
Central Asia emerged from the crisis as one of the fastest growing regions within the EBRD’s remit. Even in 2009, when the average emerging economy slumped by more than 5%, central Asian economies grew by an average 3%. According to EBRD estimates, the region’s economies grew by 7.2% last year. The bank forecasts 6.7% growth across central Asia this year.
The Kazakh mining operator Kazakhmys, registered on the London Stock Exchange, has been so successful it forms part of the FTSE 100 benchmark. Kazakh stocks trade at a discount not just to developed markets, but also their Russian equivalents, says Rubinstein, who says she is actively looking at opportunities in Kazakhstan.
Despite positive recent performance, doubts remain over investment potential in the region. In its latest economic report, the EBRD warns that downside risks have increased. According to the EBRD’s Berglöf, the crisis “illustrated vulnerabilities” in the bank’s countries. Integrated supply chains made it difficult for central European firms to separate themselves from troubles in western neighbours. Liquidity dried up among local banks.
The recovery remains patchy. The bank expects last year’s estimated 1.3% growth in Hungary to accelerate only marginally this year, although that would still represent a substantial improvement on the 6.7% economic collapse of 2009. Recovery in south-east Europe continues to lag behind other transition economies, according to the bank.
The return of foreign capital to the region, following catastrophic outflows in 2009, has also been mixed in terms of flow composition and destination. Inflows have been dominated by volatile short-term fund flows at the expense of long-term direct investment.
Unicredit notes that of the E72.3 billion in inflows to the region last year, portfolio flows accounted for E48.6 billion. In contrast, foreign direct investment, having peaked at E76.3 billion in 2007, last year reached E16.5 billion.
SHORT SHARP SHOCKS
The most obvious threat is further trouble in the peripheral eurozone markets. “The domestic demand and degree of catch-up is enough to insulate them somewhat against vagaries in global growth,” says Rubinstein. “But if there is a big shock, they are not immune.
“Peripheral problems impact in terms of sentiment. When investors hear stories about Greek debt, or even US debt, they get nervous. It’s a psychological, knee-jerk reaction. But the markets have matured so much that the reaction to external events tends to be much more short-lived and can present buying opportunities.”
Ashmore’s Mandeng agrees: “The region has become less dependent on western Europe,” he says. “But if there is another shock, it will be the region that suffers the most.”
Hungary is holding the six-month rotating European Union presidency, a position that suggests the country is embedded within Europe. But in December credit rating agency Moody’s cut its assessment on its sovereign debt to just above junk category, warning that moves to cut the budget deficit were unsustainable.
Around 70% of Hungary’s loan stock is denominated in foreign currencies, mainly in Swiss francs. When the Swiss currency rose 10%, it caused problems for Hungarian borrowers. Growing unemployment and rising numbers of evictions have led to public anger, causing the Hungarian government to reject harsh economic reforms suggested by the IMF. In April, Moody’s downgraded its ratings for seven Hungarian banks, underlining the fragility of the Hungarian economy.
Other risks include the potential for currency wars to transmute into trade wars in the form of import restrictions. “Rising food prices and extreme weather-related food security concerns can also lead to trade restrictions in the absence of global policy coordination,” says the EBRD.
Last year the region suffered a major drought that damaged agricultural output, especially in Russia. Moves to cut back on private pension funds and the introduction of significant bank taxes “could worsen investor sentiment and create potential for a quick reversal of recent net capital inflows”, warned the EBRD.
Central and eastern Europe may have come a long way, but their troubles look to be far from over.