July 2008

EASTERN EUROPE: From Dawn to Dusk

Following a period of double-digit growth and fantastic returns, Central and Eastern Europe has finally succumbed to the global credit crunch. Is it still a worthy investment arena, asks Fiona Rintoul ... dawn_dusk.jpgThe charmed life of the Central and Eastern European (CEE) stock markets, with double-digit growth and to-die-for returns, came to a juddering halt at the beginning of this year when prices started a downward slide. As values collapsed so too, it seemed, did the comforting notion that the CEE markets were somehow immune to the global credit crunch.

“These markets are still dependent on growth in the developed markets,” comments Charles-Henri Kerkhove, an investment specialist in emerging Europe and Turkey equities at Fortis Investments. “Poland depends on the situation in Germany. You can't really say that there’s decoupling.”

The CEE markets somehow refuse to go gentle into that good night, however. The correction might have had the look of the inevitable end to an unsustainable run, but pundits continue to talk the CEE markets up. A claw-back has begun in many markets – Romania and Bulgaria registered gains of 11.9% and 10% respectively in May – while Russia, which has always behaved differently from the other CEE markets, posted a gain of 15.9%.

Supporters of the region believe the fundamentals remain strong, with domestic consumption shaping up to play a key role in future growth. “In most countries in the Eastern European region, robust domestic demand is now taking over from exports as the motor behind economic growth,” says Raiffeisen Capital Management in its June 2008 CEE Report. “Additional support is also coming from inflows of direct investment and prospects of increases in transfer payments from the EU budget in the years ahead.”

On a global basis, Russia’s strong performance has helped to make the CEE region look good against the other emerging markets. “Emerging Europe has fared well compared to other emerging markets,” says Kerkhove. “This is largely due to Russia which has held up well and is the biggest chunk in the benchmark. If you compare Russia to other emerging markets, such as India, India doesn’t have the commodities story.”  

Down but not out
As a strong commodities play, Russia is obviously its own story. Nonetheless, the fact that East Capital, the Stockholm-based CEE specialist investment house, was able to announce on 20 May that its first fund, the East Capital Russian Fund, had returned +2.067% since inception ten years previously, suggests that even if Eastern Europe is currently down, it most certainly isn’t out.

East Capital is famous for not being in the office. In the firm’s most recent monthly newsletter, CEO Peter Elam Håkansson proudly announces that he is writing the text “on board flight KC 981 (Air Astana) from Astana to Atyrau”, and he elsewhere attributes the success of the East Capital Russian Fund to the kind of the stock-picking this kind of diligence allows. “Successful fund management in Russia means active stock-picking and a long-term perspective,” he says. “An integral part of how we invest is visiting companies throughout the country.”

This is a philosophy that East Capital applies to all its funds. The Eastern European Fund, for example, is spread across 20 markets, and a wide range of sectors and companies. “We’re not just focused on oil and gas in Russia and financials in Turkey, although we like those,” says Marcus Svedberg, chief economist at East Capital. “That way we reduce our country-specific risk, our sector-specific risk and our company-specific risk.”

This stock-picking approach, applied in bad as well good times, is one that some feel could perhaps be more widely applied by foreign investors in the CEE markets where the ‘herd mentality’ has sometimes caused damage. Investors piling in when a market is flavour of the month, then piling back out again when it isn’t, can, of course, exaggerate corrections, and while one might expect that from inexperienced retail investors, it is perhaps disappointing when foreign professional investors do it too.

“Sometimes when you see foreign players coming to the market because the allocation to Poland is now 3.5% rather than 2.5%, you wonder who is sophisticated,” says Grzegorz Swietlik, a director at Fortis Investments in Poland. “If growth prospects are better in India, Brazil or China, foreign investors are staying away and not coming back. But we need an input to lift the market.”

There are a number of question marks over the CEE markets, however, chief among them rising inflation and high current account deficits. Hungary, Poland, Turkey and the Czech Republic had current account deficits of -3.4%, -5.6%, -3.7% and -7.5%, respectively, of their GDP in 2007. Russia is the exception here with a current account surplus that, commentators say, is being used wisely, but it has not escaped inflation woes; even though Russian inflation has been brought under control since the crazy days of 1998 when it topped 84%, the inflation rate is still high at 10%.

Risk aversion
For some, this all adds up to just too much risk. “We see large imbalances building up in many countries,” says Tom Beevers, head of pan-European equities at Newton Investment Management. “The current account deficit in many countries is unsustainably high. In Bulgaria it’s 21%, in Romania 15%, and its high in the Baltics too. At some point that's going to lead to an event such as a currency devaluation.”

Possible currency devaluations coupled with the high levels of FX lending in some CEE countries are, in Beevers’ view, “a recipe for disaster”. In countries such as Poland and the Czech Republic, which Beevers sees as “healthier than most”, there are other obstacles. Poland “looks expensive, while the Czech Republic is a small market”.

Thus, although the pan-European and continental European funds Beevers manages have the capacity to invest in the CEE countries, he prefers to take exposure to the region by investing in Western European companies that do substantial business there, such as Unicredito. The exception, once again, in Russia, where the Newton funds invest in the resources sector.

Unsurprisingly perhaps, East Capital takes a more benign view of economic developments in the region. Svedberg sees the recent correction as “important” because it’s the first time the region has gone through a more difficult period both in the real economy and in the markets for the best part of a decade. But he has no doubt that the region will pick up again.

“Growth is slowing down from high levels,” he says. “2006 and 2007 were two of the highest growth years since the start of transition. Inflation is picking up in the region, as it is throughout the world, because of rising food and energy prices. Inflation has been coming down for 10 years.”

Inflationary pressures driven by energy and food are worrying, Svedberg concedes, particularly as the impact of food price hikes is more keenly felt in the CEE countries where the food weighting in the consumer price index is 25% plus, compared with 10-15% in the West, but for East Capital the strength of the domestic consumption story is strong enough to carry the markets through.

“Consumption is an investment play we're seeing throughout the region,” says Svedberg. “It’s not such a big surprise. During the growth period, there was a lot of pent-up demand for consumption. Now wages are increasing, credit is available and small businesses can get loans.”

The consumption trend is one that doesn't just play out in the equity markets. Jonathan Gain, whose firm Stellar Asset Management recently launched the Stellar Baltic States Fund investing in property in the Baltic countries, cites retail growth as a key reason why his firm favours the Baltic region and is looking into other CEE markets, including Romania, Albania, Macedonia, the Ukraine and Poland.

“Significant income growth to come leads to greater disposable income and greater opportunities for retail,” he says. “The Baltic countries will have the strongest growth of retail in all of Europe in the next four to five years.”

On the bond side, meanwhile, the fall-out from the credit crunch is creating new opportunities, as financing gets more difficult to find both for governments and for corporates. “Hungary made a e1.5bn issue recently,” says David Dowsett, senior portfolio manager for emerging market debt at BlueBay Asset Management, “and the credit crunch has created some interesting opportunities on the corporate space in the region.”

The corporate opportunities are “more nuanced by country”, and a key issue is how central banks deal with inflation. “We’ve been impressed  by how central banks have dealt with it, even in Hungary which has been everyone's whipping boy,” says Dowsett.

A question of timing
In many ways, belief in the EE markets, or the lack of it, is a question of timing. Everyone agrees that Slovakia getting the green light for admission to the Eurozone from 1 January 2009 was a necessary positive signal for the convergence story. For those that are broadly bearish on the region, such as Beevers, it’s a positive signal whose benefits will start to be felt maybe ten years from now.

“If you take a long-term view, it’s pretty positive,” he says, “but many of these economies need to go through quite a bit of pain before they get there.”

For Svedberg, by contrast, the positive benefits are there for the taking now – and stack up well against what’s to be had in the supposedly less risk-developed markets.

“Everyone is concerned about slowing US consumption,” he says. “These markets are not very dependent on the US. Two-thirds of their exports are to the internal market – almost exactly the same as for the old EU members. For Russia, China is a more important market than the US because of commodities.”

But whatever their view on the region, most investors can agree on one thing: it’s a stock-picker's market. “If you are going to invest, stock-picking is essential,” says Beevers. ©  2008 funds europe

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