“CEE: the worst quarter since 2008”.
Really...?

Date: 6.10.2011

During the third quarter of 2011, Eastern European stocks fell to levels not experienced since 2008 and lost almost 30% of their value (29.6% MSCI Emerging Europe in USD terms, 24.05% in EUR terms) and underperformed in Developed Markets (US -14.3%, Europe -22.6%) as well as in Global Emerging Markets (-22.6%). The worst performing market was Hungary which fell by almost 45%. Poland lost 33%, Russia 31%, the Czech Republic 22% and Turkey “only” 15.6% (all based on MSCI indices in USD). Equity markets were affected globally by renewed worries about economic growth. Macro figures released by the US in August signalled the risk of recession in the World’s largest economy and Europe was “hammered” by the deepening debt crisis. But is Eastern Europe really the “ worst place on Earth”?

Certainly, Hungary is a special case. The government there provided us with another example of the “non-standard approach” in solving local problems and approved a new law allowing borrowers to repay early FX mortgages at below-market rates (EUR/HUF 250, CHF/HUF 180) which will significantly destroy banks' profitability and capital ratios. This is another in a series of controversial measures by Orban’s government which undermined investors' confidence and, despite attractive valuation, effectively sidelined Hungarian equities.


Strong macro data, still weak performance

But other markets in the region do not have such specific issues. Instead, the current decline looks more like the result of panic. In September, Russia lost almost 22% owing to “a deteriorating global growth outlook, posing a threat to oil demand (and, consequently, lower oil prices)” (Source: Citi – GEM Strategy); but, surprisingly, Brent Crude Oil declined by only 8.8%. Additionally, reported macro figures exceeded expectations as industrial production accelerated to 6.2%, Retail sales rose by 7.8% and inflation fell to a nine-month low. Russia is usually perceived as an “oil economy” as the energy sector generates 75% of Russian exports and commodities count for 53% of budget revenues. However, their contribution to the GDP accounts for only 23% and is continuously declining.

Poland had the second biggest decline (-33%) and underperformed in the region despite a strong set of Macro data. Retail sales, industrial output and average wages were all up from the previous month. But lower August PMI manufacturing readings, a weaker PLN and higher bond yields, suggested a slowdown of the economy during the fourth quarter of 2011. On the other hand, banking shares, which are the main tools for betting on the economy, outperformed broad indices. Negative sentiment also mounted, as shown by the latest polls, along with an unexpected increase in support for the opposition party PiS just days before the elections.

The Czech Republic outperformed other markets because of the defensive character of listed companies, supported by very high dividend yields. But even the defensive Czech market lost more than a fifth of its value over the summer while, at the same time, the rating agency Standard & Poors upgraded the country’s rating by 2 notches to AA-.

Similarly, a credit rating upgrade to investment grade was behind the positive performance of the Turkish market in September; banks performed particularly well. Also, the macro figures released in September were encouraging. GDP grew by 8.8% in the second quarter, industrial output was unexpectedly strong, unemployment declined and those figures totally overshadowed a still very high Current Account deficit and an increasing political risk related to activities of Erdogan’s government in the Middle East and the Mediterranean. These strong September figures then helped Turkey into a leading position in Emerging Europe in terms of performance.


Markets are currently driven more by feelings and sentiments than by hard facts

What is clear from the above is that markets are often driven more by subjective feelings than objective facts. Almost all countries reported strong macro figures, local demand is still growing (Russia, Turkey, Poland), countries' debts are well below the EU average (except Hungary) but, despite all this, the region is still under-performing compared with developed Europe. The price of Crude declined by only 8.8% and yet Russian equities lost a third of their value. Emerging Europe traded at 7.4 times next year's earnings, with ROE at 16.1% and with dividend yield 3.3% but underperformed Global Emerging Markets, with forward P/E at 9.2, ROE just above 15% and dividend yield at 3%. Average Earnings of Emerging Europe companies are currently at the “before Lehman-crisis” levels but index levels are still approximately 30% lower.

So is Emerging Europe really the “worst place on Earth” as it looks from a performance perspective? Probably not. As volatility probably remains high, investors will look for “safe havens”, but this region is a great combination of growth stories (Turkey, Russia), stability (Czech Republic, Poland) and very attractive valuation. Perhaps we just need time.

Author:
Petr Zajic
Senior Portfolio Manager
Pioneer Investments Austria