BlackRock's Sam Vecht says the investment case for Eastern European equities is compelling
What a rollercoaster! After the turmoil of 2008, Eastern Europe markets recovered sharply last year with the MSCI 10-40 Emerging Markets Europe Index showing record returns, up 130.9% over the year. This was after the market bottomed out in March 2009, when as fears of a global recession began to recede. Even then, as global markets recovered and foreign investors returned to emerging markets, inflows into the region lagged behind Asia and Latin America.
This was in part driven by fears the economic instability seen in the Baltic States would spread across Central Europe. The weakness in the Polish zloty and Hungarian forint, where FX lending had been relatively high, added to investors concerns.
Resilience
As the year went on, however, it became clear this negative sentiment had got ahead of fundamentals and the Central European economies proved resilient, notably Poland, which did not even enter recession. Russia responded to pressure from capital flight and significant forced deleveraging by keeping its monetary policy effectively tight. This has led to Russia being in a stronger position as we move through 2010, with less inflationary pressure and more policy flexibility than many other countries. The Hungarian Government’s fiscal discipline in the wake of the credit crisis has given the economy a solid base from which to grow. The cuts in expenditure trimmed the budget deficit and restored investor confidence. As a result, Hungary is forecast to have one of the strongest structural fiscal balances globally in 2010. Unlike many of the newer members of the EU, the macroeconomic background is supportive of an earlier-than-expected entry to the eurozone, which would be extremely beneficial to local equities.
Eastern European markets were affected by the global economic crisis later than Western Europe and their falls were just as steep and in some cases even greater than their global peers. However, emerging Europe is now well placed to benefit from economic recovery. Shares are still attractively valued, trading at significant discounts to their global peers. Furthermore, sentiment towards the Central European markets seems to be improving with the increasing recognition of their positive economic growth prospects and this return to the region should aid price recovery.
Russia
In terms of the region, we have a highly positive view on Russia. It is our preferred economy in global emerging markets and comprises approximately 60% of total assets in the Eastern European Trust. After a very turbulent 2008, Russian shares rebounded sharply in 2009.
Supported by firmer commodity prices and an increasingly optimistic growth outlook for 2010, the dollar-denominated RTS Index in Moscow gained 77% in the period 1 May 2009 to 31 January 2010. Despite this rally, Russian equities traded at a significant discount to other large emerging markets. Russia’s economy continues to improve and the Central Bank has room to cut rates further, while inflation is falling and is expected to reach a record low this year.
Looking at the financial sector, Sberbank, Russia’s largest bank with a 50% retail market share, is highly leveraged to the recovery of the Russian economy. Shares have rallied significantly from the very depressed levels seen in 2008 and early 2009. The company undertook aggressive cost-cutting measures, enabling it to improve margins and increase efficiency.
Non-performing loans appear to have peaked and expectations are Sberbank will be able to reduce provisioning levels during 2010, providing a significant boost to earnings. Cheap deposits and lower competition allow the company to earn high margins.
Turkey
In contrast to Russia, we are apprehensive about the outlook for Turkish equities. While there is much to like on a medium-term view, we believe the market has not priced in a number of concerns. The recent political turmoil has served to reinforce our concerns surrounding the equity market and we are cautious about the Turkish financials sector, which is often the focus of foreign investors. Optically, the environment looked positive. The Turkish Central Bank initiated an aggressive easing cycle in 2009, bringing interest rates to a record low of 6.5% in December, while inflation fell sharply. We are concerned about the extent to which local banks have been buying short-dated local government bonds. The banks assume the interest-rate-easing cycle will continue; should rates rise from their current record low levels, large-scale selling of the bonds could emerge with significant consequences both for the banks and the broader Turkish economy. The most recent inflation figures are not comforting as the pace of economic growth and the recovery in commodity prices have helped to push inflation to 8.2%, well above the headline interest rate.
Equity outlook
With regard to the other regional equity markets, the Czech Republic looks quite compelling, but in Poland we are wary of the large number of Polish companies coming to market in 2010. While positive in the longer term as it will broaden the investment universe, such a large IPO pipeline is likely to take liquidity out of the market over the near term.
The investment case for Eastern European equities is extremely compelling. Despite the recent rallies, regional equities remain very attractively valued relative to both other emerging markets and the rest of the world. The potential for re-rating is high as investors begin to appreciate the positive macroeconomic backdrop and a steady supply of earnings upgrades.
Sam Vecht is portfolio manager of the BlackRock Eastern European Trust
