Emerging Europe, emerging prospects

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05/11/2015
The continuing failure of established European economies to recover from the financial crisis may mean investors overlook the opportunities offered by their emerging neighbours.

Definitions of ‘Emerging Europe’ differ – some refer to Eastern Europe only, others include central Europe, others Russia, others Turkey, some even Austria.

While the geography of the informal region may vary, what is certain is the developing portions of Europe represent a growing proportion of the world’s stock market capitalisation and are expected to grow faster than their developed counterparts for the foreseeable future.

While problems in the eurozone may dominate mainstream coverage of the continent, investors may wish to look past the headlines and consider investing in Emerging Europe.

Rewards

Emerging Europe has enjoyed significant growth in recent years. In common with other key emerging markets, economies in the region have valuable resources, low debt to GDP ratios and expanding middle classes.

Comparisons of Eastern and Western European economic growth produce stark results. In GDP terms, last year Western Europe’s largest economies (with the exception of the UK) all lagged significantly. France grew by 0.4 per cent, Germany by 1.6 per cent, Italy by -0.4 per cent, Netherlands by 0.9 per cent and Spain by 1.4 per cent.

By contrast, Hungary grew by 3.6 per cent, Latvia 2.4 per cent, Lithuania 2.9 per cent, Poland 3.4 per cent, Romania 2.8 per cent and Slovakia grew 2.4 per cent and that’s merely EU member states in the region. Others, like Moldova and Turkey, grew by 4.6 and 2.9 per cent respectively.

As a result, the MSCI Eastern Europe index has begun to outperform the MSCI World index. For Russ Mould, investment director at AJ Bell, this could represent a return to the “glory days” of 2001-07, when the region offered investors double-digit capital gains for seven consecutive years.

Marcus Svedberg, chief economist at East Capital, notes investor disregard for the region means relative bargains abound.

“Poland and Central Europe enjoy economic and political stability, but this isn’t always reflected in financial markets,” he says.

EU member states in emerging Europe currently enjoy average growth rates of 3-4 per cent annually, with inflation hovering around zero. Svedberg believes these countries are likely to grow around current levels for the next five years at least, with inflation likewise remaining under control.

“The frontier markets in the region are a very diverse group of economies that remain largely unexplored by mainstream investors and there’s plenty to get excited about there.”

Partially driving emerging Europe growth is the recovery of Germany and Russia, the two primary trading partners of the region.

“Russia’s RTS – the biggest and most influential stock market in the region – has bounced sharply, and Germany seems to be on the mend in a big way too. Improved economic momentum in those countries, even if tentative, will have positive implications for the region as a whole,” notes Mould.

Finally, since the financial crisis, emerging European states have moved to liberalise their economies, relaxing foreign ownership limitations and privatising or publicly listing state-owned businesses. Simultaneously, lessons have been learned from Western Europe, and strict rules on lending and capital requirements have been imposed on constituent banks.

Risks

Emerging Europe has not been completely immune to the ongoing monetary and economic issues within the eurozone. Estonia, Latvia, Lithuania, Slovakia and Slovenia all use the euro and the currencies of Bulgaria, Croatia and Poland are all pegged to the euro. Many countries in the region, the Czech Republic, Hungary and Poland in particular, depend heavily on exports to Western Europe.

As a result, the current risks associated with investing in Western Europe apply to emerging Europe via osmosis. A further decline in the eurozone’s fortunes could hamper the emerging region’s growth prospects. Furthermore, the continuing problems in the eurozone has meant less money flowing into emerging Europe from the West.

“Before the financial crisis, there were concerns among European investors that banking and economic problems in emerging Europe could spread westward, now the tables have turned,” Mould says.

The region’s close economic association with Russia means its fortunes could fall if Russian growth falters again. There are indications that tough times may lie ahead for Russia, with increased oil output from Saudi Arabia and the prospect of Iranian supplies resuming in the near future potentially putting the country’s economy at risk. Such uncertainty could serve as a disincentive for more cautious investors.

However Svedberg notes that the biggest risks in emerging Europe tend to be country-specific.

“This means investors should take an in-depth rather than general approach to investments in the region,” he says.

“For instance, Turkey faces political uncertainty following June’s general election, there are rising levels of inflation and the country has a growing current account deficit. The country will likely suffer when the US raises interest rates due to its dependency on foreign direct investment, and the lira will come under significant pressure. But, this may not have significant implications for the wider region.”

Recommendations

Investing in emerging Europe is not necessarily an easy task for those based in the UK. Information on emerging Europe economies and the companies operating within them is not as readily available as data on Western shares and may require specialist local knowledge and understanding to track effectively.

Some may wish to eschew individual stocks in favour of low-cost trackers, such as country-specific exchange traded funds (ETFs) to access economies such as Poland, Russia and Turkey.

There are also region-wide ETFs, such as the db-x MSCI EM Eastern European Index and SPDR MSCI EM Europe, which have annual ongoing charges of 0.65 per cent and 0.55 per cent. Both trackers have a significant Russian weighting. For investors who wish to avoid investing there, the Amundi ETF MSCI Eastern Europe tracker excludes Russia.

Mould believes actively managed funds offer value to investors keen to access emerging Europe.

He recommends BlackRock Emerging Europe, an investment trust primarily comprised of Russian (55 per cent) Turkish (22 per cent) and Polish (10 per cent) stocks.

“The shares trade at a 12 per cent discount to the stated net asset value of the fund’s holdings, offering some degree of downside protection as well as gearing into any upside – the discount could close if sentiment toward the region improves,” Mould notes.

Mould also tips the Neptune Russia and Greater Russia fund, which offers a 4.8 per cent yield.

“This fund is a well-established and strongly performing collective, although it has been far from immune to the region’s political and geopolitical woes.”

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