Central & Eastern Europe: Up against the odds

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    Written by Petr Krpata and Christian Theis 20 November 2013

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Central & Eastern European assets have unexpectedly been star performers in emerging markets this year. We are constructive on their equities, but would be selective on currencies. Domestic factors suggest stable bond markets, external shocks permitting.

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Currencies: time to add alpha

Contrary to expectations at the beginning of the year, the Central European currencies (CE3 – Czech koruna,CZK, Polish zloty, PLN, and Hungarian forint, HUF) emerged as star performers in the EM FX space. As Figure 1 depicts, the currencies outperformed LatAm, EM Asia and the broader CEEMEA space both in year-to-date terms and since the taper-caper sell-off of EM assets in May. The performance of two other regional currencies, the Russian ruble (RUB) and Turkish lira (TRY), was more mixed. RUB was mildly down against USD (but in line with the average performance of EM Asia FX, and better than LatAm), but TRY collapsed due to its weak external position (down around 10% this year).

CE3 currencies benefited from the revival of the euro area economy and stronger EUR

In our view, the strong CE3 performance can be attributed to the following factors. First, there was too much negativity priced into these currencies, particularly in the context of their close trade links to the euro area (as Figure 2 shows, all CE3 countries are significantly levered to the euro area/German growth) and the market’s overly bearish view on the region at that time. It thus came as no surprise that with the euro area recovery and its subsequent positive effect on surrounding EM economies (indeed, CE3 PMIs have been strong in recent months), the sentiment towards this FX segment improved.

The second factor is related to the first: CE3 currencies are usually closely correlated with the performance of EUR (due to those trade links). With EUR being the best performing G10 currency this year (up by 4% against USD), it pulled CE3 currencies higher with it – indeed, this may have explained most of the CE3 gains (Figure 1).

Thirdly, the CE3 countries’ external position has improved markedly (Figure 3), with current account deficits in the Czech Republic and Poland narrowing compared to their previous 5-year average, and Hungary’s turning to surplus. In the context of taper-related concerns about the external financing of EM countries, this mattered.

In this respect, TRY underperformance is not surprising. TRY has one of the biggest external deficits in the EM world, and it has been getting larger. Smaller trade links than the CE3 with the euro area (and Germany) also didn’t help.

Looking ahead, we advocate a selective approach to the region’s currencies. We think that the fortunes of EUR/USD will reverse next year (see October Compass) and CE3 currencies will no longer benefit from the tailwind of a rising EUR. We would therefore avoid establishing long positions against USD beyond the near-term.

We prefer PLN to CZK due to the likely divergences in monetary policies

Within CE3, we have a cautious view on CZK. The economy should benefit from a pickup in global growth (it is a small open economy with trade links with Germany) but we expect the currency to remain broadly flat against EUR (and thus underperform USD) as the Czech National Bank (CNB) continues to lean against currency appreciation: a meaningful rise would likely be met by at least verbal intervention. CZK instead offers attractive funding (official interest rates are at 0.05%) for regional relative value trades.

We prefer the Polish zloty. Like the Czech Republic, Poland should benefit from a pick-up in the global manufacturing cycle and the euro area recovery. However, the Polish central bank is less likely to lean against currency appreciation (against EUR), given improving growth prospects and potential for slowly rising (but still below-target) inflation. Valuation-wise, PLN looks the most attractive currency in the region (Figure 4).

We see very limited upside to Hungarian forint against the euro. The slowly recovering economy and subdued inflation (1.4% vs. 3% target) is likely to keep the central bank’s dovish bias in place, with further rate cuts down the road likely. Moreover, with the bank pumping large amounts of liquidity into the market (to subside SME lending), the implied FX yield on HUF is likely to remain compressed compared to levels suggested by simple differentials in official interest rates. All this makes further upside in HUF unlikely against EUR, with a softening bias in months and quarters to come.

We see the recent rebound in Turkish lira as reflecting a correction from a technically oversold position, rather than any improvement in the fundamental outlook. The stretched external position (current account deficit, high net foreign liabilities) continues to suggest downside risk, particularly when the QE taper debate gains traction next year. Moreover, despite its fall, TRY is still not cheap (Figure 4). We prefer RUB, mainly due to its materially better external position and less activist central bank (which is less likely to lean against currency appreciation) as well as our constructive outlook on oil prices.

Overall, we would rank the five currencies as follows: PLN, RUB, CZK, HUF, TRY.

Bonds: domestic factors offer support for now

European EM bonds, as represented by Barclays indices, have outperformed their regional EM peers, both in local and hard currency terms year-to-date (YTD). Moreover as Figure 5 shows, this outperformance has been particularly pronounced since May (when US Treasuries’ yields started to rise). Bar Turkey, each rate market has outperformed US 10-year Treasury (UST), both in terms of YTD returns and since May. Hungary was a clear outperformer, with local bond markets benefiting from the dovish policies of its central bank (it cut rates by 2.35% this year and introduced further liquidity measures).

EM European equities valuations look attractive

Looking ahead, we expect “QE-for-longer” to be a supportive external factor for local sovereign bond markets. Within the CE3 space, the near-term outlook for Hungarian rates looks particularly benign, mainly in the context of a dovish central bank and potential for further rate cuts. Indeed, subdued inflationary pressures (often below central banks’ targets – Figure 6) should prevent most regional central banks from tightening monetary policy. Moreover, the lower correlation of Hungarian rates with UST (as measured by the 10-year yield) compared to its peers also suggests relatively lower downside risk if and when US yields start rising meaningfully again.

We remain cautious on Turkey and do not advise long positions in local sovereign bonds. Firstly, while nominal yields remain high (2-year at 7.6% and 10-year at 8.5%), high inflation (7.9%) makes local real yields negligible and poses interest rate risk. Secondly, despite stabilisation of both rates and TRY in recent weeks, both local bonds and the currency might sell off again when the QE tapering debate revives (though we do not expect the same magnitude of underperformance seen between May and August).

For Russia, a disappointing economic outlook (our economists have cut their GDP forecast by 0.6% and 0.9% for this year and next) and what seems to be a peak in inflation suggests that the CBR should retain its dovish bias. This, coupled with attractive local rates and a robust external position (a current account surplus and a positive net international investment position) should cause Russian bonds to be one of the better performers. Russia’s healthy external position vis-a-vis Turkey in particular has helped drive Russian bonds’ relative performance there.

Equities: undervalued and to benefit from the global recovery

As with currencies and bonds, Emerging Europe equities have been the best-performing EM region this year, partly as a result of the euro area revival and its spill-over effect to EM Europe, and partly due to too much bad news having been priced in to start with.

With the global economic outlook improving and a euro area recovery underway, we expect those markets with a cyclical sector bias to outperform. As a result, the Polish equity market might benefit most (given its more cyclical nature – Figure 7), while the more “defensive” Czech market might lag. That said, the concentrated nature of all these EM Europe indices is a potential risk, and contrasts markedly with Asia (for example).

Valuation wise, the region looks attractive. As Figure 8 shows, it is not only inexpensive in PE terms, but it is cheaper than both other emerging and developed market equity regions. As noted earlier, we are not yet tactically positive on emerging markets generally, and valuations alone are never a good enough reason for investing: the Russian market is usually inexpensive, for example, but this likely reflects its heavy weighting in the (low PE) energy sector (56%), and its idiosyncratic corporate and political governance.

What to pick in the EM Europe world? 

CE3 currencies have been star performers year-to-date, but most of that is likely over and investors should be more selective. We favour the zloty. For local bonds, as long as external factors remain supportive (QE in place and lower UST volatility), domestic drivers (low inflation and no urgent need to tighten monetary policy) should be supportive of the rate outlook over the short-term. Here, Hungary appears to stand out. That said, we would expect local rates to grind higher over the medium-term in line with rising global (and US) yields, and in keeping with our views in most other regions, we would favour stocks ahead of bonds.

Central European markets offer a way of implementing our constructive view of the global and euro area outlook, albeit it a relatively high risk one (particularly given the high weighting of Russia in regional benchmarks, a market we are less positive on). We are tactically neutral on emerging stocks as an asset class, but this could be a good time to start building long-term positions, most suitably for most clients via actively-managed emerging market funds.