Almost exactly one year ago, I wrote an article that struck an optimistic tone about Central European stocks. At that time I thought that we had, for the most part, gotten past the painful economic adjustments that had lasted for so many years, and that an economic revival could be in the cards. Instead stock prices have continued to stay down, their valuations kept low as a result of depressed corporate profits, while elsewhere in the world asset values have been rising because of money printing.
One year later, we can say that this initial though was right; throughout the region most of the countries have seen economic growth. Moreover, as the diagram below shows, the economies of Central Europe, to the delight of their citizenry, saw higher economic growth in 2014 than either the United States or Western Europe.
Real GDP Growth in 2014
Despite all this, the region’s stock prices have not reflected the good results of the past year. In the diagram below, we can see that the CETOP index (in black), which tracks Central European stock performance, has not kept pace with either the S&P 500 (in gray) or the Euro Stoxx 50 (in orange).
If we are looking for explanations for the divergence between the performances of the economy and that of the stock markets, we can point to a few. One of the most important factors has been the price of oil, and its role in the collapse of the Russian Ruble. Although the region’s economies are more dependent on Western Europe, a few of the region’s larger corporations’ (for example, OTP and Richter Gedeon) results have been significantly impacted by the Russian-Ukrainian situation. Another negative factor was the Swiss franc’s drastic strengthening in January this year, which hurt Polish banks because of their significant number of franc-denominated mortgages. The largest bank in the region, Erste Bank of Austria, has also lost value, driven by its foreign-exchange loans liability in Hungary and stricter-than-expected bank oversight in Romania, which forced banks to get their reserves covering bad loans in order.
At the same time, if we look ahead a couple of years, we continue to believe that the conditions for growth are there. Numerous positive factors have occurred over the course of the past year that supports our contention. One of these is foreign exchange. Better growth prospects in the US, expectations of an interest rate hike there and the effects of European money printing have all helped to weaken significantly the euro (vs. the dollar), making European production more competitive, including Eastern European as well (whose countries’ currencies have followed the euro in lockstep lower).
The dollar’s strength and the collapse of the oil price can be viewed as positive developments, for the majority of European countries are energy importers. The money saved at the gas station will, sooner or later, be spent on other goods and services whose purchases have heretofore been delayed (for example, flat renovations, traveling etc.).
Burgeoning money printing has managed to push the cost of financing to new lows. The yield on German 10-year bunds has fallen to 0.3%, but the yields on the periphery countries (Italy and Spain) have also significantly come down, the impact of which has made its way into Eastern European bond markets, as can be seen in the diagram below. The debt burden (consumer, state and corporate alike) will be easier to manage as a consequence, while the willingness to borrow (as lending sources abound) grows. Moreover, following the European bank audit (Asset Quality Review) that occurred last fall, it is probable that the banks’ appetite to lend will be better in the future. Signs of this already can be seen in Western Europe, while here in Hungary, the government, in an effort to stimulate economic growth, has eased the bank tax in exchange for increased bank lending.
Regional 10-year bond yields over the past year
All of these factors are equally positive for Western as well as Eastern Europe. We are of the opinion that this year investors could be in for a pleasant surprise in terms of Western European growth, which is the main market outlet for the Eastern European economies. Since the beginning of the year, market participants have begun pricing in the good news, pushing Eurozone stock markets up 10%, while regional markets still have not decided what to do. It seems the uncertainty surrounding the Russian economy has kept international investors from allocating capital here.
According to data gathered by EPFR, last week was the first time there was a minimal in-migration of capital to Eastern European markets, following twenty-four(!) consecutive weeks of out-migration. Since 2011 (when our region’s stock market performance began to deviate from the US’s rise), an accumulated $10 billion has been pulled out of regional equity funds investing in European emerging markets. In our opinion, this disinterest is no longer justified by the fundamentals. If we are right about the durability of growth, then the trend will reverse itself. I believe our region, with its cyclically-adjusted low valuation, remains an attractive investment opportunity, especially in a world where yields are zero and international markets are expensive in comparison.
Original date of Hungarian publication: February 23rd, 2015 – written by Lombard in Alapblog/hu