Emerging Europe: does the rally still have legs?
The ingredients for continued strong performance are all there, but we don’t believe these are fully baked into valuations.
Emerging European stocks have delivered strong returns for investors so far this year. As we noted back in early October, the combination of compelling valuations, and accommodative monetary and fiscal stimulus were just lacking a sustainable catalyst for economic normalisation.
The discovery of vaccines has proven to be the missing ingredient for a rally in emerging European stocks and currencies. And there is good reason to believe that there is room to run for stocks in the region.
Here is why.
What is the state of play with regards to the pandemic?
After a relatively modest start, the vaccine roll-out across emerging Europe, with the exception of Russia, has accelerated.
This is enabling the recovery in economic activity across the region and we expect momentum to build as we move through the year.
The CE3 markets of Poland, Czech Republic and Hungary, together with Greece, should be major beneficiaries of the EU Recovery fund. And tourism in Greece, a major contributor to GDP, is coming back, even if it is still below pre-pandemic levels,.
In Russia, although there appears to be some hesitancy in the vaccine roll out, the economy has remained open throughout the second wave. Meanwhile the pickup in commodity prices has been beneficial. As a result, economic activity has remained on the path to recovery.
How have regional stocks performed since vaccine discoveries were announced?
Emerging European stocks have enjoyed a strong bounce since the announcement of vaccine discoveries last November, as the chart below shows. Hopes for global recovery saw regional stocks outperform wider emerging markets into 2020 year end.
This was before a blip in Q1 as major second waves and a slow start to vaccination programmes overshadowed the near term outlook somewhat. However, confidence has returned and the region has started to outperform wider emerging markets again recently.
Why the market rally could have further to run
In emerging Europe, cyclical stocks, which tend to move closely with the ups and downs of the economy, dominate with a share of around 75% of the MSCI Emerging Markets Europe Index. These are sectors such as financials, energy and materials.
Last year was an environment in which, globally, stocks and sectors with long term growth stories independent of the broader economy benefited, as demand accelerated during the pandemic. Within emerging Europe, this was most evident in the consumer discretionary and communication services sectors with e-commerce companies and gaming companies shining brightly. As well as the demand spike from the pandemic, the lower interest rate environment brought growth stocks into favour with investors.
This dynamic has changed. There is now an expectation that over the next 12 months, the region should have exited the pandemic and economic activity normalised on a sustainable basis. We are already seeing this GDP rebound come through.
While the debate continues over the extent to which global reflation, the recovery in growth and inflation, has taken hold, in emerging Europe we think there is good reason to believe that this is just the beginning.
Inflation across the region has picked up and we expect this to be more sustained. As a result, we expect central banks in a number of emerging European countries to tighten monetary policy over the coming 12 months. This is well ahead of major global central banks.
The Czech Republic and Hungary have lifted their respective benchmark interest rates in the last few months; both central banks indicated a belief that the increase in inflation is not transitory. We think that Poland will follow this path. Russia’s central bank had already commenced a rate hiking cycle, amid concern that long term inflation expectations could become unanchored. It has taken its policy rate up by 125bps so far this year to reach 6.5%.
Of course, the picture is not uniform across the region. Turkey is the notable outlier. Headline inflation sits at 17.5% in June. This is well above the central bank’s medium term 5% target and the policy rate is 19%. President Erdogan’s unexpected removal of the central bank governor in March marked a return to unorthodox policymaking. As a result, market expectations for further tightening have been replaced by anticipation of a reduction in the headline interest rate before year end.
Which areas of the market could benefit and why?
The financials sector is particularly attractive at this point. We think that there are a number of banks which offer potential upside regardless of whether inflation and higher interest rates come to pass.
In many cases these stocks are trading at very depressed earnings and valuation levels. In our view these are firmly in the value style bucket; stocks which trade at a discount to their investment fundamentals.
Banks typically benefit from higher interest rates and stronger economic activity, and demand for loans and mortgages is already showing signs of a pickup. Concerns over bad debts emerging as pandemic-related support programmes expire are a risk. However, non-performing loans, where borrowers have defaulted on payments, have remained at reasonable levels.
This is likely due to the fact that economic activity has been more resilient than expected in the face of activity restrictions, and as banks’ exposure to industries such as hospitality is only a small share of their business.
We also continue to find interesting opportunities within the materials sector. However, the outlook is far more stock specific, and dependent on particular commodity prices. The conundrum for investors in commodities more broadly is where prices will settle sustainably relative to current spot prices.
In some cases we think the recent rally may be peaking. As economies recover, demand for commodities naturally accelerates, providing support to prices. However, supply eventually responds to this demand, and prices ease. The duration and strength of the rebound in demand, and the extent to which supply bottlenecks persist are therefore key factors to monitor.
By contrast, the outlook for some commodities is dominated by longer term factors. The energy transition is an important piece of the puzzle in reducing green house gas emissions. Various industrial metals will see demand accelerate from use in areas such as electric vehicle batteries through to renewables energy technology such as wind turbines. And this follows a period since the global financial crisis in which investment in commodities production has been limited. In certain areas, supply may therefore take longer to respond, which ought to be supportive of prices, with flow through to company earnings.
In the energy space we also see depressed valuations with very high cash flows and dividend yields due to long term concerns over the demand picture. As a result it is an area to tread carefully, and our integrated ESG approach, and the associated tools and specialist resources are crucial.
We agree that the long term picture is weak, but the question is whether the market is too pessimistic relative to price developments in the space before we move to a much lower carbon world. Capital investment in the oil sector is very low and demand could remain more robust in the medium term due to growth in emerging market GDP and population.
We can be fairly sure about where oil and gas demand ends up. However, the return pathway could be more resilient than currently expected due to the rapid decline in capital invested relative to the transitional demand profile. As one of the lowest cost producers we believe that Russia will be one of the last countries to produce oil.
Market dynamics emphasise the outlook
The fundamental outlook for value stocks in emerging Europe is in our view positive. But there are other signs in the market which indicate that we are at an early stage of this thesis.
For example, we continue to see a strong pipeline of growth companies coming to public markets with initial or secondary offerings. These include e-commerce companies from Poland to Turkey. Meanwhile, companies in more value-oriented areas such as commodities have seen offerings cancelled. Two gold mining companies in Russia have postponed their plans to list on public markets this year. In addition, others such as Kaz Minerals have been taken private.
The valuation picture
We believe this is indicative of the market outlook: valuations in growth areas are in many cases at elevated levels while value stocks in the region remain cheap and out of favour. We believe this is another sign that the divergence between growth and value styles within the region is peaking.
So the ingredients for performance are all there, but we continue to believe valuations do not fully bake in this positive outlook. Various valuation metrics for the MSCI Emerging markets Europe Index, such as price-to-earnings and price-to-book ratios, have picked up. This is as we would expect given the economic recovery coming through.
On a relative basis, however, the valuation gap to both broader emerging markets and global equities is at least as wide as it has been for 20 years on these two metrics.
One important caveat to this is that the composition of these indices has changed over this period. There are other factors, structural and political, which have constrained ratings in the region somewhat, and it could be argued that other regions are overvalued. Even so, this gap looks too wide in our view and underlines the point, stocks in the region are far from expensive.
And company profitability within the region has significant scope for improvement. Return on equity for the MSCI EM Europe Index is 10.2%. This is relative to 11.3% for the MSCI World Index and 11.1% for the MSCI World Index. As we discussed, this should improve as earnings for the materials, energy and financials sectors recover.