Can emerging Europe close the performance gap?
Emerging European stocks are cheap. So why have they lagged the rally in global equities?
Across the world, we wait in hope and anticipation for a vaccine for Covid-19. Financial markets reflect optimism that one will soon be found, and that the economic recovery will sustain.
Investors in emerging Europe will be particularly keen for some form of normalisation to come through. Emerging European equities are down almost -30% in US dollar terms so far this year, as measured by the MSCI Emerging Markets Europe Index on 29 September.
While developed markets, and the North Asian emerging markets of China, Taiwan and South Korea have rebounded and more than recouped their Covid-19-related losses, emerging European markets overall have continued to flounder.
There is a confluence of factors behind this performance.
Why have emerging European stocks lagged the rally?
Various letters have been used to illustrate an array of potential paths for the recovery of the global economy. We think a K-shaped best describes what has happened from a stock market perspective.
Technology companies, particularly e-commerce companies, have rallied strongly while banks and old economy sectors have remained under pressure. And this point is equally characteristic of both emerging and developed markets.
In emerging Europe, banks and old economy stocks, such as energy and materials, account for approximately 70% of the index. These sectors tend to move closely with the ups and downs of the economy, whilst the energy sector also faces environmental, social and governance (ESG) challenges over the long term as the world attempts to de-carbonise. The precipitous drop in economic activity over the second quarter collapsed energy demand and prices, as well as leading to concerns around bad debts for banks.
Relative to emerging North Asian markets, there are fewer investment opportunities in technology companies. And long-term thematic growth stories, which are independent of general economic growth, such as electric vehicle batteries, are not present by any comparable degree in emerging Europe.
The low interest rate environment has seen investors favour growth stocks, companies with an outlook for high earnings growth, which have far smaller representation in emerging Europe. Meanwhile, the value stocks, companies which trade at a discount to their investment fundamentals, that dominate the regional index have performed relatively poorly.
What might be the catalyst for the performance gap to close?
We would expect the prospect of a sustained global economic recovery and an exit from the pandemic to drive a recovery in emerging European stocks, both in absolute terms and relative to other markets.
It seems logical that this hinges on a vaccine being found, although better therapies, or perhaps herd immunity, might also provide the necessary tonic.
Governments across the region are deploying a combination of fiscal and monetary stimulus. This should continue to provide support through 2021. Meanwhile, the EU recovery fund is due to begin distributions in the second half of next year. We think much of this benefit is yet to be reflected in stock markets.
The agreement of the recovery fund is potentially the first step towards further debt-mutualisation in the EU, and it significantly reduces the near term macroeconomic risks surrounding many emerging market EU member countries. As a result, these countries have seen their borrowing costs fall.
The combination of stimulus measures, and return to more normal routines should deliver a recovery in economic activity and lift demand. A reflation of economies is typically supportive of old economy stocks, the dominant sectors in emerging Europe.
What are the risks?
Should the economic revival stall, and recovery be delayed, there is a risk that old economy value stocks continue to underperform the broader market. This is essentially a continuation of some of the challenges we have seen so far this year. Potential scenarios include a resurgence in the virus, new waves of outbreaks and fresh lockdowns.
Specific macroeconomic challenges could deteriorate, notably in Turkey. Unorthodox policy measures continue to favour consumption, high inflation and currency weakness without addressing long term challenges with productivity and therefore current account deficits.
Geopolitics is an important consideration for investors in emerging markets in general. In emerging Europe, the key issue to monitor will be the US presidential election in November, and the implications for US-Russia relations. A Biden victory could see the US adopt a tougher stance than that taken by President Trump over the past four years.
Regional politics, such as the protests in Belarus following presidential elections, are further risks to consider. There have been tensions between Turkey and Greece recently, in relation to drilling rights in the Aegean Sea. Although we do not invest in Armenia or Azerbaijan, tensions in the Caucasus also bear monitoring given regional geopolitical and energy supply implications.
Valuations are compelling
When we look at stock market valuations globally, using a range of measures, there are few markets, emerging or developed, which are as cheap as emerging Europe.
On a price-to-book basis, for example, emerging European stocks trade on below 1x, as measured by the MSCI Emerging Markets Europe Index. The price-to-book ratio reflects the market value of a company relative to its accounting book value. This is relative to 1.8x for the MSCI Emerging Markets Index and 2.7x for the MSCI World Index.
Meanwhile, the gap in return-on-equity (ROE), a measure of profitability, is relatively narrow. ROE for the MSCI Emerging Markets Europe is 9.1%, relative to 9.7% for broader emerging markets and 11.0% for the MSCI World.
It could be argued that this difference relates to the fact that accounting regulations prohibit technology companies from recognising the value of internally generated assets such as intellectual property, for example. With these intangible assets not accounted for in book value, this results in a higher price-to-book ratio.
But other measures are equally as compelling. The 12-month forward price-to-earnings ratio of the MSCI Emerging Markets Europe Index is 8.9x, relative to 15.1x for wider emerging markets and 20.7x for the MSCI World. This measure looks at the price of the stock relative to forecast earnings per share. Of course, there is much uncertainty associated with forecasting earnings in this environment, but the same is true for other comparator indices.
Dividend yield is another valuation measure which is favourable. Emerging European stocks offer a yield of 4.7%, superior to the 1.9% from the MSCI World Index and 2.3% from the MSCI Emerging Markets Index. This is the dividend paid per share as a percentage of the share price.
Could a powerful rally be on the cards?
The next few months, as we head into winter in the Northern hemisphere, may be an important barometer of what is to come. Will we face further, potentially more serious, waves of the virus? Will ongoing vaccine trials be a success? Or will the current new normal persist through 2021?
Returning to the subject of a vaccine. Russia’s state-run Gamaleya Institute recently announced the development of a vaccine which it claims induces a safe immune response in healthy adults. Phase 3 trials are yet to be finalised but it has nonetheless been approved for civilian use. China and the US also expect to have vaccine programmes in place prior to the end of the year.
The timing of the global economic recovery is still very hazy. But if fiscal spending continues, and a return to something close to what we previously knew as normality comes to fruition, we think there could be a powerful rally in emerging European stocks.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.