It has been a tough year for global emerging markets (EM) given a combination of strong US performance, and weak China performance.
Dispersion of returns within the EM universe has been wide, and there have been winners and losers. Emerging Europe is one region that has delivered standout returns so far this year. The MSCI EM Europe Index has advanced by more than 26% year-to-date, as of 22 November 2023. Election results that are supportive of the longer-term outlook are one factor. This performance also follows a difficult 2022, with the region hit by the energy price shock and the impact of Russia’s invasion of Ukraine, which also led to the removal of Russia from the investment universe.
From an investor’s perspective, EM Europe includes Czech Republic, Greece, Hungary, Poland, and Turkey, although there are also investable frontier markets in the region. EM Europe may be smaller in market capitalisation terms relative to the rest of the global EM universe, but it encompasses some attractive long-term structural opportunities.
The positive economic growth picture in EM Europe
The 2024 outlook for economic growth for most emerging European markets is positive, with an expansion of 2% or more for all the regional economies, based on International Monetary Fund (IMF) forecast data as of October. Turkey is something of an exception, but for the other economies the outlook is underpinned by falling inflation, allowing for more interest rate cuts, which should support consumption. European Union (EU) cohesion funds, and the post-pandemic Recovery and Resilience Facility (RRF) are additional supports, although there are some risks in Hungary and to some extent Poland. Improvement in the global outlook would also be supportive of the export economy.
The central banks in the CE3 economies of Czech Republic, Hungary and Poland have raised interest rates significantly since monetary policy tightening began in 2021, to counter rising inflation. This was complicated by the energy price shock that followed Russia’s invasion of Ukraine. As a result, the degree of policy tightening was quite significant, notably in Hungary where rates were raised by more than 12 percentage points.
As with elsewhere, inflationary pressure has been falling this year, and this is illustrated for the CE3 in chart below. A significant fall in the price of natural gas has been a notable support.
There is work to do, however, in order to return inflation closer to target, and policy rates may remain higher for longer in the region, even if central banks in Hungary and Poland have started to ease. Indeed, real policy rates in Poland and Hungary remain in negative territory.
In Greece, headline inflation, despite a recent pickup, has fallen to a comparatively lower level and was 3.4% year-on-year (y/y) in October. As a eurozone member, monetary policy for Greece is set by the European Central Bank (ECB). After hiking its policy rates to 4.0% and 4.5% in September, Schroders’ economics team expects the ECB to remain on hold until next year when rate cuts are anticipated.
The status of natural gas storage in the EU has been monitored closely since Russia invaded Ukraine, after which energy supplies to Western Europe began to be cut off. The restructuring of energy markets from a regional perspective has so far achieved its aim. Warm northern hemisphere autumn temperatures have also helped. Data from the Schroders Investors Insights Unit shows that the temperature in the EU 27 for September, October and to the 19 November has been above the average of the last decade. Successful gas procurement combined with higher temperatures means that eurozone gas storage sits at a record level versus the average of the last 10 years with storage at 99.5% of capacity.
The exception: Turkey
Turkey remains something of an exception to the rule. We wrote a more detailed note on Turkey earlier this year, making the comparison to the positive outlook in Greece.
The headline rate of inflation in Turkey remains unanchored and has accelerated to 61% y/y with pass-through from Turkish lira weakness. The central bank, following the appointment of a new governor, has hiked its policy rate by more than 25 percentage points to 35%, but the real rate remains deeply negative. Ahead of municipal elections in 2024, there is significant incentive to support the economy, and therefore the risk of another policy U-turn remains high.
Attractive long-term growth drivers
In the long term, EU recovery and cohesion funding should be supportive for member economies. Politics complicates this driver for Hungary, and until recently Poland, but the latest elections could change this.
Various regional markets are also projected to be among the key beneficiaries of de-globalisation and the nearshoring trend. This should help to attract foreign direct investment (FDI), with some of this related to the energy transition.
Our research shows that Poland is among the most attractive economies globally for multi-national companies looking to diversify their manufacturing exposure. The election results reinforce this outlook, given that relations with the EU are expected to normalise (more on this below). The announcement from semiconductor manufacturer Intel of plans to build a new assembly and test facility in Poland highlights this potential. Electric vehicle battery manufacturing is another sector attracting FDI in Poland. South Korea’s LG Energy Solution operates one of Europe’s largest giga-factories in Poland, and other multi-national companies such as Mercedes-Benz have plants under construction.
Other regional markets also rank highly as beneficiaries of deglobalisation – some which are not in the MSCI Europe Index, but which are investible. The ranking is shown in the table below.
Balance sheet positions improving
Fiscal accounts across the region are in deficit but, with the exception of Hungary, are at reasonable levels. EU projections suggest improvements into 2024, even if Poland may see some deterioration this year due to higher spending ahead of the election. The incoming government is likely to honour the pre-election pledges from the previous government. Even so, debt-to-GDP remains reasonable relative to other major economies at below 50%.
In Hungary, the fiscal deficit is expected to fall to 4% for this year, down from 6.2% in 2022, according to EU forecasts. Debt-to-GDP was 74% at the end of 2022. Gross debt to GDP is also elevated at more than 70% of GDP, far higher than its CE3 neighbours.
From an external account perspective, current accounts moved into deficit or widened following last year’s energy price shock. Most current account deficits are now improving on lower energy prices and, in some economies, as activity decelerates.
As noted, Turkey is an exception. The economy has recorded an annual current account deficit since 2003 and funding the deficit is increasingly complex and now expensive due to higher global interest rates.
The elections that boosted the equity markets
Falling inflation, and receding energy price risks, have supported various regional markets this year. For Greece, and more recently Poland, politics has provided another boost.
In Greece, the centre-right New Democracy party was re-elected with a majority in the second round in June. The result provides greater confidence in the outlook for reforms over the next four years. This includes measures targeted at reducing bureaucracy, lifting investment and judicial reform.
In Poland, the Law, and Justice Party (PiS), which led the governing coalition, won the most seats in October’s election, but fell short of securing a majority. The opposition coalition is expected to form the next government. This may take time as PiS has been given the first opportunity to form a government by President Duda; current projections are for a new opposition-led government to be in place by the end of the year.
This outcome was market positive as under PiS relations with the EU had deteriorated. Rule of law was a key issue and had led to the withholding of RRF funds. The anticipated normalisation of EU relations under a prospective new government should unlock this funding in time. Less risk of intervention in markets and better management of state-owned enterprises were also perceived by markets. These two factors should also improve the attractiveness of the economy to FDI.
What are the risks to the outlook?
One clear risk to these economies is the potential for another energy price shock, and a more severe slowdown in the eurozone. This risk has to some extent eased, with global energy prices having moderated, and EU gas storage in good shape. However, the scenario of high energy prices remains a threat to the outlook, given the potential impact on growth and inflation. Renewed escalation in Russia’s conflict with Ukraine could also drive risk premiums higher again.
While Poland’s relations with the EU are expected to improve, in Hungary these risks remain. Poor relations with the EU have been a long-term feature under the leadership of Prime Minister Orban. It appears that some cohesion funding of around €13 billion may be released in relation to judicial reform. Recovery and Resilience Funding (RRF) remains held up. If external funding requirements increase in 2024, further agreement may be found in order to release at least some of these funds. Higher fiscal deficits are a further risk for Hungary in particular, as is the potential for new sector taxes.
In Turkey, the key risk is that policy becomes more unconventional once again.
What do valuations look like?
Valuations on a combined z-score basis, which is relative to their own historical average, are cheap across the region. Hungary stands out relative to the rest of the region, as well as broader emerging markets, although macroeconomic risks are also higher.
From a currency perspective, the Czech koruna is expensive on a real exchange rate basis versus the long-term average. Other CE3 markets are more reasonably valued. Turkey appears to be cheap versus history, but this cheapness is more than justified given where inflation sits, the negative real policy rate, wide current account deficit and ongoing uncertainty over the policy outlook.
Our view on the emerging European markets
We do not favour Turkey or the Czech Republic. In Turkey, this is due to ongoing doubts about the long-term commitment to orthodox policy. There is also the ongoing currency risk. In the Czech Republic, the macroeconomic outlook is improving, with support from EU recovery funding, and valuations are reasonable. However, bottom-up opportunities are limited.
We hold a positive view on Greece, Poland, and Hungary, with aggregate valuations attractive across all three markets. In Greece, the strong long-term outlook remains in place, aided by ongoing support from EU recovery funding, together with reform momentum. This outlook is reinforced by elections earlier this year when New Democracy was re-elected with a majority.
In Poland, the medium-term growth outlook is positive, supported by improved EU fund flow and nearshoring. Expected political change after the October election also underpins the longer-term picture. Inflation should continue to moderate, in time opening the door for further monetary policy easing. Despite the post-election equity market rally, valuations remain attractive.
In Hungary, political risk remains a concern, while economic growth has been weak. However, inflation is now falling from an elevated level, and the central bank has begun to loosen monetary policy.
The views and opinions contained herein are those of the individuals to whom they are attributed and may not necessarily represent views expressed or reflected in other Schroders communications, strategies, or funds.
Any reference to regions/ countries/ sectors/ stocks/ securities is for illustrative purposes only and not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy.