When it comes to investing in emerging markets, Eastern Europe is often overlooked. Marcus Svedberg outlines the opportunities available in this corner of the globe.
Investments in Eastern Europe are sometimes thought of as synonymous with investments in Russian energy.
But the Eastern European equity markets are much wider and deeper than that.
Although Russia is the dominant market in the region — for historical as well as economic and financial reasons — and is likely to keep its absolute leading position, it is less clear whether the relative importance of Russia in general and oil and gas companies in particular will be maintained.
Russia is the most obvious investment opportunity in Eastern Europe in the short term on the back of a very substantial valuation discount to its emerging market peers.
But Eastern Europe is nevertheless widening from an investment perspective — we include no less than 30 countries in our investment universe — and these markets do not necessarily move in tandem since the region is large and diverse in terms of geography, religion, political systems and economic structure.
Rapid recovery
The sharp contraction in 2008 during the global financial crisis (GFC) caused some analysts to dismiss the growth model in Eastern Europe and to claim the region was structurally imbalanced.
Admittedly, Eastern Europe was hit harder than any other emerging region during the crisis, but the recovery has also been faster than expected since the imbalances were more temporary.
I would like to argue that the Eastern European growth model is working and that the region has actually outperformed in terms of growth that really matters for investors.
Let’s consider a few supporting facts. On economic growth, Eastern Europe has clearly been growing slower than China and India but that is not surprising since the latter are low-income countries and the former is a middle-income region.
Eastern Europe is simply growing from a higher base with consumption being a more important growth driver.
Gross domestic growth (GDP) per capita, which is a good proxy for the consumption power, has and will continue to grow faster in Eastern Europe than in all other emerging regions (except for Asia) even though those regions are growing from a much lower base.
GDP per capita in the Eastern European sub regions, CEE and CIS, grew 74 per cent and 109 per cent respectively during the past ten years and is expected to grow another 27 per cent and 34 per cent respectively in the next five years.
The other structural issue of great importance is the level of indebtedness.
One of the reasons Eastern Europe was hit hard during the crisis was because it had a lot of short-term external obligations, primarily through bank lending or current account deficits, which had to be corrected rather quickly.
But the structural debt levels are surprisingly low. Public debt is among the lowest in the world — 8 per cent in Russia and around 40 per cent in Eastern Europe on average — and the private sector is not very indebted either.
Households in particular are not very leveraged since mortgages and consumer credits were held back by high interest rates.
We believe there is plenty of scope for Eastern Europe to grow faster than not only the developed world, but also many of its emerging market peers, given the low level of indebtedness and strong consumption base in the economy.
The consumption theme is certainly important in Russia, where the consumption class (per capita PPP income of $6000) makes up 68 per cent of the population, compared to 31 per cent in Brazil, 13 per cent in China and only 3 per cent in India.
Russian revival
The Russian economy was hit hard by the GFC. The crisis had a negative impact on growth and the economy contracted substantially in 2009.
But the economy has recovered fast and the macro economic situation has stabilised considerably throughout 2010.
The currency and the foreign exchange reserves, which dropped significantly during the crisis, are almost back at pre-crisis levels.
The economy is expected to grow around 5 per cent in 2010 driven by a healthy mix of external (exports) and internal (consumption and investment) demand.
Perhaps more importantly, the recovery is taking place in an environment where inflation and interest rates are at historically low levels.
Even though the cycle has turned (and may be exacerbated by the summer and drought during the summer) inflation and rates are expected to stay deep in single digits.
This will have a profound impact on the domestic credit and debt markets.
During the past few months, the rouble-denominated bond market has developed rapidly, thus reducing the dependence on foreign capital; and the interest rates on consumer credits and mortgages are starting to come down to levels when ordinary people can afford to take them, which will have a positive impact on consumption.
Fascinating fundamentals
The Russian economy remains dependent on natural resources in general and oil and exports in particular, but the direct effect should not be exaggerated because Russia is a large economy that is more dependent on consumption than exports.
But the prices for oil and other commodities also have substantial indirect effects on the economy as it drives the appetite for the currency and, more generally, foreign investment into Russia.
It is also important for the Russian Government in terms of budget revenues.
The current oil price, around US$80 per barrel, is almost ideal as it makes Russia interesting enough for investors but does not automatically lead to hot petro dollars flowing into the country, driving up inflation and the currency in an unsustainable fashion.
The Government should, under normal circumstances, also be able to balance the budget at the current oil price. But the budget expenditures have been increased during the crisis, and Russia will run a deficit this year and in coming years.
The Russian government went to the international debt market in April 2010, for the first times in a decade, in order to raise money to finance the deficit.
The offering was quite successful with a spread on the five and 10-year bonds only around 130 basis points over US Treasuries, and Russian bonds currently trade at a premium to the emerging market bond average.
Realistic risk rewards?
The situation is the opposite in the equity market as the Russian market is trading at an almost historical high discount to its peers.
The Russian market is currently trading at a price-earnings level around eight for 2011, which is roughly half compared to Brazil, China and India.
This valuation discrepancy is particularly noteworthy since the Russian market is expected to have the highest earnings growth of the large emerging markets this year.
The current valuations are not only curious in a comparative perspective but also in a historical context.
The Russian market returned over 750 per cent in the first decade of the millennium but valuations have increased less than 30 per cent, which means that the main driver of the performance has been companies’ earnings.
Earnings per share growth has been over 20 per cent annually in the past decade, and we expect it to stay above 15 per cent in the coming years — and well above 50 per cent for companies with domestic exposure.
We think the current risk/reward ratio on the Russian equity market is flawed and should change considerably in the near future.
Marcus Svedberg is the chief economist at East Capital.
