Eastern European markets brace for convergence play

LONDON – Impending European Union membership is allowing stock markets in Central and Eastern Europe to shake off some of the pressures hitting bourses elsewhere and tempting fund managers with an EU convergence play. European strategists say that while most of the gains from investing in enlargement countries’ government debt have already been made, «equity convergence» may be just about to start. The prospect has prompted many to take a closer look at stocks in countries such as Hungary, Poland and the Czech Republic within their emerging market holdings. «You see more and more Western European portfolio managers looking at the region,» said Dimitris Chatzoudis, manager for Eastern European equities at ABN AMRO Asset Management in Amsterdam. «Most of the countries are trading at about a 30 percent discount to their Western European peers.» Eight Central and Eastern European countries have been accepted by the EU as new members, along with Cyprus and Malta, and will join the bloc next year, assuming the moves are endorsed locally in various referendums. With these countries likely over time to join the eurozone, investors have been looking for tighter budgets, lower interest rates and an infusion of EU money to boost growth in much the same way as they did for poorer existing EU members like Greece. The focus has mainly been on Poland, the Czech Republic and Hungary, but Slovenia, Slovakia, Estonia, Latvia and Lithuania are also expected to benefit. «There’s good mileage to be had out of these markets,» said John Pollen, head of emerging European equities at Pioneer Investments in Dublin. Growth and certainty Joining the European Union confers an unusual status on emerging markets. It spreads the riches to the extent that poorer economies are brought along by the richer mainstream and it also brings a degree of stability and even predictability. For example, the knowledge that interest rates in Greece would be lowered as its economy converged to join the eurozone triggered a huge play in then-drachma bonds, and also helped fuel a frenzied – but ultimately damaging – demand for shares. Investors have already been deeply immersed in the new enlargement debt market, tapping into attractive interest rates with predictable capital growth. Yields on the Polish 10-year benchmark bond have fallen from 8.43 percent at start of 2002 to 5.74 currently. Czech bonds have gone so far as to overshoot and now have a lower yield than the benchmark 30-year Bund. In Hungary, the play in bonds has been so frenetic as to trigger a currency crisis that authorities have met by driving down short-term rates. «The best part of the convergence from the bond markets is largely over,» Pollen said. «We think it is just beginning now for equities.» Fund managers say the enlargement factor has at least partially been protecting Central and Eastern European stock markets from the Iraq war and US economy concerns that have sent Western markets into a spin. In effect, they have decoupled somewhat from US and other large bourses, although they are not immune to global pressures. Steffen Gruschka, head of emerging European equities for DWS Investments in Frankfurt, says the correlation between enlargement markets and developed markets is between 0.4 and 0.5, meaning that they are marching somewhat to their own drum. This was seen last year when the Czech and Hungarian bourse indices rose 30 percent and 35 percent, respectively, in dollar terms. The Polish market fared worse – up just 1 percent in dollar terms – but even that compared well with slumps of 17 percent and 24 percent for the Dow Jones industrial average and S&P 500. Companies on the enlargement bourses are still widely seen as attractively priced, with price-to-earnings ratios of around 10 compared with 16 for developed markets. «Valuations compare well with those of Western Europe, although they are not as attractive as say one or two years ago,» Alisdair Reynolds, head of emerging market research at Scottish Widows Investment Partnership, said in a statement. Risks Despite the potential and relative cheapness of enlargement shares, however, fund managers say investing in the region can pose difficulties and won’t top the returns list this year. Stocks on the bourses of emerging markets in Asia are widely seen as outperforming all other equities this year, as underlined in a Reuters poll last week that found managers moving overweight into non-Japan Asia. Eastern Europe, meanwhile, suffers from a dearth of local investors to drive convergence stock market booms such as the ones that took off in Greece – and which eventually ended up fizzling spectacularly. Some of the markets are also quite small and restricted, limiting opportunities. Hungary’s recent currency troubles underlined the risks of convergence plays and actual eurozone membership is still many years away for the newcomers. This has left many fund managers conducting so-called «bottom up» investing – looking for specific targets rather than making country plays. «You have to look at where the value is on a stock-by-stock basis,» said John Paul Smith, head of emerging markets investment at Pictet Asset Management in London.