Post-pandemic outlook on Emerging Europe

The second wave of COVID-19 is making headlines across the globe and one cannot help but wonder: will most countries return to full lockdowns? If so, how hard will economic activity get hit? What does that imply for Central and Eastern European markets? As the probability for the above increases by each passing day we sat down with Gábor Szőcs our portfolio manager of HOLD’s dedicated Emerging European equity strategy to dissect some of these issues at hand and get a glimpse into his thinking of how he is planning to position his portfolio in these potentially turbulent times.  

As the second wave of COVID has been hitting most countries around the globe, what is your take on preparedness in the CEE region compared to rest of Europe or the US? How would that impact your regional allocations?

  • A full lockdown such as the one we experienced during the spring is highly unlikely at this point. On one hand, countries’ health care systems has become better prepared to fight against the virus; on the other hand politicians realized that the economy along with their popularity wouldn’t bear the repeat of the shock.
  • Whether the investors will become worried due to the inevitable and painful second wave of the virus or they will look past it and concentrate on the imminent success of the vaccine remains to be seen in the second half of 2020.
  • CEE markets have been laggards behind the wider emerging and developed markets since the appearance of COVID-19, even though it was less severely hit by the pandemic and the Q2 GDP fell less than in the Euro-Zone (-10% vs. -15% yoy.) However, these economies are well integrated in the European and global value chain having high export to GDP levels, so they are not immune to external shocks.
  • Valuation-wise CEE markets became more attractive recently. Gap in the forward and cyclically adjusted Shiller P/E ratios became wider compared to developed Europe and the wider emerging universe as well. Therefore I believe the risk/reward outlook of this region is attractive both in relative and absolute terms.


As a sidenote, I think it is important to mention a widely known fact that apart from Poland most local markets are rather small with liquidity on the lower end of the spectrum. What sectors or specific names do you think have a chance to outperform the wider markets this year and does liquidity constrain your investment strategy at all?

  • Not surprisingly the classic defensive sectors such as telecom, utilities and pharma sectors have quite stable cash flows and benefit from yields staying lower for longer. Within the telecom sector Romanian Digi and the Hungarian Magyar Telekom are great choices for bearish investors as they can easily withstand the COVID-era and are traded at attractive valuations, especially Digi which is an owner operated business, where interests are better aligned.
  • It is true that the CEE markets are rather illiquid, which keeps many large funds especially those with shorter term investment focus away, however as we have multiple years investment time horizon, we aim to convert this illiquid nature to the so called “illiquidity premium”.

If you could share your view on the performance of Emerging European equity markets for the remainder of the year. What are some of the factors that make the region attractive? Any factors or developments that should keep investors away?

  • Our equity strategy has a long term investment horizon. We don’t ignore the upcoming months that for sure will be impacted by newsflow around the virus, but we need to set our sights farther down the line in order to achieve superior returns.
  • CEE is a small island of the emerging universe that global investors tend to overlook. The core CEE countries went through a painful adjustment and deleveraging after the GFC (Great Financial Crisis), while the wider emerging world with the leadership of China became even more levered. Reduced private and public indebtedness and low levels of external debt exposure make these countries less fragile to an economic shock (except for Turkey). Households and corporates have learned after the mistakes of the GFC not to live beyond their means. This makes this region more resilient.
  • For years EU funds or „free handouts” if you will, have been providing tailwind of this region’s GDP convergence story towards Western Europe. The recently adopted Next Generation EU fiscal package is going to boost significantly the speed of this convergence.
  • For instance between 2021 and 2027 Hungary will be eligible to receive 35% more financial aid than in the previous term in real terms and this aid is huge, it could equal to more than 40 percent of the Hungarian 2019 GDP spread over the next 7 years. Other CEE countries’ economies will benefit from this pool alike as well as Greece.
  • On top of this, the pandemic diverted the focus of manufacturers from global to local value chains and from cost reduction to safety considerations. As Central-Eastern Europe is within the boundaries of the EU customs union and moreover have relatively cheap and skilled labour force, we expect increasing FDI in the following years due to this structural shift in value chain optimisation strategy. Turkey and Greece will also benefit from this.
  • We think these arguments are not reflected in the valuations. The cyclically adjusted Shiller P/E ratio of this region (CETOP index) stand at 11.9 versus the wider emergings’ 15.5 level.

 

By looking at all the countries in your coverage which ones do you expect to see outperform or underperform the wider index?

  • We are upbeat on Poland. The WIG20 became one of the cheapest indexes of the world based on Shiller P/E after a combined effect of increased state involvement, pension money outflow and the CHF debt saga, and last but not least the pandemic. On the other hand Romania had a great bull run in recent years and outperformed during COVID-19. Expectation of inclusion into the MSCI Emerging Index and the local pension funds’ flow have inflated prices of Romanian equities – with some exceptions – to less attractive levels. You can buy for example Polish Pekao Bank which is almost CHF debt free for 0.6 times BV while in Romania banks are traded at 1-1.3 times BV.
  • The Greek market is attractive as well given a selective approach is followed. Greece went through a crisis like the Great Depression and now has almost a decade of accumulated pent-up demand and valuations are far from reflecting the normalisation of consumption and investments.
  • However, on the other side of the Ionian Sea, Turkey finds itself in a very fragile situation. On one hand it is appealing that the market in dollar terms is at its 2004(!) level, on the other hand Turkey is on the verge of a macroeconomic collapse similar to what happened in 2018.

 

One cannot miss reading about the growing involvement of the Polish state in economic affairs. Briefly, if you could give us a couple of examples that it clearly comes through?

  • This tendency has been going on for many years. In the financial sector, a large bank tax and increased contributions to deposit guarantee and bank resolution funds put pressure on banks’ profitability. The State started to increase its ownership in the banking sector. State owned PZU bought stakes in Pekao and Alior banks.
  • In the utility sector, household electricity price freeze was initiated before the elections. Consolidation plans to establish national champions within the sector weighed on share prices. The troubled, below the water coal mining sub-sector has been kept alive via cross financing and bailouts by the utilities owned by the state due to social and political reasons. (IMPORTANT: this is about to change as the state wants to spinoff coal assets to a fully state owned entity, and with the help the EU funds wants to restructure the industry, making the most coal exposed country in the EU into much greener.)
  • These “interventions” – among others – contributed to gradually falling share prices, as more and more investors turned bearish and classified Poland a high risk, low return stock market. What investors forget these days is that low valuation levels already imply the extrapolation of value destruction and suboptimal earning levels. Current cash flow yields are attractive and the option for a positive shift is almost priced at zero, whilst the probability of it is significant in a 5-year horizon.

 

Speaking of state involvement, there is another country in your investable universe that has been facing some rather difficult times mostly due to an unorthodox approach to economic matters, resulting in volatile currency markets and falling reserves. What could bring calm to Turkish markets?

  • After the 2018 crisis prime minister Erdogan indirectly took over the monetary control lowering the real interest rate to minus 2-3 percent, while boosting lending exorbitantly via state owned banks. Turkey still sits on a huge external debt pile and since the outbreak of the pandemic the current account deficit widened as the economy particularly suffers from the absence of tourism. To keep this balance the Turkish Central Bank burnt tens of billions of dollars from its FX reserve to prevent lira depreciation. As the Central Bank runs out of reserves, there is no place to hide. Lira started to depreciate and the stock market in dollar term fell almost 20 percent in early August
  • A “hidden”100-150 bp interest rate hike has already happened smoothing the pressure, but I doubt that it will be enough. I expect that at least the elimination of negative real interest rate is necessary that will inevitably make Turkish assets cheaper.

What is your take on Turkish equities in general, and what would prompt you to buy more of Turkish stocks? Do you still consider Turkish equities cheap?

  • We lowered our underweight in Turkish stocks in August, however we keep our gunpowder still relatively dry and willing to pull the trigger when the crisis escalates further. Our preference is on manufacturers having substantial export exposure that gain a competitive edge with lira’s devaluation.

If you could give us an example of a couple of investments this year that did not perform as well as expected? Any that exceeded your expectations?

  • It proved to be rewarding being contrarian and long in Polish utilities (Energa, Tauron). COVID-19 induced lower interest rates inflated the value of stable cash flows, the diminishing electricity price reduced the pressure from the government household tariff freeze move. Even more importantly the government’s „make Poland greener” strategy, the plan of coal assets spinoff reduced the so called „ESG discount” of the shares as well as the magnitude of future cross-financing liability.
  • On the negative side our Greek bank exposure suffered a big negative hit. The pandemic delayed the long-awaited economic recovery, however due to regulatory ease of provisioning, we think banks will be able to emerge from the crisis without any capital increases.

Apart from COVID what do you consider to be a focus in the markets for the remainder of the year?

  • Upcoming US elections can be a game changer. US markets seemingly ignore the fading chance of Trump’s reelection. Whilst this could trigger a structural and long-term turnaround favoring Main street versus Wall Street, triggering a more „socialistic” economic policy that gives an answer for the ever-growing inequality problem. Additionally, the probable future downtrend of the USD can turn the path of emerging market assets that have been suffering for nearly a decade now.