Central & Eastern Europe Investment: The twin peripheries
After years of turmoil, Europe has two groups of reformed economies at its southern and eastern edges. But Charlotte Moore finds that they are not equally-positioned, and both still include countries with deep problems
Classifications often do not stand the test of time. Take southern and central Europe. Before the financial crisis, southern European countries were considered sound developed economies. In contrast, central European states such as Poland, the Czech Republic and Hungary are still viewed by many investors as emerging economies, despite their EU membership.
Now these two regions seem to be on a more even footing. That entailed southern Europe’s dramatic fall from grace, with current account and budget deficits ballooning and banking sectors teetering on the brink of collapse – a conflagration of economic problems usually more closely associated with developing rather than developed economies.
Although, often viewed as European outliers, the southern and eastern economies are both closely connected to the region. Southern European countries (and some eastern) are members of the euro while central European countries are almost as closely interlinked.
“Central Europe is heavily integrated with the euro-zone from almost every perspective,” says Marcus Svedberg, chief economist at East Capital. “It depends on it for trade, most foreign direct investment comes from western Europe and it’s completely dominated by Western European banks.”
Before the financial crisis, central Europe’s current account and public financial positions were in better shape than southern Europe, but its reliance on Western Europe meant it had to contend with the headwinds of lower economic growth and a withdrawal of foreign investment. That resulted in a collapse in domestic demand.
“Now that the economic outlook for Western Europe is looking more positive, I’m optimistic that a growth in exports will help to bolster economic growth in central Europe, albeit from a low base,” says Svedberg.
For the economic recovery to be sustainable, however, it would require domestic demand to pick up, as well as revival in the banking sector and businesses investment. “Exports will lead the growth but I’m cautiously optimistic these other parts of the economy will start to revive,” Svedberg adds.
It’s not only central Europe that has a more optimistic outlook. Tough economic measures have gone some way to turning around the fortunes of southern Europe. While their membership of the euro made it impossible for these states to devalue their currency, austerity measures imposed by their governments resulted in a deflation of prices, benefits and labour costs.
“No politician would usually choose to put their country through such pain but it had the desired effect – all southern Europe countries now have a current account surplus,” observes Sandra Holdsworth, fixed income manager at Kames Capital. “Exports continue to increase and make a larger contribution to GDP growth.”
The net result is that both regions have experienced similar economic trends since the financial crisis.
“There has been some commonality between southern and central Europe – both have seen a big improvement in their current account position while both have also experienced a collapse in domestic demand,” says John Taylor, fixed-income manager at Alliance Bernstein.
While broad macroeconomic trends have been similar across both southern and central Europe, investors need to be aware of the significant differences between countries within each region. Spain has experienced a 10% decrease in labour costs relative to the European average since 2009, for example, while Italy’s workforce has become more expensive. That has not only caused an aggressive increase in direct foreign investment in Spain, but also resulted in a shift of production there away from places like France.
Still, Spain’s labour costs have not fallen to a level that makes it competitive with central Europe. “Labour costs in Spain are still two to three times higher than in central Europe,” Taylor notes.
Improvements in the outlook for both southern and central Europe should not obscure the risks in both regions.
Austerity measures have improved the economic competitiveness of southern Europe but they have come at a significant cost – unemployment in Spain, for example, remains at high levels. Svedberg says: “Spare capacity in the labour market should help to keep a lid on costs.”
But high unemployment rates can cause political instability that could derail further economic improvements. And there is still plenty of cleaning up to be done. “Many southern European countries spent a decade building up their debts in every sector – household, corporate and government,” says Jurgen Odenius, principal for international economic and strategic research at Pramerica Fixed Income. “That’s going to take a long time and lot of discipline to unwind.”
In contrast, there is an entirely different attitude in central Europe. Svedberg says: “There’s not the same sense of entitlement. That’s resulted in a much tighter fiscal discipline and there are much lower levels of debt.”
But the financial crisis did illustrate one major risk in the central European model – its heavy reliance on Western Europe and Germany, in particular. “This is an important risk,” warns Nick Brown, emerging market debt fund manager at Schroders. “Some countries have been broadening their export base to the Middle East and China but are still heavily reliant on Western Europe.”
While budgets are in much better shape in central Europe, politicians in Poland and Hungary have recently made some highly questionable decisions around nationalising pension systems, so the majority of their populations’ benefits become unfunded.
Investors should review their investment strategies for both regions to reflect the recent changes in economic trends in both southern and central Europe. Wouter Sturkenboom, European strategist at Russell Investments, says: “The recovery in the economic fortunes of southern Europe has already been priced into sovereign debt. While these bonds still offer a better coupon than elsewhere in the region, we do not think there is much more scope for yield compression.”
Brown adds: “There are more opportunities for investors in central Europe because these countries are not yet part of the euro-zone, so investors can take a view on how local interest rates and currencies will perform in the future.”
Southern European equities, however, still remain attractive.
“I would lean towards southern European, rather than central European equities – even though the valuation gap between the two regions is not that large,” says Sturkenboom.
Southern European profit margins are currently depressed, so if the competitive advantage can be maintained these should be reversed. Since both regions have similar valuations, an improvement in margins for southern European equities should translate into greater returns for investors than for central European equities.
But perhaps now is the time for investors to change the way that they classify the different European regions. While there are risks for both southern and central Europe, the outlook for both of these supposed European outliers is much rosier than it is for those European stalwarts, France and Italy.
“There are two countries in euro-zone that are doing things right at the moment and that’s Spain and Germany,” as Svedberg puts it. “Meanwhile there are two countries that are not doing much at all – France and Italy.”