Central & Eastern Europe Investment: Fundamentally compelling
Despite emerging market turmoil, David Zahn argues that fiscal rectitude and a shared desire to join the euro sustain the investment cases for many eastern European bond markets
When considering investment allocations in Europe, the risks of assuming uniformity in the prospects for growth and structural reforms in the region are underlined by the significant historical dispersion of sovereign bond returns.
We would urge investors to focus on the growth and debt metrics of individual European countries, rather than fall into the habit (or trap, as we would argue) of viewing Europe through a prism of pessimism. Regardless of how the fundamentals of the euro-zone, the European Union (EU) or Europe are presented, investors should avoid viewing these units as homogenous or a combination of groupings and, instead, focus on pinpointing the individual countries whose debt potentially offers the most attractive risk/return profiles.
Nowhere, is such an approach more necessary than in differentiating between developing European countries. The clouds hanging over these countries have been building lately, with many buffeted by the euro-zone recession, which, although shallow, had stretched back to 2011. Two of the largest countries, Poland and Hungary, were forced to cut benchmark interest rates to record lows in an effort to stimulate their faltering domestic economies.
Now, investor sentiment towards developing Europe is being further tested by concerns that emerging economies around the globe may be entering a secular slowdown after years of elevated growth. Detractors also argue that the plentiful liquidity resulting from quantitative easing in the US and elsewhere has artificially enhanced capital inflows into the emerging markets. Ever since the US Federal Reserve hinted that it might start winding down its bond purchases if the US economy continues to improve, most emerging market assets have stumbled, giving rise to talk that market volatility could trigger an emerging market debt crisis similar to those of the 1990s.
We believe that such concerns run the risk of writing off developing European countries too quickly, and, moreover, fail to distinguish between their disparate economies. Several are undoubtedly experiencing cyclical slowdowns, but when their individual credit fundamentals are closely examined, several still appear to demonstrate superior growth and debt metrics compared with many other European countries. Despite the impact of the protracted euro-zone recession, levels of economic activity in some of these countries have been significantly higher than elsewhere in Europe, and are projected to remain so at least until 2018, according to the International Monetary Fund (IMF). As in many other emerging markets, the rising disposable incomes of a newly-created and expanding middle class is helping to drive the growth of domestic demand.
In terms of their success in avoiding or escaping the constraining effects of high debt levels, several developing European countries also come out ahead of most of their western counterparts. In the case of Poland, its fiscal framework even includes a constitutional article on the level of public borrowing, which caps gross debt at 60% of GDP, the highest of three thresholds.
The Polish economy’s strong growth momentum allowed it to escape a recession during the 2008-09 financial crisis, making it one of only a few economies to do so, but a slowdown since late 2012 as a result of the stagnation in the euro-zone left tax revenues well below projections. The Polish government reacted by suspending its lowest, most stringent 50% debt-to-GDP threshold, a breach of which would have triggered potentially damaging austerity measures. However, the government’s pullback was not interpreted as heralding a broad loosening of Poland’s fiscal policy, which is viewed favourably (compared with many members of the EU) for its tight discipline and relatively low level of borrowing.
Poland’s structural reforms have been implemented more or less continuously since the country began its transition to a market economy in 1990. Crucially, few of the successive waves of modernising reforms brought in by governments – ranging across all parts of the economy and the public sector – have been reversed when opposition parties came to power, underlining the consensus among policymakers about the general reform path that needed to be taken.
With the neighbouring euro-zone finally out of recession, and helped by a sustained easing of monetary policy by the Polish central bank, Poland’s economy appears to be gaining momentum after its recent cyclical trough. The latest IMF forecasts predict growth will pick up from 1.3% in 2013 to 2.4% in 2014, while some analysts estimate that the figure could be nearer 3%.
In Lithuania, successive governments have kept debt at relatively low levels and the country became a large-scale bond issuer only after undergoing a deep recession in 2009. Rather than turn to the EU or the IMF (like its neighbour Latvia), Lithuania decided to finance its budget deficit through the international capital markets, issuing US dollar-denominated bonds worth over $7bn (€5bn). Since then, with the help of structural adjustments, the government has successfully reduced its deficit to around 3% of GDP, resulting in Lithuania’s debt-to-GDP ratio stabilising at a little over 40% by 2012. In comparison, across most of the euro-zone and the UK, debt-to-GDP ratios remain stubbornly high, in many cases approaching 100% and in a few countries, higher.
The Lithuanian economy recovered strongly from its 2009 recession, posting growth of almost 6% in 2011, driven mainly by the export sector as competitiveness improved and labour costs adjusted, with the country benefiting from its proximity to the more robust northern portion of the euro-zone. Since then growth has returned to a sustainable level, and domestic demand has played an increasingly important role in driving the economy as consumers have regained a measure of confidence and wages have started to rise again.
Bulgaria may have recently experienced political turmoil, but the country’s commitment to fiscal rectitude in the past decade has been impressive, leaving it with a debt-to-GDP ratio below 20% from 2007 until 2012. In 2012, Bulgaria issued its first sovereign Eurobond in a decade, but only to roll over existing debt that was soon to mature. While growth may be relatively low in comparison with other parts of developing Europe, the Bulgarian government has initiated encouraging structural reforms and, in our view, the reasonable medium-term prospects for Bulgaria’s economy could potentially improve further if it were to receive more EU funds. Of course, Bulgaria, along with Lithuania and Poland, would be vulnerable to any flare-up of the euro-zone sovereign debt crisis, but we believe that the relatively high sovereign yields currently on offer in each case may sufficiently compensate for such a risk.
For these eastern European countries, fiscal discipline is crucial to pave the way for their eventual adoption of the euro. Lithuania is furthest advanced in this regard, with a target date of 2015 to join its Baltic neighbours Estonia and Latvia (which joined in Janaury 2014) as part of the euro-zone. Poland and Bulgaria have both expressed a wish to see further progress in finding durable solutions to the euro-zone’s debt crisis before becoming part of the single currency bloc, although both countries are committed to doing so as part of their respective EU accession treaties. We believe such objectives can open up additional opportunities for investors to add value through the use of currency allocation.
Exposures to Poland, Lithuania and Bulgaria, whose bond markets are relatively small, can sit alongside allocations to other, larger countries in the region that we believe offer value potential. Their fiscal credentials seem underpinned by a shared desire to join the euro-zone, which may also speed the pace of their structural reforms compared with the slower progress within the euro-zone, where political consensus is often harder to achieve. Their track record on growth has generally looked equally superior, auguring well for continued strong economic performance. The potentially attractive opportunities offered by Poland, Lithuania and Bulgaria – which, in our view, become compelling when analysing the economic, fiscal and political characteristics that are likely to influence their credit fundamentals over the medium term – serve to underline for investors the critical need to consider different country allocations.
David Zahn is the head of European fixed income at Franklin Templeton Investments