Eastern Europe: The Emerging Domino That Didn't Fall
Eastern Europe, the runt of emerging markets regions by volume, is proving to be the stoutest. Here's why.
Well, not quite everywhere. Eastern Europe, the runt of emerging markets regions by volume, proved the stoutest during last week’s bloodbath. The most liquid ETF for the Polish market, iShares MSCI Poland (NYSEARCA:EPOL) is back to where it was before the stampede started on Aug. 14, and shows a 20% gain over the last 12 months. The NASDAQ OMX Baltic Index—uniting the reviving economies of Latvia, Estonia, and Lithuania -- sold off by less than 1% and is also up 20% from a year ago. EEM has about broken even since Aug. 2012.
There are reasons for the ex-Soviet Bloc’s outperformance. The common, rather hastily patched-together explanation for the rout elsewhere is that developing countries, like US consumers and homeowners before 2008, have been living beyond their means on cheap credit. They have used global capital, which was desperate for some kind of return faced with pathetic interest rates back home, to import more than they exported, running up what economists like to call current account deficits.
This logic is itself a bit questionable. The current account deficit of Indonesia, the markets’ whipping boy of the moment, was 2.4% of GDP last year, according to the CIA World Factbook. That compares with 3.1% for the USA. But that is a question for another day. To go on with the standard narrative, investors’ “hot money” is now fleeing back to T-bills whose return has been boosted by the rumor of rising US interest rates. Emerging markets are being yanked off their steroids, and their currencies are destined to sink as capital goes home to the almighty dollar.
But Poland and the rest of Eastern Europe are removed from this T-bill-Hot Money axis. They belong to Europe not only in name, but politically and economically as well. And rightfully or not, Europe is back in vogue among investors, its Euro Stoxx 50 index rising more than 15% over the past year.
Economically, Poland is essentially a province of Germany, but with rather more pep. Its economy grew by 2% last year, while the giant western neighbor eked out 0.7%. Germany gobbles up one-quarter of Poland’s exports and other European neighbors most of the rest. The Polish zloty has traded for years within a tight range (5% up or down) to both the euro and the dollar. With unemployment above 12%, Poland has plenty of economic slack to pick up if Germany, as expected, regains its economic mojo. (The country grew by more than 3% in 2011.)
One more emerging market that kept its cool during the August meltdown was Russia. The value of the commonly traded Market Vectors Russia ETF (NYSEARCA:RSX) is just a hair off where it was on Aug. 14.
That should not be surprising either. One problem Russia, the world’s largest oil exporter by far, does not have is a current account deficit. It racked up an $81 billion surplus last year, the world’s fifth largest. With oil prices settling in comfortably above $100 per barrel, nothing seriously threatens that dynamic, and its beaten-down ruble looks rather undervalued. It sounds like a safe haven from turmoil in more thinly capitalized nations.
The problem with Russia is that it's … Russia. It has some excellent private companies, like food retailer Magnit (MCX:MGNT) or cell phone provider Megafon (MCX:MFON), that continue to deliver outstanding returns despite a macroeconomic slowdown. But the index, and thus the available ETF, is dominated by sclerotic state or proto-state giants like Gazprom (OTCMKTS:OGZPY) and Lukoil (OTCMKTS:LUKOY), where long-entrenched management seems well beyond even the pretense of self-improvement.
So without a sharp upward jolt in energy prices, which seems unlikely for many reasons, the market is likely to remain static. The immediate future is also rich with possibilities for more misanthropic actions by Russian President Vladimir Putin – from undermining whatever Western action might be coming in Syria, to quashing dissident Moscow mayoral candidate Alexei Navalny in case he does better than expected in early September’s election.
Poland, the Baltics, and the Czech Republic, whose main index has reversed weak performance with a 10% run in July and August, look like a better bet. They will mirror a recovering Europe, and then some.
Also see: Sorry, Investors, You're Wrong About Emerging Markets.
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