Tuesday, May 14th, 2013

Collateral damage

Since the beginning of March, we have been making cautious noises about the outlook for emerging market equities relative to the rest of the world. It is now time to take a closer look. The basic dynamic is very simple. If the US and Japan are both performing strongly – benefiting from some aggressive monetary policy – then by definition most other equity markets must be underperforming a global index. This is clearly the case against emerging markets, but there is one group that deserves special attention: Poland, Hungary and the Czech Republic, the so-called CE3.

These three countries are currently all in the bottom quartile of our 44 country ranking, and have been there for much of the last 12 to 18 months. In global equity terms, the region is more depressed than Latin America or Emerging Asia. Many emerging markets have suffered as a result of their high exposure to commodities, but that does not apply to any of these three – though Russia is also in the bottom quartile. So there must be something else at work.

The obvious culprit is the euro-crisis. As economies and financial markets, these three countries are too small and too inter-connected with the rest of Europe to avoid the impact of what is happening in the West. We often speak about the impact of austerity on the countries of Southern Europe, but it’s clear that there are other victims as well. It is must be very frustrating for policy-makers in the CE3, knowing that even though they have the freedom to set interest rates and influence exchange rates, nothing they do will have much effect.

But there is a positive side to this story. If there is ever a recovery in the periphery of the Eurozone, it is likely to benefit the equity markets of Central Europe as well. In other words, policy-makers won’t need to do much to take advantage of it. The timing is highly uncertain, but if/when Spain, Portugal and Italy start to outperform the core equity markets, investors should make sure that they have some exposure to Central Europe as well.


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