Since joining the European Union just over 12 months ago, central European markets have delivered im...
Since joining the European Union just over 12 months ago, central European markets have delivered impressive returns. Yet recent volatility has raised the question as to whether the re-rating of central Europe is fully played out on the stockmarkets or whether there is further to go in the convergence story.
The ongoing improvements to the region's macroeconomics over the past couple of years have led to further interest rate cuts this year, which have underpinned domestic liquidity and boosted local consumption. The Czech Republic has recently posted its largest balance of trade surplus since 1994 and Poland's current account has now moved into positive territory, helped by the fact that exports have remained robust despite a stronger than expected zloty.
The picture in Hungary is a little less rosy, reflected by Fitch's recent downgrade of the country's local currency debt, citing concern over its poor fiscal position and the ongoing deterioration in its budget and current account deficits. The government has repeatedly missed targets for EMU entry and this has now been postponed to 2010.
On the positive side, the macro risks in Hungary are felt to be largely reflected in valuations and, over the short term, the high yielding forint is likely to be supported by foreign investment. Although a currency crisis is a clear risk at some stage, it is unlikely to be on the scale of those in Russia and Asia in the late 1990s.
It is clear that foreign direct investment into the region is continuing to rise, with a number of sizeable deals taking place, including Telefonica's recent acquisition of the Czech telecoms company, Cesky Telecom. M&A activity in Western Europe is also having a positive knock-on effect in Central Europe as the forthcoming merger of UniCredito and HVB Bank, both of which have controlling stakes in Poland's second and third largest banks, will form the largest bank in Poland, giving it critical mass. The increasing number of Western European companies outsourcing their business to the region to benefit from its attractive labour costs and low taxation has also been a significant driver of economic growth.
Moving forward, Central Europe still has a considerable way to go in terms of meeting the Maastricht criteria and there is concern that the pace of reforms will slow ahead of the elections. All three countries have failed to implement the necessary fiscal measures to rein in their budget deficits. There is a real risk the country's adoption of the euro may be delayed until after 2010. A more significant threat, however, is local currency risk, especially if rising US interest rates and a further strengthening of the US dollar lead to a sharp unwinding of the dollar carry trade.
Ultimately, it is unlikely that central European markets will be able to deliver the same level of returns of the past two calendar years, given their fairly full multiples, the possibility of further risk aversion and a further unwinding of the US dollar carry trade.
European inflation should be subdued despite a commodities boom.
The management of many European companies is improving.
However, it is vital to avoid companies that are stuck in their old ways.
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