East Capital Outlook 2012

The outlook is based on a muddle through scenario for the Euro zone (no financial collapse but weak growth) and a modest slowdown elsewhere, with global output around 4% and an oil price at USD 90-100 for Brent. We acknowledge that there are risks on the downside, especially in the Euro zone, and that Eastern Europe will be affected if these risks materialise. At the same time, we believe the long-term growth outlook remains solid, even though growth will stay below trend in the near term.

We believe that the larger, more balanced, predictable and domestically-orientated an economy is, the better the outlook for 2012. That means that we have a preference for Russia and Poland. The outlook for Hungary and Turkey is more uncertain, while the Czech Republic is somewhere in between. Further afield, Kazakhstan looks quite good from a macro perspective, while the opposite is true for Ukraine, although both countries have lingering problems in the banking sector. We also think the Baltics will be able to keep up growth better than the Balkan economies in the short term, although the medium-term growth prospects are arguably better in the latter group due to its catch-up potential. We do not expect any major political changes in the region, but rather more of the same, with the Russian presidential elections as the most obvious example. We do not, however, rule out political turmoil in some of the countries in the periphery, most notably Belarus and Bosnia. 

Can emerging economies grow when the developed world slows down?

We do not believe in decoupling in general and particularly not in Eastern Europe, but we do believe that these economies can grow as long as there is no deep recession in the Euro zone. More importantly, the medium-term outlook remains good for economies with substantial catch-up potential and/or low debt levels. 

Most emerging economies will slow down in 2012, while most developed economies will continue to grow below potential. The outlook for the global economy is thus rather bleak and we believe the consensus forecast – currently around 4% for 2012 in purchasing power terms – may be revised down further. Many developed economies, especially those in the Euro zone, are in the process of announcing consolidation plans, and that should put negative pressure on demand. Emerging economies should, however, be able to continue to grow 3-4 times faster than their developed peers.
 
Average growth in Eastern Europe should be somewhere in the 3-5% range in real terms and 7-10% in nominal terms, and increasingly driven by domestic demand in the next couple of years. We believe Eastern Europe can grow close to the global average in 2012, i.e. significantly faster than Western Europe but also much slower than the emerging market average. Eastern Europe on average is expected to grow 3.5%, with a handful of economies in Central and Southeastern Europe bringing down the average by growing around 2% due to their high level of integration with the Euro zone, while another handful in Central Asia and Caucasus are expected to grow by over 5%. 

The medium-term potential growth for the middle income economies in Central Europe is probably somewhere between 3 and 4%, but they may not reach those rates in the next couple of years due to the slowdown in the Euro zone.

Real GDP Growth (% annual change)

Average CPI (% annual change)


Source: OECD (November 2011)

All these forecasts are based on a muddling through scenario in the Euro zone, as outlined in the previous section. If the Euro zone goes into a deep recession, triggered by financial breakdown, Eastern Europe will not be able to withstand the shock and may move into recession as well.

Real GDP Growth (% annual change)


Source: EBRD (October 2011)

Do we expect any dramatic changes in the region in 2012? 

No major economic or political changes, but rather a continuation of the incremental economic reform process and political continuity.

Eastern Europe has shown that it is possible to implement radical economic reforms during difficult times. The economic imbalances that put the region under pressure at the outset of the global financial crisis in 2008 have been reduced substantially during the past three years and the consolidation is expected to continue. Financial markets and international financial institutions have put a lot of pressure on these economies and many still have IMF programs or relatively low credit ratings, forcing them to continue to consolidate. We think this is good as it imposes discipline and should also lead to better credit ratings and lower yields over time. The Baltic states have excelled in this category, but countries like Romania and Serbia have also stayed on course. The recent track record in Ukraine and Hungary is more worrying, although it is not unlikely they will call in the IMF again after dismissing the fund in 2011.

Macro consolidation 2009-2012

Source: EBRD (October 2011)

Poland is one of the best run economies in the EU, and the budget and debt problems are quite modest compared with its neighbours. The re-election of the government in late 2011 and its pledge to continue to consolidate bodes well for 2012. Russia enjoys strong public finances but has shown considerable slippage on the fiscal front. The resignation of Finance Minister Kudrin in 2011 aggravates the worries on future budget discipline and we believe the line-up of ministries after the elections will be an important signal in this regard. The views on Turkey are very divergent on the back of its economic slowdown and unorthodox monetary policy. We believe growth may slow down considerably as the current account deficit is being reduced. The fiscal situation will remain under control and the lira should be able to appreciate once the outlook becomes clearer.
  
There is a series of elections in the region in 2012, but we do not expect any major changes, as most polls will be characterised by policy continuity. There are, however, a few potential sources of turmoil in the region. The political stability in Bosnia has deteriorated over a long period of time and the current structure is not sustainable. The economic difficulties in Belarus may trigger overdue political reforms, which could turn violent. We also believe the political situation in Ukraine has deteriorated, and although we do not expect any major crisis, we struggle to see any positive triggers in the short term.

What about China?  

Our baseline scenario is that China will stay on course economically and politically in 2012. Economic growth will slow down somewhat, to around 8%, inflation will stabilise around 5-6% and the currency will continue to appreciate slowly but steadily. We also expect selective monetary easing and measures stimulating growth in general and consumption in particular. The leadership transition starting in October 2012 will ensure continuity and steady economic growth.

Public finances are in good shape  – official public debt is below 20% and the fiscal deficit below 2% of GDP – and the financial sector looks fine in the short term, with loan-deposit ratios and NPLs on the low side, even though there are emerging problems originating from the 2009 stimulus program. China thus seems less vulnerable, at least directly, to the financial turmoil in the Euro zone. A slowdown in economic growth in the developed world will, however, hit Chinese growth, given its trade dependency. But the economy is gradually becoming more domestically-orientated, and the state has resources to stimulate the economy if needed. Our biggest concern about China is domestic and more medium-term; related to the banking and property sectors.

Can markets perform in this environment?

The macro backdrop is obviously not great, but we do believe that markets with solid fundamentals can perform if/when the global financial turmoil subsides. In particular, large markets with attractive fundamentals and a supportive base effect should be able to rebound once the focus shifts from Euro zone sentiment to market fundamentals.

But most emerging markets have lost much more than their developed peers since the beginning of the crisis. The large index markets are down between 35 and 55% from their respective pre-crisis peaks, while some of the frontier markets in the region are down more than 75%. We therefore believe there is plenty of upside potential for these markets, especially as valuations are attractive.

Consensus P/E 2012 

Performance since peak (USD)

Source: Bloomberg

The Russian market is among the cheapest in the world and is trading close to an all-time high discount to other emerging markets. The outlook for earnings growth in Russia and elsewhere in the region is obviously weaker and is being revised down on the back of the economic slowdown, but the medium-term earnings outlook remains robust. 

The Chinese equity market is cheap after the sell-off in 2011, and we believe China will be one of the first markets to benefit when investor appetite returns to emerging market equities. The combination of strong economic growth, stable public finances and low valuations should support the market in 2012.

We do not, however, think that the equity markets in Eastern Europe, Asia or in emerging markets in general can revalue in any substantial way as long as the focus is on crisis management in the Euro zone. And we do not think that an eventual rebound will be as indiscriminate as the sell-off. Investors are likely to focus on the largest companies and markets with the most attractive fundamentals in the first phase. Liquidity should eventually also trickle down to smaller stocks and markets with solid fundamentals.

Risks

We see three broad kinds of risk facing the countries in Eastern Europe in 2012; dependence on external sources of growth (exports and capital in general and the Eurozone in particular), substantial economic imbalances and/or domestic political turmoil. More generally, uncertainty should be punished while stability and continuity should be rewarded from a risk perspective.     

There is a high but uneven degree of economic dependency between Eastern Europe and the Euro zone in general and Germany in particular. There are three main transmission mechanisms between East and West; (i) trade, (ii) investments, and (iii) credit. The Central European economies are most vulnerable to a slowdown in the Euro zone as they export to and receive investment and credit from the Euro zone. Weighing different linkages, summed up as an index calculated by the EBRD, indicates that Hungary, Slovakia and Bulgaria are the most vulnerable, while Croatia, Slovenia, Romania, Poland and Estonia also have a relatively high degree of integration with the Euro zone. From a purely macro perspective, the ratios (also confirmed by recent data) suggest that exporters from the Czech republic, Hungary, Slovakia and Slovenia, as well as investment dependent companies/sectors in Bulgaria, Hungary, the Czech Republic and Croatia, are the most vulnerable.

A related source of vulnerability comes through the banking sector. There are substantial risks for the sector in some countries in Eastern Europe, even in a muddling through scenario for the Euro zone.  It is clear that Western European banks have to raise their capital adequacy ratios next year and there is a risk that they will do so by cutting down their exposure to daughter banks in Eastern Europe, at least to some extent, as it is deemed more difficult to raise fresh capital. The EBRD has already sounded the alarm and called for a second Vienna initiative. A handful of Central European markets seem most vulnerable – most notably Croatia, the Czech Republic, Slovakia and Hungary – as more than 80% of the banking sector is controlled by Western European banks. A number of economies in Southeastern Europe – such as Romania, Bulgaria and Serbia – are also vulnerable. Ukraine is also at risk as it is not unconceivable that some of the 17 foreign banks will reduce their exposure one way or another.  The Baltic banking sectors are dominated by Scandinavian banks and are thus not as vulnerable, whereas the Turkish and Russian banks are predominately domestically owned. Poland is relatively exposed but enjoys a special relationship with Germany, which is sometimes even considered a home market.     
  
It may not be a big problem to run economic imbalances during good years, but 2012 is not likely to be a particularly good year for the world economy. Countries running large current account deficits, budget deficits or public debt may therefore be punished. In general, Eastern Europe has improved significantly on these fronts since 2008, but there are notable exceptions.

A number of the smaller economies run worryingly large current account deficits, but Turkey is the real concern of the larger economies, as its deficit is around 10%. Poland’s deficit is also a source for concern as it is above 5%, although there have been no problems with financing to date. Economies like Poland, the Czech Republic and Romania are expected to have budget deficits above 3%, which is generally regarded as a prudent level, but as they all have credible plans to reduce the deficits in the medium term, the market and rating institutes may choose to give them the benefit of the doubt. Some of the frontier economies may have inflation in double digits, but the trend is generally a positive one in Eastern Europe. Recent inflationary pressure in Turkey, forcing the central bank to change monetary regime, is a cause for concern, even though the pressure is expected to ease during the course of 2012. 

Conclusions

The outlook for next year is both dominated and clouded by the global financial turbulence caused by the debt problems in the Euro zone. We believe a muddling through scenario is the most likely, although we do not rule out the probability of other scenarios, and draw six main conclusions for Eastern Europe and China.

Firstly, there will be an economic slowdown in 2012 due to weakening external demand. Almost all emerging economies will slow down on the back of falling exports to developed economies, and Eastern Europe is no exception; quite the contrary given its high degree of integration with Western Europe.

Secondly, domestic demand is expected to remain quite robust, at least in the largest economies in the first half of the year. Consumption and investment activity has surprised in Russia, Poland and Turkey during 2H 2011, and we believe the momentum can continue for another couple of quarters before slowing down during the second half of the year. Moreover, the nominal medium-long term potential growth remains strong for most of Eastern Europe, even though we do not expect growth rates to come back to pre-crisis levels.

Thirdly, there are plenty of risks and most of them originate from the Euro zone. In general, the more externally dependent and integrated into the Euro zone, the more vulnerable economies will be in 2012. Countries with balanced economies, few uncertainties and large domestic economies should be safer, although no economy is completely shielded.

Fourthly, we do not expect much dramatic change on the political front. The Russian election is obviously the biggest event, and we do not expect any significant change, as the current elite is expected to stay in power. We also expect a smooth leadership transition in China, focusing on continuity. A number of countries should get new coalition governments, but we do not expect any significant policy change. Overall, we believe the incremental reform process and economic consolidation will continue.

Fifthly, we believe that markets can perform even when growth slows down. But we do not think that an eventual rebound will be as indiscriminate as the sell-off. Investors are likely to focus on the largest companies and markets with the most attractive fundamentals in the first phase.

Lastly, even though the focus is very much in the short term, we like to emphasise the long-term prospects. The present concerns over debt, deficits and low growth in much of the developed world should lead investors to put more rather than less money in emerging markets in the long run. Eastern Europe is expected to grow more than three times faster than Western Europe, while having three times lower debt levels over the next five years. The ratios for China are even more appealing.

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