Hans Engel, Stephan Lingnau and Friedrich Mostböck of Erste Bank -

Emerging markets have outperformed many a global equity index in the past quarters. Especially, the broader European emerging market indices (eg. Stoxx Eastern Europe) have yet again been among the winners in the year to date. The question now is: how long can this last?

Equity investors across Europe clearly differentiate with regard to the different economic environment of the various countries. Not only company specific factors argue in favour of emerging European shares. Macro-economic facts, too, signal a relatively positive environment in most of the CEE countries. This means that the basis for a sustainable outperformance of equity investments in CEE is intact.

Given that the influencing factors represent an important part of the long-term framework for corporate activities, we expect emerging markets equity indices to outperform other European markets on a long-term basis as well.

The following chart shows the share price performance in the PIGS (Portugal, Ireland, Greece, Spain), of the Eurostoxx 50, and of the Stoxx Eastern Europe (STXEE 300 index).

European equities are likely to outperform US shares in the coming months again - as not only (clearly) suggested by the beginning relative strength of important European equity indices (DAX, Eurostoxx 50), but in particular by the improving environment of Europe vis-à-vis the US.

The following chart illustrates that German shares have gained particular strength in the past weeks, relatively speaking. Even the Eurostoxx 50 index, which is dominated by rather sluggish blue chips, has recently shown a convincing performance relative to the S&P 500.

We regard the fact that investors are apparently following a differentiated approach and taking into account the macro-economic scenario in the respective countries and regions in the investment decisions as a positive aspect in the current market environment. Thus, the situation for equities differs substantially from the downward phase two years ago.

The following table illustrates the heterogeneous picture of the various countries and regions in Europe. We would like to draw your attention to the new debt and the changes in yields of government bonds issued by the various countries, and highlight the influence these factors have had on the performance of the specific equity markets and regions in the past quarters.

We expect equity investors to take the relevance of these fundamental market parameters into account in the long run.

Equities from the countries with the lowest debt, and those with the lowest volume of new debt, clearly outperformed the others. Our selection of CEE countries exhibits an average total debt of 51% (to GDP). Up by 38%, the equity indices of this region achieved a clear outperformance relative to other European countries - particularly to the equity indices of countries from Southern Europe (average total debt: 90% to GDP), which posted a mean performance of 1%.

Only North European equity indices recorded as slightly better y/y performance at +39%. The debt of these countries is mostly also below average and, at 57% (to GDP), only marginally higher than that of the aforementioned CEE countries. Northern Europe exhibits the lowest rate of new debt (3.3%) of all regions.

The concern of many equity investors that (more substantial) tax hikes are likely in the countries with higher debt than in those with lower debt rates is one crucial reason for this heterogeneous performance. Another relevant issue is the fact that industrial production has also recorded the highest increase on average in the countries with the lowest government debt. Most of the CEE countries (industrial production y/y +7.6%) even exceed Northern Europe (industrial production y/y +5.4%) in this respect. Germany and Turkey posted even higher increases at +13.3% and +17%, respectively. The relative strength of these markets is mainly based on their above-average growth dynamics. The higher GDP forecasts for most of the CEE countries also substantiate the assumption of stronger growth for industrial production. Given that share price performance is positively correlated with the industrial production of the various countries, we still see a bright outlook for the CEE equity markets.

The chart below illustrates that increased government debt goes hand in hand with a relatively inferior share price performance (y/y).

Total debt in absolute terms as well as changes to it, and liquidity are the most important influencing factors of yields and changes in yields. The following graph highlights the fact that the equity indices recorded the highest increases in the countries where the yields posted the strongest declines. Due to its positive environment, emerging Europe managed to benefit above average.

The development of earnings forecasts in the various countries in Europe reveals a picture consistent with the performance of the equity markets. The 2010 and 2011 earnings in the PIGS have been revised downwards by 6 and 7%, respectively, in the past three months.

In the CEE region, on the other hand, earnings estimates have been stable for almost three months. Earnings estimates in the CEE countries for 2011 have been up 25% in the past six months and thus exhibit about the same strong momentum as the countries in Northern Europe. And the CEE region also shows a slightly better set of data than the US.

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The 2010 price/earnings valuations should also continue to attract investors to the CEE markets. After the earlier corrections in May, the CEE indices are now traded at a PE of 10.7x on the basis of 2010 estimates and at 9.0x for 2011, which means they are now around the level of the PIGS indices.

However, on the basis of the better earnings expectations, the higher expected GDP growth rates, and the lower government debt the CEE countries are more attractive for investors.

The euro has been caught in a technical downward trend since July 2008 (EUR/USD 1.60). Currently the euro is actually traded only slightly below its long-term average of 1.28. The volatility on the foreign exchange markets is above average at the moment, but we saw similar levels during the mid-80s and at the beginning of the 90s. The 30-day volatility is currently 13%. In comparison, the long-term average of volatility is 8%, at a standard deviation 4%. Technically speaking, the nearest support marks are at 1.17 and 1.08. On the upside, 1.25 represents a strong resistance.

Since a low euro comes with positive effects for exports, company earnings in the Eurozone will continue to outgrow those in the US. The comparison of the expected earnings of US companies with those of the European corporate sector turns out positive for Europe. We expect the trend to be of a sustainable nature this time as well, and we envisage the relatively more attractive valuation of European shares in comparison with US equities (expected PE 10.0x vs. 12.2x; European shares are traded at a 20% discount to their American peers) to lend support to the equity markets in the Eurozone and the CEE region.

In the past, a weak euro would most often support the relative performance of European equities vs. American ones (in local currency) as well. The time series of 1983 to 2010 exhibits a strong correlation, with the trend reversal of the relative performance usually starting on the back of a reversal of the exchange rate and then spilling over into the equity market. And over the past weeks we have seen a trend reversal, as described at the beginning of the report.

The comparison of the development on the equity markets since the low in March 2009 with the March 2003 low reveals a few interesting similarities. Back then, too, a year of high returns opened out into a slightly negative sideways movement that lasted about nine months. It took the Stoxx 600 one year (to January 2005) to reach new highs. Interestingly, earnings continued to receive upwards revisions both in 2003 and in the current sideways trend.

The spread between share prices and earnings expectations would have to narrow for the Stoxx 600 index to be able to continue on its upward path. We saw a similar development on the Japanese equity markets after the crash in 1989 and on the Nasdaq after the technology bubble had burst in 2000.

We can see our "neutral" recommendation for equities in the second quarter confirmed by the development on the equity markets and expect the volatile sideways trend to continue in the coming months. We regard the risk of further price slumps as limited as long as the earnings revisions remain on the positive side. For the time being we do not see a trend reversal. The environment in the CEE countries is still better than in most of the rest of Europe, which is why we definitely expect the outperformance to last.