2017, so far, has been the best year for Central European equities since 2012. The CECE Composite, an index provided by Vienna Stock Exchange that reflects the performance of the 28 largest stocks listed in Warsaw, Prague and Budapest (CEE3 thereafter) gained 22% from the start of the year to August 15. In sharp contrast, the Russian index has been the worst performing market globally outside the Middle East, losing almost 20% over the same period (all performance data are in Euro-terms).
What looks like a strong investor vote on the economic outlook for Central Europe versus Russia appears much less striking from a longer-term perspective. To a large extent, this year's performance is the reversal of trends seen in recent years.
CEE3 stocks actually fell three years in a row from 2013 to 2015 and posted only a small gain in 2016. The dismal performance was mainly driven by Polish stocks, which dropped more than 30% in 2015 alone, related to the political changes in the course of the year. Hungarian stocks fared much better, but the performance of the Hungarian market is driven by just three stocks (OTP, MOL and Gedeon Richter), which together account for almost 90% of Budapest’s total market capitalisation.
The Russian stock market, after losing more than half of its value in 2013 and 2014 in response to the drop in crude oil prices and to Western sanctions, already stabilised in 2015. In 2016 it posted a strong recovery (+57% in euro terms) on the back of higher oil prices and hopes of better relations with the US following Donald Trump's surprising win. However, oil retreated in the first half of this year and the anticipated Trump-effect on US-Russian relations evaporated quickly in step with some of his other policy intentions.
CEE3: Fundamentals still supportive
The rebound of Central European stock markets this year was clearly driven by improving macroeconomic fundamentals on the back of accelerating Eurozone growth. After a soft patch in most of 2016, growth in CEE3 economies picked up, driven first by exports and, more recently, by strengthening domestic demand. Annual GDP growth has been in the 3-4.5% range in the first half of 2017, well above Eurozone growth figures.
More importantly for equity investors, the better macroeconomic fundamentals are reflected in rising company earnings. In 2017, in Poland aggregate earnings of the listed corporate sector are expected to rise by 20%, in the Czech Republic by 13% and in Hungary by 5% (according to Erste Group Research).
Similarly important: earnings revisions are pointing upwards. While sell-side analysts often enter the year with elevated earnings expectations that are subsequently lowered, this year forecasts were steadily revised upwards in response to incoming earnings and macro-economic data.
Despite the strong performance year-to-date, the valuation discount to core West European peers has remained quite stable, reflecting the strong earnings momentum. On average, CEE3 stocks are presently trading on 11.8x 2017 estimated earnings, representing a discount of around 25% to West European equities (based on the Euro Stoxx 600).
Both economic momentum and valuation suggest that the backdrop for the region’s stock markets will stay benign. Monetary policy will likely remain supportive for some more quarters, notwithstanding the recent rate increase in the Czech Republic from practically zero to 0.25%. Also the global environment continues to provide support. The global growth outlook has improved in recent quarters; the dollar is anticipated to stay weak, and commodities seem to have found a bottom in the course of 2016 after falling for almost five years.
Russia: Oil remains key, the economy will provide support
Both Russia's stock market index (in US dollars) and the price of crude oil fell by 13% in the first half of 2017, confirming that oil still is the main driver for Russian equities. Earlier this decade, the relationship between oil and index levels seemed to have loosened, but since the first quarter of 2016 the RTS, Russia’s main stock index denominated in US dollars, has returned into a remarkably narrow trading range of 20-22x the price of crude oil.
During the first quarter of 2017 the index – elevated by Trump-related hopes – was climbing towards the top end of the range, but it has moved to the bottom end since then, as US-Russian relations have soured again.
There are reasons, however, to assume that the weakness of Russian equities has come to an end. First, the improvements in the Russian economy are for real. The economy moved out of recession in the second half of 2016 and is now expected to grow by around 1.5% in 2017 and 2018, with some upward risks in the second year.
Second, monetary easing has further room to go as inflation is falling rapidly. The policy rate could go down to 8% by the end of 2017 and fall another 200 basis points in the course of 2018.
Thirdly, while earnings expectations had to be lowered during the first half the year, the recent rebound of crude prices has also improved the earnings outlook again.
Finally, valuations remains undemanding. The Russian market has recently traded at a price-earnings ratio of slightly below seven times 2017 estimated earnings, implying a discount of about 50% to the wider emerging markets space. This partly reflects the high share of cheap carbon-related stocks, but also stocks outside the oil & gas sector have on average traded at a 40% discount to emerging market peers (according to Bloomberg consensus estimates).
The bottom line is that Central European stock markets will likely continue to enjoy tailwinds, while the outlook for Russia seems to brighten. Of course, the usual health warnings (presently mostly related to geo-political risks and the Chinese credit situation) apply.