FUND SURVEY 2016: CEE/CIS bond funds benefit from the ‘Great Migration’

FUND SURVEY 2016: CEE/CIS bond funds benefit from the ‘Great Migration’
By Nicholas Watson in Prague August 31, 2016

Bond funds investing in Central and Eastern Europe/Commonwealth of Independent States (CEE/CIS) performed well over the past year as what BlackRock dubbed the “Great Migration” saw the search for yield bring investors back into the emerging market fold. It was another poor year in general for equity funds invested in the region, though there were some bright spots like Hungary. 

In bne IntelliNews’ 10th annual Fund Survey, the performance of the region’s funds during the survey period (July 1, 2015 to June 30, 2016) showed a clear trend of bond funds in the main performing well, while equity funds struggled – a pattern that has been repeated in many years since the 2008 financial crisis. (A pdf of the “Fund Survey 2016” with the full table of funds can be downloaded here  Fund_Survey_2016.pdf.)

This was matched by the flows of money. According to the fund tracker EPFR, the category “all emerging market equity funds” saw outflows during the first half of 2016 worth $7.314bn, with Emerging Europe equity funds seeing a net $56mn disappearing and Russian equity funds in particular being hit by $379bn of outflows. Frontier market equity funds saw outflows of $805mn during the January- June period. 

“EMEA Equity Funds recorded their biggest weekly outflow in over eight months during the [second] quarter as the authoritarian drift of politics in Turkey, Poland and Russia, the impact of the Eurozone’s flagging recovery on CE3 and other Emerging European markets, depressed oil prices and South Africa’s economic struggles took their toll on investor sentiment,” EPFR said. 

The situation with fixed-income funds couldn’t have been starker: the first half of this year saw emerging market bond funds take in a net $5.904bn, as investors were enticed by emerging market debt yields at an average of 4.4%, compared with just 0.46% for developed countries. 

“We believe emerging markets debt looks well positioned to receive inflows of money fleeing low-to-negative rates in developed markets as major central banks turn even more dovish post the Brexit vote. We think it’s time for investors to consider joining this Great Migration,” BlackRock portfolio managers Pablo Goldberg and Sergio Trigo Paz said in their “Emerging Markets Debt Strategy” note in July. “Investors seeking income stability and total return across hard and local currency debt can opt for an unconstrained EM strategy.” 

Margarete Strasser, senior fund manager and head of EMEA at Pioneer Investments Austria, whose “Pioneer Funds Austria - Bond Opportunities 6/2019” was the winner of the “bne IntelliNews Best Fixed-Income Fund 2016” with a return over the year period of 7.00%, noted that: “Increasing oil prices helped Russia in the first half of the year and Turkey performed pretty well until the failed coup – it was the second best performer after Russia in the CEE area.” 

As well as the hunt for yield, there was some tightening on the spreads of the hard currency bonds, while local currency bonds were helped by the better performance of local currencies, many of which like the Hungarian forint, Croatian kuna and Romanian leu are trading higher in 2016. Not so the Polish zloty, which has been hurt by the actions of the populist, right-wing Law & Justice party since it returned to power in the October 2015 elections. 

“Turkey, Romania, Poland, Hungary – these are our key markets, as well as some other markets, as of late we invested quite intensively in Serbia, and almost entirely invested in local currencies, because when we perceive it’s a good time to invest in particular countries, then we are also constructive on the local currency. Put another way, when we are afraid of visibly weak currency prospects, it makes sense to be absent from the bonds,” says Ondrej Matuška, fund manager of Conseq Investment Management’s “Conseq Invest New Europe Bond Fund”, which returned 5.28% during the year period. “Most of these local currency curves are in our view more attractive from a yield perspective than the hard currency yield curves.” 

With yields on average 10 times higher than advanced countries, economies that are growing twice as fast with low inflation, and now fading political risks, it’s not surprising that more money is flowing into emerging market bond funds. “Due to growth concerns focused in Asia and to commodity exporters, CEE had been seen as kind of save haven, supported also by ECBs bond purchase programmes,” says Ronald Schneider, head of bonds, CEE & Global Emerging Markets at Raiffeisen Capital Management, whose Raiffeisen-Eastern European-Bonds fund returned 3.85% during the survey period. “As these concerns have eased during 2016, the focus of investment flows seems to have shifted to EM Asia and Latam again.” 

Pioneer’s Strasser reports inflows on both the retail and institutional side, though the institutions remain more cautious, as investors still see an increasing yield environment in the US, which will hurt emerging markets. Futures now price in a 50-50 chance of a Federal Reserve interest rate hike sometime this year. “But fund managers have to deliver yield, and especially pension funds and insurance companies are now searching for yield in the emerging markets,” she says. 

This is expected to continue, as there is little sign of yields rising in Europe or Japan in the near future, though a US rate hike this year is more likely. Put simply: right now, emerging market debt yields are too attractive to pass up. 

The main problem for emerging market debt investors is finding the bonds to buy with the new money they have to allocate. According to JP Morgan estimates, emerging market companies will sell not more than $220bn this year, with Russian corporates still struggling under sanctions and Turkish companies delaying plans since the failed coup, which is well down on the 2012-2014 period when annual corporate bond sales averaged $355bn. 

“We believe the outlook for emerging markets is still on an improving path, thus, we see greater potential that investors will be able to capture the near 6% coupon offered by the asset class,” said BlackRock. 

The July 1, 2015-June 30, 2016 period for equity funds was another tough one, with most funds in our survey posting negative returns, hurt especially by the second half of last year. That has been a feature for some years now; global emerging markets represented by the iShares MSCI Emerging Markets Index have declined by 15% over the past five years, while European emerging markets represented by the MSCI Emerging Markets Europe Index fell by more than 42% during the same period. 

“2015 was a rough year,” admits Joanna Sawicka, a research analyst with U.S. Global Investors, whose “Emerging Europe Fund” was down almost 13% during the survey period. “Currency devaluation played a major role in the region’s underperformance. Geopolitical tension, falling commodity prices, political turbulence and the rise of populism in Europe all weighed on the region.” 

This year has been little better: until the beginning of August, the Czech stock market was down around 10%, Romania’s about 2.5% and Poland’s 1.5%. “What has happened a few years ago in Hungary is now happening in Poland,” says Martin Pavlík, fund manager of Conseq Investment Management’s “Conseq Invest Equity Fund”, which returned -7.93% during the survey period. “There could be other negative news regarding pension reform in Poland and there is not yet a final version of the plan for the conversion of Swiss franc banking loans.” 

But there are bright spots. Russia’s Micex Index is up almost 14% this year, which is reflected in the performance of Russian funds: Deutsche Asset & Wealth Management’s “DWS Russia” fund was up 2.40%, Pioneer Investments’ “Pioneer Funds Austria - Russia Stock” was up 2.20%, and Raiffeisen Capital Management’s “Raiffeisen-Russia- Equities” fund was up 2.19% during the survey period. 

“Russia has been the best market in our universe year to date,” says Angelika Millendorfer, head of equities, CEE & Global Emerging Markets at Raiffeisen Capital Management, whose Raiffeisen-Russia-Equities fund returned 2.19% during the period. “The swift recovery in the oil price and the stabilization in economic activity supported the stock market and lifted share prices across the board. At this moment it looks like we might have seen the best part of the move. The oil price will set the tone going forward and determine the direction of the Russian market.” 

SEB’s “Eastern Europe Small Cap Fund”, a fund which invests in smaller companies (up to €2bn market cap) listed on the equity markets of Emerging Europe, including Russia, returned 16.57% during the period. “Here at SEB Eastern Europe Small Cap Fund we are bottom-up investors focusing on smaller companies which are often overlooked by the market and we managed to find some excellent gems among them during past 12 months which have delivered the results to investors who trusted us,” Marko Daljajev, the fund’s manager, tells bne IntelliNews. “Regardless of the economic cycle, there are always companies and strong motivated teams that show substantial growth and can give excellent returns to investors who have the patience to wait for more than one quarter. Finding them is what we focus on every day.” 

However, the standout performer was Hungary, whose stock market is up about 14% so far this year, after being up 40% last year, which helped Erste Asset Management’s “Erste Stock Hungary” fund return 19.47% in our survey period, making it the winner of the “bne IntelliNews Best Equity Fund 2016”

“The main factors behind this performance was the big change in the political rhetoric of the Hungarian government at the beginning of 2015,” says Máté Dudás, senior equity fund manager at Erste Asset Management Hungary. “We saw many foreign investors come back to the market and were buying again Hungarian stocks that they kept out of their portfolios for almost three years.” 

“What other markets made in three years, the Hungarian market made in one year,” Dudas adds. 

Hungary’s catch-up over the last year with other CEE markets makes another performance like that an unlikely prospect. U.S. Global Investors’ Sawicka worries that Hungary and Poland could be laggards over the next year. “Hungary’s economy is the most exposed to the UK, and the UK’s vote to leave the EU could have a negative effect on the country. The Polish government has moved quickly with its promised reforms to increase social spending, and the budget deficit could cross above 3% of economic output next year,” she explains. 

Looking at other countries, if the oil price recovers further and sanctions on Russia are removed, that country will continue to outperform, while Romania is attractive, too. “It is one of the fastest growers in Europe with high-paying dividends stocks and a supportive government,” says Sawicka. 

Conseq’s Pavlik is positive overall on the outlook for global emerging markets. “Each country has its specific issues – we know the problems in Brazil, in Russia and the cooling down of growth in China – but the worse is behind them,” he says. 

And the winners are… 

bne IntelliNews Best Equity Fund 2016 – Erste Stock Hungary 

“Erste Asset Management Hungary offers a broad range of mutual funds for retail and institutional clients, as well as discretionary portfolio management for individual clients in Hungary. We are very glad that ‘Erste Stock Hungary’ won bne’s award for the best equity fund in the CEE region. From my point of view, the award has to be dedicated to the Hungarian companies which are trading on the Budapest Stock Exchange, as the fund is tracking the BUX-Index (blue chip stock market index of the Budapest Stock Exchange) very closely. The Hungarian stock market outperformed due to excellent fundamentals and an attractive valuation, especially in comparison to other countries in the CEE region. There has also been a change in government policy, which turned out to be more market friendly. One example is the lowering of the banking tax starting from 2016. Furthermore, there are a number of corporate actions which will improve the business models of the largest stocks such as OTP, MOL or Gedeon Richter. Hence, the outlook for the Hungarian stock market is positive, as the macroeconomic development remains strong and the Hungarian stocks are still trading at a large discount.” – Máté Dudás, Senior Equity Fund Manager, Erste Asset Management Hungary 

bne IntelliNews Best Fixed- Income Fund 2016 – Pioneer Funds Austria - Bond Opportunities 6/2019 

“Although the last year (July 1, 2015 to June 30, 2016) did not bring the expected recovery of global economic conditions, the fund performed very well (+7.0%). The low economic growth and the increase of oil and gas production (fracking!) caused lower demand for oil and a supply surplus at the same time. This contributed to a massive decline in the oil price (Brent) from $72 in June 2015 to approximately $30 in January 2016. Only in the first quarter of 2016 was there a rebound in the oil price, mainly because of the partial covering of massive short positions and a slight decrease in US oil production. Together with the slow recovery of the global economy, the decline of the oil price caused a clear decrease of inflation and interest rates. The announced end of the Federal Reserve’s quantitative easing was an important event in terms of risk appetite and capital flows of international investors. In December, the Fed made the first increase of interest rates. Further hikes, which were expected by the market originally, were priced out again regarding the weak economic growth. Thus, emerging market currencies, especially those with high interest spreads, such as the Turkish lira and Russian ruble, performed well. Our fund has an exposure of 6% to the Russian ruble and 6.6% to the Turkish lira. In line with the rising oil price from January on, investors also started to buy Russian hard currency instruments again. 27% of the fund is invested in Russian bonds. Best performer was Gazprombank (+11.2%).” – Margarete Strasser, Senior Fund Manager, Head of EMEA at Pioneer Investments Austria. 

bne IntelliNews Best Balanced Fund 2016 – ELANA Balanced Euro Fund 

“ELANA Balanced EUR Fund is one of the first mutual funds in Bulgaria with a decade of history. Its strategy is to balance income from debt instruments with growth from the riskier half of the portfolio and look for opportunities mainly on domestic ground, as well as throughout Europe. The ECB's QE program helped fixed-income investment in Europe to post another strong year. With a huge portion of the market trading at negative yields, switching to low-investment grade corporates proved to be a good strategy. We kept our core positions in Bulgarian and Romanian sovereign bonds and added some corporate names. While equity markets saw some wild moves, we focused on simple balance sheets and strong income generation for our equity picks. As risk events including terrorism and Brexit were spooking the market, we were more defensive, reducing duration and staying in quality names, while maintaining high cash balance. This helped us weather the storm, which proved rather short, and allowed us to make some nice entries at depressed prices.” – Ivaylo Penev, Head of Asset Management and member of the Board of ELANA Fund Management