Nicholas Watson in Prague -

The returns of ING Investment Management's Invest Emerging Europe fund gives a fair reflection of how the region's markets have developed over the past five years: growth peaking at a remarkable 70% in 2005 before falling to more normal emerging market levels and finally entering negative territory in the wake of the sub-prime mortgage crisis. That's not to say, stresses Gus Robertson, senior portfolio manager of emerging markets equity at ING, that the emerging Europe story is over - far from it.

"We enjoyed over the last few years going into 2004, 2005 and 2006 a considerable amount of re-rating," says Robertson. "We've more or less moved on from that, so from hereon in it'll be much more about earnings growth, which makes it more difficult to see the types of return like the 66% seen in 2005."

What was driving a large part of the re-rating was the increase in appetite amongst investors in general for emerging market risk. According to EPFR Global, which provides fund flows and asset allocation data, the amount of money that flowed into global emerging market funds reached $125bn in 2006 and almost $150bn in 2007, even as funds investing in the US, Europe and Japan began suffering outflows.

In the summer of 2007, however, the housing slump in the US and attendant credit crunch caused an immediate de-risking of emerging markets and in the space of six weeks, what had been record inflows into emerging markets and emerging Europe were wiped out. "We haven't really recovered the momentum going into that period," says Robertson.

The important question going forward is when that marginal investor - not the dedicated emerging market investor - will return to the market. This type of investor was instrumental is helping emerging markets achieve their incredible returns, but at the first sign of trouble was quick to pull money off the table and put it back into the now more cheaply valued stocks in the developed markets of US, Western Europe and Japan.

What may tempt that investor back sooner rather than later is if emerging markets continue to hold up relatively well during the current crisis. While Robertson says there are signs that the economies of emerging Europe could be decoupling from the US and Western Europe, it's still too early to say their stock markets have too. "What we've seen in the last few months shows that emerging Europe economies might be decoupling, but stock markets aren't mature enough in emerging markets to decouple," says Robertson. "When it gets risky, people take money off the table and that's why we see countries where the risk perception, such as those with large current account deficits, suffer most."

Indeed, the Baltic states, Bulgaria and Romania, which all have large current account deficits, are still enjoying robust growth, but have their seen their stock markets suffer as investors take fright. The BET index of Romania's top 10 companies has lost some 25% since the beginning of 2008, while the BET-FI index of financial investment companies declined by more than 30.5%.

"You could argue that emerging markets should be seen as more of a safe haven than we have indeed witnessed, but we aren't ready for full stock market decoupling yet. Perhaps over the next six-12 months if we see stability in Russia and other markets hold up very well and show strong growth, then perhaps investors will come back, saying 'yes we believe in these markets.'"

Russian story

Russia is the country that Robertson is most bullish on. "In Russia we're overweight, so yes we're bullish on Russia. It's definitely one of, if not the, most interesting investment opportunity in the European space over next 10 years."

On the macro side, Robertson cites the Russian government's strong balance sheet and foreign exchange reserves approaching $500bn. "And we're quite comfortable with the political situation there. [President-elect Dmitry] Medvedev is a reformist, a market friendly guy, and it's a positive appointment," says Robertson. On the negative side, there are the perennial problems of corruption and fraud, but they're "moving to a slightly better situation than worse."

In terms of sectors, Robertson says he's more comfortable with the gas part of the energy sector than oil. The latter is suffering from aging fields and infrastructure, while its costs in rubles are growing as revenues denominated in dollars are falling. The gas sector, meanwhile, is set to enjoy better earnings from the government's decision to liberalise prices for consumers. "Gas is more interesting than oil names. The operating environment in oil is becoming slightly more challenging," he says.

In Central Europe, Robertson sees domestic demand driving earnings of companies in Poland, the Czech Republic and Slovakia - though the exception here is Hungary, which is suffering from economic problems and political instability.

For example, annual retail sales in Poland rose in February by 23.8%, their fastest annual pace in almost four years and up from the 20.9% growth seen in January. "On top of that you've got structural funds from EU. In Poland this is huge, over €80bn over the next few years. Investment of that money will drive the economy and earnings growth will filter through the economy."

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