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Source: Pictet Asset Management, CEIC, Datastream, February 2018. *Based on 30 EM consumer prices indices, GDP weighted.
As Fig. 2 below shows, the inflation differential between developed and emerging markets and EM hard currency yield spreads appear closely linked. Even if inflation is expected to pick up modestly in emerging markets, we believe it will rise less than in developed markets, and this supports a further narrowing in emerging hard currency debt spreads.
Source: Pictet Asset Management, CEIC, Datastream, January 2018
As mentioned, one cluster of countries bucking the falling inflation trend is the Central and Eastern Europe (CEE) markets of the Czech Republic, Hungary, Poland and Romania. This is mainly because of wage growth, which has ticked up in all four countries.
Source: Pictet Asset Management, CEIC, Datastream, February 2018
The four markets in the CEE region account for over a trillion dollars of GDP and around 80 million people. Poland is the region’s powerhouse accounting for half of GDP and half of the population. The richest market in terms of GDP per capita is the Czech Republic.
Population, dependency ratios, unemployment and GDP per capita
Source: Pictet Asset Management, CEIC, Datastream
Left chart - Central Eastern Europe unemployment rates (%)
Right chart - Central Eastern Europe minimum nominal monthly wages (EUR)
Source: Pictet Asset Management, CEIC, Datastream, February 2018
Dependency ratio is the percentage of population outside of working age: 0-14 year, 65 years +
Source: Pictet Asset Management, CEIC, Datastream, January 2018
What does this mean for debt investors? Although rising wage growth in the CEE is a sign of strong economic conditions, the risk of central banks falling behind the curve is a threat for the region’s local currency debt.
Overall CEE central banks have been slow to react to inflation. Poland and Hungary in particular have not started the tightening yet. The Czech National Bank was first to hike rates after the removal of the EUR/CZK floor in April 2017.
Romania's current account and fiscal balance (% GDP)
Source: Pictet Asset Management, CEIC, Datastream. Current account January 2017, fiscal balance January 2018.
Although the Bank of Romania began hiking rates in February 2018, we believe the country is the most at risk. As Fig 7 shows it is the only market in the region with a ‘twin deficit’ – trade and current account - which is deteriorating. We believe this increases the pressure on CPI inflation through an expected depreciation of the currency, in addition to the rising domestic inflationary pressures. We expect a more rapid pace of rate increases in the year ahead.
Christmas decorations in Vaci Street, Budapest, Hungary
The CEE region is booming. In our view this is best captured through stocks exposed to consumption and credit, such as banks and consumer companies backed up by strong fundamentals. Valuations here look reasonable, trading at a slight discount to western European markets. In addition, we believe that forward expectations do reflect strong macro growth dynamics.
Change to 2019 net income expectations
Source: Bloomberg, March 2018
As Fig. 8 shows, both financial services and consumer sectors have seen their earnings forecasts upgraded quite consistently over the past year.
Despite the overall positive trend, the market has been paying greater attention to company fundamentals and rewarding those with the strongest growth prospects. In our view, the increasing dispersion of returns between the market's winners and losers is creating a fertile ground for stock pickers.
28.02.2018
Source: Datastream, Bloomberg, data as at 28.02.2018 and in USD. Equity indices are quoted on a net dividend reinvested basis; bond and commodity indices are quoted on a total return basis. The currency rates evolution is treated as a performance calculation based on FX rates.
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