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EM Monitor: Central Eastern European economic growth

July 2019

Central European economies: decoupled from the Eurozone

Central European countries are defying Eurozone weakness with strong rates of growth. What is the reason and how can investors benefit?

Central and Eastern European economies have managed to generate surprisingly robust growth rates and seem to have decoupled from the Eurozone slowdown. Their resilience can be attributed to buoyant domestic demand, led by consumer credit. How long can the boom last and how can investors benefit?
Rising Consumer credit in CEE4 countries
Fig.1 - CEE4 household consumer credit growth
CEE4 household consumer credit growth

Source: Pictet Asset Management, CEIC, Refinitiv, data to April 2019

There are three aspects to consider.

1. Tight labour market conditions

Very tight labour market conditions resulting from record low unemployment rates and strong employment growth are boosting consumer spending (see  Fig.2 and Fig.3 below).
Falling unemployment and rising employment lead to tight labour market conditions
Fig.2 (left) - Unemployment rates / Fig.3 (right) - Employment growth
Unemployment rates and Employment growth

Source: Pictet Asset Management, CEIC, Refinitiv. Left: Hungary and Romania data to March 2019; Poland data to April 2019; Czech Rep. data to May 2019. Right: Czech Rep. and Hungary data to March 2019; Poland and Romania data to April 2019.

This has transmitted into strong nominal wage growth in all CEE4 countries: from 7.1 per cent for the Czech Republic, to 21.6 per cent in Romania – in strong contrast to the Eurozone’s 2.4 per cent.
Unlike in the Eurozone, Wages in CEE4 countries have been on the rise

Fig.4 - Nominal wages, % Y/Y, 6mma

Nominal wages in CEE4 countries

Source: Pictet Asset Management, CEIC, Refinitiv. Data to March 2019 for the Czech Rep., Hungary and the Eurozone. Data to April 2019 for Poland and Romania.

2. From wage to consumer price inflation

The second part of the transmission channel, from wage to consumer price inflation, has also materialised in the CEE4, unlike in the Eurozone. Both headline and core inflation rates have picked up (see below).
Strengthening wages feeding through to inflation
Fig.5 - Average of headline & core CPI, % Y/Y
Average of headline & core CPI

Source: Pictet Asset Management, CEIC, Refinitiv. Data to May 2019 except for the Eurozone which is as at June 2019.

3. Central banks

With inflation pressures creeping up, central banks would be expected to ramp up measures to contain inflation. However, this has been the missing piece of the puzzle so far, except in the Czech Republic and, to a limited extent, in Romania.
Central banks slow to respond to inflationary pressures

Fig.6 (left) - Central banks key policy rates / Fig.7 (right) - Romania CPI & PPI inflation

Central banks key policy rates; Romania CPI & PPI inflation

Source: Pictet Asset Management, CEIC, Refinitiv. Left: all data as at June 2019 except for the Eurozone which is as at May 2019.
Right: PPI inflation as at April 2019, CPI inflation as at June 2019.

The most worrying example is Romania, where inflation has surged above the targeting range (see fig.7 above on the right), after the central bank started normalising monetary policy last year but then paused the tightening stance.

Investors in the CEE4 economies will need to watch out for a normalisation of monetary policy soon. This is justified by the upbeat domestic conditions which are feeding into higher core inflation. The Eurozone would have wished to be in this case, but finds itself at the other end of the spectrum. Nevertheless, investors also need to watch out for some economies at risk due to rising current account deficits, deteriorating public finances and increasing public debt. This is particularly the case in Romania and Hungary.

Conclusion

CEE4 countries’ wage-driven growth has made them largely immune to the slowdown in the Eurozone. We believe this provides investment opportunities, especially in the equity space (see next section).
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THE VIEW FROM OUR EMERGING EUROPE EQUITY TEAM

By Christopher Bannon, Senior Investment Manager, Pictet Emerging Europe

Whilst a rising tide lifts all boats, a booming economy does not always lift all stocks – and this is very much the case across CEE4 economies. Taking Poland for instance, the year-to-date underperformance of index heavy-weight sectors, i.e. financials and energy, has been striking versus the very strong outperformance of the mid-cap space of consumer staples and communication services.

Consumer-driven sectors leading the way up

Fig.1 - MSCI Poland indices

MSCI Poland indices

Source: Pictet Asset Management, Bloomberg L.P., as at 30.06.2019

Consumer-led growth has come at the expense of banks and energy firms – the fiscal funding source of expansionary policy.
Moreover, CEE4 markets are expensive relative to benchmark peers* Russia and Turkey (see chart below).
CEE4 markets are expensive compared with benchmark peers*
Fig.2 - CEE4 valuations
CEE4 valuations

Source: Pictet Asset Management, Factset, as at 30.06.2019

As a result – we view CEE4 economies as stock picking markets where we invest selectively and with high conviction. Today, we hold positions predominantly in Polish companies exposed to consumer spending, eschewing financials and banks.