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.
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.
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.
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.
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.
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.
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.
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