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Special report: Emerging markets

Investors giving more respect to overlooked parts of Europe

Established countries offer welcome boost to less developed neighbors

Ulle Adamson is bullish on Central and Eastern Europe, with low inflation and double-digit wage growth contributing to increased consumer spending.

Central and Eastern Europe could be a successful bet for emerging markets investors this year, thanks to growing domestic consumer wealth and the countries' proximity to an improving developed Europe.

Money management executives said they are beginning to increase exposure to a wider swath of Central and Eastern Europe — Poland, Hungary, the Czech Republic and Romania — following solid performance for the regions' equities markets. The MSCI Emerging Market Eastern Europe index returned 17.21% last year and 37.79% in 2016, compared with -4.69% in 2015.

Sources said the outlook is so strong because of the region's economic reliance on developed European economies, which are expected to continue to strengthen in 2018.

"We increased our allocation to Central and Eastern Europe in September," said Ulle Adamson, vice president and portfolio manager of the emerging Europe equity fund at T. Rowe Price in London. T. Rowe Price upped its exposure to Romania to 4.99%, from 3.13%. It also increased exposure to Hungary to 4.89%, from 4.40%. Earlier in 2017, the fund increased allocation to Poland and Czech Republic to 9.68%, from 4.73% in 2016, and to 2.38%, from 1.28%, respectively.

Ms. Adamson said the fundamentals in the region look solid: Fueled by double-digit real wage growth, consumer spending is driving economic growth.

"The inflation is low and the unemployment is low. These conditions paired with strong prospects of growth in Western Europe could mean more global funds becoming interested in the region," she said.

T. Rowe Price had $181.3 million in its Eastern European fund as of Nov. 30.

Russia, too, is catching the eye of money managers due to improved fundamentals and the central bank's effective management of inflation, sources said. Russian equities returned 4.48% in the fourth quarter of 2017, compared with 0.08% for the whole of 2017, according to MSCI data.

Expansion in Russia

Russia's attractiveness to money managers is no longer a reflection of trends in global commodity markets.

Although the outlook for oil prices is positive for 2018, sources said better opportunities exist in consumer-driven sectors, in particular the stock of domestic retailer Magnit PJSC. Because of this, managers with specialist Eastern Europe strategies said investors could end up getting value out of investing in Russia, even when commodity markets are down.

"After a weaker year, (the) Russian market started to move towards a recovery in December," said Julian Mayo, director at Fiera Capital Corp. in London.

"Higher interest rates pushed inflation down to some 4%. The costs of trading were high. But a fall in interest rates had a leverage effect on stock prices in Russia," Mr. Mayo said. Fiera Capital, formerly Charlemagne Capital, had €104.8 million ($126 million) in assets under management in its Eastern European strategy.

At Pictet Asset Management, "we like Russia because of its high beta, cheap valuation and expectations for commodity price to rise next year on weak dollar, late-cycle asset class," said London-based Luca Paolini, chief strategist. The Swiss money manager has €149 million in its emerging Europe fund, which invests in Russia and Turkey.

Even trade sanctions on Russia, which were renewed for an additional six months by the U.S. and European Union in mid-2017, did not stop the improving investment opportunity in Russia, supported by central bank policy.

In addition to retailers like Magnit, Russia provided interesting pockets of opportunity last year in e-commerce companies such as Yandex N.V.

Asia instead

However, some global and European managers that previously invested in the region increased allocations to Asia at the expense of Eastern Europe.

"Asian countries are showing better value for global managers, (to) which (managers) have increased their exposure at the expense of Eastern European countries," said Kathryn Langridge, senior managing director and head of global emerging markets equity at Manulife Asset Management in London.

Manulife has $1.14 billion in the global emerging markets equity strategy managed by Ms. Langridge.

Managers in Asian markets can capture consumer-driven growth opportunities on a larger scale than in Eastern Europe, sources said.

"That scale is missing in Eastern Europe, where consumer patterns are changing much more slowly and on a smaller scale," Ms. Langridge said.

Some managers said they do not consider Eastern Europe a "huge" opportunity because of the lack of depth of stock markets in the region.

Ian Smith, portfolio manager at AXA Investment Managers U.K. said that "earlier in (2017) we held a position in Polish insurer, PZU but by November we had no exposure (to Central-Eastern Europe.)"

"However, we are (still) watching the region with interest and trying to identify good companies that are undervalued by the market and that are set to benefit from the broadly improving backdrop," Mr. Smith said.

Going further into 2018, more investment opportunities could open up in the region for investors looking to get in to equity, money managers said. The more recently vulnerable Turkey, due to political instability could be one of them if inflation comes down next, sources said.

Mr. Paolini said "pure value could be found in Turkey as it scores well on both growth and valuation but political risks are too high for us to get involved at the time being.''

On the fixed-income front, debt managers continue to hold government bonds of Central and Eastern European countries as yields don't disappoint.

Poland's 10-year Treasury bond yield stood at 3.34% as of Jan.11, 2018, while Hungary's counterpart was 2%. This compares with 0.5% yield on 10- year German bund and 0.8% on a French oat.

Not even the ongoing risks associated with populist governments in countries such as Poland and Hungary in 2017 made managers sell these bonds. It remains to be seen if the December decision by the European Commission to punish Poland with sanctions restricting access to EU structural funds — a major source of economic growth — will affect the value of these assets.

"Polish bonds do well as the Polish economy is incredibly integrated to Germany," said David Zahn, head of European fixed income at Franklin Templeton (BEN) in London. "The yield outlook is positive as fundamentals are in much better shape than many eurozone countries."

Franklin Templeton European €540 million total return fund had a 6.67% allocation to Poland as of Nov. 30, 2017.