Eastern Europe – New Markets in the Old Continent

Europe comprises around 50 countries, 750 million people and an economy similar in size to those of North America and East Asia. When discussing the region, most investors focus on a handful of large developed economies and multinational companies listed on the stock exchanges of London, Paris or Frankfurt. Since the region is so fragmented and multifaceted, this desire to focus on the familiar is understandable. But doing so risks overlooking some of the best opportunities Europe has to offer.

While it is tempting to think of Europe as an economically developed region, much of the east and south-east comprises emerging markets. Members of Platinum’s investment team have a long history of investing in emerging markets. During the 1980s, the firm’s founding members were very active in Latin America and Asia. Since the 1990s we have focused particularly intensely on Asia, devoting significant effort, resources and time to this region. Yet, we had not invested in Eastern Europe until 2014. This begs the questions: why not and what has changed?

1990 – 2008

Following the end of the Cold War, the so-called Eastern Bloc countries worked to adopt Western systems of government and economic management. This was no simple matter. Industrialisation and economic organisation under Communism did not evolve organically. Industrial development was an artificial construct directed by bureaucrats, which was piecemeal in nature and poorly integrated with the local economy, never mind with global markets. Much of the labour and capital engaged in these uncompetitive endeavours needed to be redeployed.

Such transitions entailed considerable confusion, economic turmoil and social upheaval. There was a high risk that the process would derail in any given country. For investors, this is no bad thing. High uncertainty, combined with the potential for rapid growth, often leads to an abundance of attractive investment opportunities.
However, in Eastern Europe, two factors made such opportunities scarce.

Western European investors and companies saw these newly opened-up economies as their backyard. They were familiar with the region, closely tracked the transition processes and scoured them for opportunities. Instances of true neglect, the likes of which we found in South-East Asia following the 1997-98 Asian Financial Crisis or periodically in India, Korea and China, were rare and short-lived. There was tremendous political will to achieve a successful transition on the part of both Western European governments and the ordinary citizens of Eastern Europe. Investors never really lost sight of this and the mood of long-term optimism was rarely shaken.

The other complication was that as a successful transition began looking increasingly likely, domestic economic actors became ever more optimistic. Consumers began to extrapolate their income growth, expecting their incomes to soon converge with those of Western Europeans. Household spending began to increasingly reflect this aspirational level of income, rather than actual earnings. Households were borrowing to live beyond their means with Western European banks only too happy to provide the funds. These imbalances would ultimately result in significant indebtedness and an erosion of competitiveness, similar to what we observed in Asia in the lead-up to the 1997-98 crisis.

What changed post-2008?

In Eastern Europe, these vulnerabilities were laid bare by the 2008-09 Global Financial Crisis and the 2012-13 European Sovereign Debt Crisis. These episodes severely restricted credit availability, forcing households to adjust spending to match their income. Businesses had to adjust to lower levels of activity by cutting staff, cutting hours and cutting wages. The public sector also had to resort to pay and pension cuts. Competitiveness was restored and imbalances righted the old-fashioned way, via the market mechanism. The imbalances were large and hence the recessions were typically severe.

Hungary is one of the more extreme cases. Hungarian domestic demand contracted by 9% in 2009 while Gross Domestic Product (GDP) contracted by 7.5%. Unemployment reached 11%. Property prices fell 25%. The current account deficit fell from 7% to 1% of GDP in 2009 alone.

Allowing markets to adjust is painful but undeniably effective. Admittedly, Hungary is an extreme example, but it is illustrative of what happened in the region more broadly. Today, Hungary is a fiercely competitive economy, as evidenced by the following (recall that 2008 was the previous peak year for economic performance):

1. Hungary’s current account swung from a 7% of GDP deficit in 2008 to a surplus of 6% of GDP in 2017, driven by strength in exports.
2. Direct foreign investment rose from EUR 4 billion in 2008 to EUR 8 billion in 2017, indicative of the appetite among Western European businesses to relocate productive capacity to Hungary.
3. The proportion of working age people participating in the labour force improved from 54% in 2008 to 62% in 2017. Despite this 11% increase in labour supply, unemployment fell from 8% in 2008 to 4% in 2017.

Amazingly, participation among 60-74 year-olds has tripled over this period and they now account for nearly 10% of the workforce. This illustrates just how strong demand for Hungarian workers is in the global economy.

The other big change during 2008-13 was a dramatic reduction in indebtedness across the region. Again, using Hungary as an example, bank loans owed by Hungarian households and businesses were 20% lower in 2017 compared to 2008, yet nominal GDP had grown by 40% over this period. As a share of GDP, private sector indebtedness had just about halved between 2008 and 2017.

Being highly competitive with minimal indebtedness makes Eastern European economies very resilient to economic shocks. Yet, perversely, investor interest in the region has greatly reduced. Before 2008, investors tended to see the region as emerging markets in terms of growth, but as developed markets when it came to risk. The 2008-13 experience unveiled the flaw in this thinking and cured many of their exuberance. At the same time, rising support for populist politicians, push-back against perceived European Union (EU) encroachment, and some steps to undermine the rule of law, freedom of the press and civil institutions have caused scepticism to replace long-term optimism.

Meanwhile, the long-term structural appeal of these emerging economies has not diminished. Like most emerging markets, Eastern Europe offers relatively cheap labour and an abundance of unexploited opportunities to deploy capital. Moreover, they are endowed with other favourable structural characteristics that most emerging markets lack:

• The population is highly educated, allowing them to compete in high valued-added sectors.
• The European Union Structural and Investment Funds provide an unwavering stream of capital to pay for infrastructure and other development projects.
• As EU members or as participants in the accession process, these countries must respect EU principles, treaties and laws. They must also submit to external oversight by EU institutions, including the EU judicial system. Essentially they are ‘importing’ strong, independent institutions which uphold the rule of law, rather than having to develop their own.

The last point is particularly important. The primary reason that most emerging markets fail to ‘emerge’ is that their political, judicial and civic institutions are too weak to prevent elites in business and government from subverting the rule of law in pursuit of personal interests.

So what has changed about Eastern Europe since 2008? Firstly, our concerns around the erosion in competitiveness and rising indebtedness have been comprehensively addressed. Secondly, investor optimism has been replaced with scepticism even though the favourable structural characteristics of these markets remain very much intact. This has piqued our interest in the region.

With this backdrop in mind, we travelled to the region last month, visiting a broad range of companies and government institutions in Vienna, Bucharest, Warsaw and Budapest. Being relatively new to these markets, we adopted a cautious approach and focused on learning and discovery. In what follows, our aim is to give the reader a taste of the kinds of investment themes we were exploring on our trip and what the region has to offer.

Eastern European Consumers

We found abundant evidence that Eastern European households are in excellent financial shape.

Job security is very high and employment prospects are excellent. Unemployment is at record lows throughout the region. More importantly, demand for labour is underpinned by competitiveness in the global labour market, not a temporary overheating of the domestic economy.

Wages are rising 5-10% per year, depending on the country. Hungary is resorting to enticing 60-74 year-olds back into employment. Poland is keeping wage growth relatively low at 4-5%, but had to import 1.3 million Ukrainians on short-term visas to achieve this. Local firms are locked in a struggle to stop workers from migrating west. For example, the entire region is grappling with a drain of doctors and nurses as aging populations in Western Europe compete for their skills.

With minimal inflation and low taxes, this wage growth flows through to hip pockets. Most households also own their homes outright, having received title when Communism ended. This means most people’s monthly expenses do not include any mortgage repayments, interest payments or rent. Without mortgages, most households have very little debt. Finally, many households have significant savings set aside. For example, 45% of property transactions in Hungary do not involve borrowing.

These consumers are confident, have significant under-utilised spending power, and are resilient to economic shocks. Higher interest rates are of little concern to households with little debt. As for a slowing economy, firms typically fire their least cost effective workers first, meaning that the highly competitive workers of Eastern Europe should be more insulated than most. Contrast these consumers to their counterparts in the United States, the United Kingdom and Australia who are tapped out and heavily indebted. Their circumstances could not be more different.

As households in this part of the world enjoy rising incomes and wealth, their demand for financial services, travel and consumer goods will grow. Markets for these goods and services in Eastern Europe remain small and fragmented, and carrying on business there entails significant operational risk. Many large global firms have bigger fish to fry, leaving these markets for local or regional providers.

Lufthansa is not rushing to connect Debrecen, in Eastern Hungary, to the world. ASOS is not going to build distribution centres that enable same-day delivery in the Balkans when it has Western Europe and the United States to fight over. This allows regional firms like low-cost airline, Wizz Air, and fashion-retailer, LPP, to tap these increasingly wealthy yet neglected consumers, largely unchallenged.

Oil Refineries

Eastern Europe’s energy infrastructure was built during the Communist era and designed to process oil imported from Russia. The region has complex oil refineries designed to process the heavy, sour crudes from the Ural and Volga regions. These refineries have considerable flexibility over the feedstock they can process and the mix of outputs they produce.

Such flexibility would be irrelevant if all feedstock types are readily available and demand growth is similar for all outputs. But this is not the case. Demand for mid-distillates (diesel, kerosene) is growing more rapidly than demand for light fractions (gasoline) and heavy products. Complex refineries have greater capacity to increase their mid-distillate yield than simple refineries. Eastern European refiners also have pipeline access to Russian heavy crude which is well suited to producing mid-distillate yields, but can process a range of different crudes if price disparities develop. This will prove advantageous if supply growth continues to be dominated by light crude (US shale), condensate and natural gas liquids.

The other interesting attribute of Eastern European refiners is that they have extensive distribution networks in the region. This is something of a barrier to competition from seaborne imports, with the hinterland being landlocked.

As incomes grow, people will drive more, fly more and buy more goods that need to be trucked around. They will also consume more plastics. These local refiners have a decent lock on these markets, tremendous flexibility in terms of inputs and outputs as well as the capacity to direct less valuable light products to petrochemical manufacturing.

Hydroelectric Power Generators

The Danube River flows through many countries in the region and is an important source of hydroelectric power. Hydroelectric power plants are capital intensive, requiring extensive civil works. However, once built, they produce power from a free input – water. The design life of the turbines is typically 40 years, but with proper maintenance they can last 90 years (and counting). These are fantastic fixed cost assets that are tremendously profitable when power prices rise.

Eastern European electricity markets are connected to the Synchronous Grid of Continental Europe. Pricing is deregulated and domestic power is often priced off German wholesale prices. Power prices in Europe have appreciated markedly in recent years, driven by rising coal and gas prices, a big rebound in carbon prices, and slightly higher demand. Many countries in Europe are moving to phase out coal power plants, which will put pressure on gas prices and increase power price volatility as a source of inflexible production is removed.

Eastern Europe and Austria have some great hydroelectric power assets. There is also some potential for pumped storage to help manage the intermittency problem that will only grow as the share of renewables in the
generation mix increases.

Summary

Eastern Europe has changed markedly since 2008. Investor sentiment has waned while the problems of high indebtedness and eroding competitiveness have been comprehensively addressed. At the same time, the favourable structural characteristics that differentiate these countries from most emerging markets remain in place. The region’s prospects look quite promising though it is by no means without its challenges.
We spent a week travelling in Eastern Europe in November. This was our first trip to a region we had not followed closely in the past. We met a range of companies and found some interesting potential investments, particularly among businesses serving local consumers, such as banks, airlines and retailers as well as oil refiners and hydroelectric power producers. As we are relative newcomers, our approach is cautious and our positions will initially be small as we take time to build our understanding of this part of the world.
 

DISCLAIMER: This information has been prepared by Platinum Investment Management Limited ABN 25 063 565 006 AFSL 221935, trading as Platinum Asset Management ("Platinum"). It is general information only and has not been prepared taking into account any particular investor’s investment objectives, financial situation or needs, and should not be used as the basis for making an investment decision. You should obtain professional advice prior to making any investment decision. The market commentary reflects Platinum’s views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Platinum as to their accuracy or reliability. To the extent permitted by law, no liability is accepted by Platinum or any other company in the Platinum Group®, including any of their directors, officers or employees, for any loss or damage arising as a result of any reliance on this information.