Some Emerging Markets Post Eye-Popping Growth Rates

 | May 17, 2017 | 9:00 AM EDT
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Those who bought emerging markets a year ago have been richly rewarded, as the MSCI emerging markets index is up 30.7% since May 16 last year, according to FactSet data. This performance leaves developed markets, which are on a robust upward path themselves, in the dust, as the one-year return on the MSCI World with Developed Markets Exposure index is 11.7%.

Hindsight is, of course, a wonderful thing. Very few people would have ventured in emerging markets at a time when uncertainty about what interest rates would do to the asset class was high. In 2013, during the "taper tantrum," emerging market assets were hit by withdrawals of funds.

I suggested that people should buy emerging markets back in March last year, when the ascension of this asset class was beginning to show. There is still time for investors to catch some of the growth in emerging markets if they choose their spot carefully.

As the Federal Reserve prepares to raise interest rates again, one region seems to be in a better position than others: Eastern Europe. This region depends much more on interest rates in the eurozone than on those in the U.S. due to its proximity to Western Europe, the main destination of its exports.

The recovery in the eurozone has boosted these economies. In the first quarter they recorded eye-popping rates of gross domestic product growth. Poland, the biggest country in the region, saw its economy advance by 4.1% year on year. Romania, the second-largest, posted 5.6% growth. Hungary's economy expanded by 3.7%, Bulgaria's by 3.4%, the Czech Republic's by 2.9% and Slovakia's by 3.1%.

This was their best performance since 2008, just before these countries (except for Poland) were plunged into deep recessions as they suffered the consequences of capital flight because of the global financial crisis. Their current outperformance looks set to continue for a while.

"We expect growth in the region to remain strong over the course of this year, as the drag from construction sectors continues to fade and as loose fiscal policy filters through," Liam Carson, emerging Europe economist at Capital Economics, a think-tank in London, wrote in a recent research note.

It is relatively difficult for retail foreign investors to get into these countries' equities markets. For Poland, there is the iShares MSCI Poland Investable ETF (EPOL) , which tracks a market-cap weighted index of the broader Polish equity market. There is no ETF for Romania, the stock market of which is expected to be upgraded to emerging market from frontier market this year. However, investors could look for actively managed funds that have exposure to it, such as Franklin Resources (BEN) .

Listed in London is the iShares MSCI Eastern Europe Capped UCITS ETF (IEER:LON), but almost 64% of its exposure is to Russia. While that country's economy is recovering, its dependence on oil prices, the sanctions imposed by the West after the invasion of Ukraine and generally poor corporate governance make it a risky investment. It is true that looking at cyclically adjusted price/earnings ratios, Russian equities are very cheap compared to equities in developed markets, but perhaps they deserve to be.

Those who are in emerging markets for the long run could try to open local brokerage accounts. The process has been made easier and the offers for foreign investors from local brokerages has increased, so it shouldn't be too much of a hassle. This would give investors the freedom to pick their own stocks -- along with the responsibility of checking on their performance, of course.

Generally, institutional investors find these countries' foreign exchange and fixed- income markets more attractive than their equities markets. Bond and forex markets are deeper, with even Romania classified as an emerging, rather than frontier, market in fixed income -- which means its bonds are a relatively liquid asset class.

For currencies, analysts at Oxford Economics looked at real effective exchange rate (REER) deviations from their 10-year averages and found that the Turkish lira (TRY), the Hungarian forint (HUF), the Polish zloty (PLN), the Czech koruna (CZK) and the Russian ruble (RUB) are all below their averages.

However, the analysis found that the Russian ruble's REER is some 15% higher than it should be, taking into account its long-term relationship with crude oil prices. That leaves the other currencies for investors looking for undervalued foreign exchange picks.

Investors should be aware of one key risk for emerging markets this year -- that of tightening credit conditions in China. More tightening would slow growth in the world's second-largest economy and undoubtedly would have an impact on developing countries. But Eastern Europe seems to be more sheltered from this risk than Asian or Latin American countries.

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