March 6, 2012
|Leigh Innes, lead manager of the T. Rowe Price Emerging Europe & Mediterranean Fund|
Emerging European economies, because of their close proximity and close economic ties to the eurozone, are very sensitive to developments related to the European sovereign debt crisis. Still, emerging Europe offers its own long-term investment opportunities, challenges, and risks, and its markets do not necessarily move in lockstep with those in developed Europe. Leigh Innes, lead manager of the T. Rowe Price Emerging Europe & Mediterranean Fund,* believes that focusing on domestic-oriented companies with strong balance sheets, low leverage, sustainable growth, and attractive valuations will help the portfolio navigate through periods of volatility and political and economic uncertainty while pursuing long-term capital growth. In this Q&A, Innes talks about the major countries represented in the portfolio, as well as the risks and the sectors she favors.
The sovereign debt crisis continues to act as an overhang for emerging Europe, particularly for the Czech Republic and Hungary, which have the strongest economic links to developed Europe. Until we see a resolution or some stabilization, markets in emerging Europe are likely to remain volatile. However, market volatility often reveals good long-term investment opportunities.
We have very little exposure to Central Eastern Europe, where macro fundamentals appear relatively weak and several countries have strong trade links to the eurozone. There is interesting medium-term potential in Poland—where the growth rate is similar to that of Russia and the economy is not as highly exposed to eurozone exports as its neighbors—but stock valuations appear high on a relative basis. In the Czech Republic, which is currently going through a cyclical slowdown, we hold only one stock, Komercni Banka, which has good fundamentals. We have no exposure to Hungary due to its high debt levels and a low growth outlook.
We believe Russia offers the best combination of investment ideas and stock valuations currently among all of the countries in the fund's opportunity set. Our 71% allocation at the end of January was slightly larger than the 66% allocation for the MSCI Emerging Markets Europe Index. Also, the country's macroeconomic situation is favorable. Economic growth in 2012 is expected to be around 3% to 4%, making Russia one of the strongest economies in the region. Other positives include a stable banking system and lower inflation than we've seen for some time.
In addition, Russian equities are trading at a considerable discount relative to their historical values and relative to equities in many emerging and developed markets. Even when adjusting for the large energy weight in the index, Russian equities remain at a significant discount. The weakness we saw in the market in December following the outbreak of protests against the legislative election results has contributed to that valuation discount.
The protests and allegations of election fraud indicate that political risks need to be considered more closely. At this stage, we do not believe that Russia will have an Arab Spring-like upheaval, but political noise may stay elevated beyond March's presidential election. As was generally expected, Prime Minister Putin was elected to become the next president amid a fragmented opposition. While he is something of a known quantity, his ad hoc policies are hard to forecast.
As a major producer and exporter of various raw materials, especially oil, Russia has been a significant beneficiary of higher global oil and commodity prices over the last decade. However, dependence on such resources could make the economy—and the stock market, which is dominated by the energy sector—vulnerable to a significant pullback in prices. In 2010, the energy sector represented 23% of gross domestic product (GDP), 54% of the Russian stock market, and 60% of total exports. Taxation and regulation of the energy sector, from which the Russian government receives approximately 70% of its revenue, are related concerns. While Russia's dependence on oil has increased, partly due to the government's increasing infrastructure spending, the Urals oil price looks sustainable at above $100 per barrel, which should help the government's efforts to balance its budget.
We are showing greater interest in trade-related transportation and infrastructure companies that should benefit from growth in consumer spending and import volumes and, over the next five years, infrastructure spending of up to $120 billion. For example, we hold Global Ports Investment, which is the largest maritime container terminal operator in Russia and should benefit from the evolution of the maritime container market. That market is underdeveloped due to a lack of investment during Soviet times.
We have broader sector diversification in Russia than the MSCI benchmark because we believe that better serves our investors' long-term interests. While we currently favor gas companies over oil firms, we are underweighting the Russian energy sector as a whole because we feel that consumer sectors, which are underrepresented in the main Russian stock market index, are poised to benefit from the growth of a consumer economy. In particular, we like banks that can benefit from increased borrowing by individuals and corporations, as well as food retailers that can grow at double-digit rates over the next few years. We also have investments in some high-quality metals and mining companies with low production costs.
|Country Diversification (Percent of Net Assets) as of January 31, 2012|
|T. Rowe Price Emerging Europe & Mediterranean Fund
||MSCI Emerging Markets Europe Index|
Turkey, which represents 14% of fund assets versus 13% for the benchmark, has a very strong structural growth story with a young and growing population, a solid banking system, and solid GDP growth. However, a combination of high inflation and an increasing current account deficit coupled with uncertainty over its monetary policy has recently weighed on the market.
The central bank has adopted unorthodox monetary policies—in an attempt to control multiple variables such as inflation, the lira, the trade deficit, and bank lending growth—that may hurt its long-term credibility if they are unsuccessful. Policy changes now take place more frequently than once per month, which can add to interest rate volatility. At present, we expect GDP growth to slow sharply this year, in part because of this unpredictable monetary policy.
The country depends greatly on external financing of its trade deficit, so Turkey is vulnerable to financial shocks elsewhere that trigger global risk aversion and cash flows away from the country. Given the central bank's unusual monetary policy, there is a risk that the economy will slow too much this year and experience a "hard landing."
Our core holdings in the country are banks with attractive fundamentals and good long-term growth opportunities. Unfortunately, bank stocks have struggled over the last year due to the unorthodox monetary policies, and we have trimmed our positions on caution. At present, we like Russian banks more than Turkish banks. We also own a few retailers in Turkey that should benefit from increasing consumer spending over time.
While these peripheral countries currently have no representation in our benchmark, we believe that they offer good long-term growth opportunities and provide us with an opportunity to diversify the portfolio. Ukraine's economy remains highly dependent on demand for its steel and agricultural products. We own MHP, a major poultry producer, and iron ore producer Ferrexpo. Kazakhstan is rich in natural resources and has benefited from growth in oil exports. The banking sector has gone through much restructuring since the global economic crisis, but we own shares of Halyk Savings Bank, which we feel is best positioned to take market share. We also hold shares of copper producer Kazakhmys.
International investing is subject to unique risks, including unfavorable currency exchange rates and political or economic uncertainty abroad. Investments in emerging markets are subject to the risk of abrupt and severe price declines. Diversification cannot assure a profit or protect against loss in a declining market.
The securities mentioned composed 10.1% of the fund's portfolio as of December 31, 2011. The manager's views and portfolio holdings are historical and subject to change. This material should not be deemed a recommendation to buy or sell any of the securities mentioned.