Following a highly turbulent year for regional markets in 2008, there are better prospects for 2009 believes Elena Shaftan, head of Jupiter's Emerging European Equities team. 

She says: "In the short term, markets often overshoot, with excesses of optimism or pessimism temporarily driving share prices above or below fair value. We think that recent turmoil has led to excessive levels of risk aversion, creating a historic opportunity to buy shares in solid businesses with excellent long term growth prospects at valuations that are still exceptionally attractive, even after the recent rally in our markets."

"Since February, fears have already started to subside, with regional currencies and stock markets rebounding as investors realise that concerns over short term debt levels in the region were overdone."

"The panic had been stoked by press articles that exaggerated the scale of the debt problem on the basis of misinterpreted data. For example, some of the figures quoted counted loans made by foreign-owned local banks as external debt - yet the bulk of these loans are funded by local deposits, which are clearly a much more stable source of financing."

"It's important to place the figures in context. Gross external debt in the region is around $1.36trillion, or 45% of GDP - this is in fact many times smaller than in the UK, which has gross external debt of $10.7trillion, or about 350% of GDP."

"For most East European economies, net external debt is about half the size of their economies - a similar level to West European countries - while public and household debt is on average well below Western levels."

"The fund has for several years focused on stronger regional economies - Russia, Poland, the Czech Republic and Turkey - whose short term external debt is relatively small compared to GDP (on average less than 20%), and is largely covered by reserves. Some of the peripheral countries (Ukraine, Hungary, the Baltic states and the Balkans) are in a weaker position. We currently have minimal exposure to these markets, due to our concerns about the state of their economies given their excessive dependence on capital inflows and exports."

"However, we note that these countries are receiving external support that should enable them to cover short-term funding gaps. We also believe that Western governments and financial institutions have strong incentives to help safeguard financial stability there, given the significant investments of West European banks in the region."

"Meanwhile the structural factors underpinning long-term growth in Eastern Europe remain in place: taxes remain low and labour costs are well below Western levels, especially following the recent currency movements. Furthermore, regional economies are still significantly underleveraged, with total mortgage debt of only 1,500 EUR per capita - less than 5% of the level in the UK. Consequently, consumers do not face the same debt overhang as in developed markets, giving them greater scope to maintain consumption in the short term and to increase it in the future."

"We believe that the Russian stock market in particular has the potential to outperform this year. The factors that drove the market down last year - the devaluing rouble, falling oil prices and forced selling by over-leveraged domestic investors - have largely played out. Valuations are highly attractive - Russia is trading at a discount of about 45% to global emerging markets. Consequently, we have been steadily adding to our positions. Russia is one of the few markets globally to deliver double digit positive returns so far this year, and we feel that this is only the beginning."

Elena suggests that rouble stability, following the completion of a managed devaluation towards the end of January, is a significant positive factor for the Russian market.

She says: "The rouble should be defendable at the new level, provided that oil remains above $40/bbl. This reduces capital outflows, particularly the speculative holding of dollars, allowing funds to flow into the real economy and creating scope for economic indicators to improve. Companies no longer have an incentive to delay activity, and can start returning towards more normal levels of production."

"Importantly, the central bank has been able to defend the currency without materially depleting reserves, which have stabilised at around $380bn-$390bn. At this level, reserves exceed Russia's entire short-term public and private sector debt - putting the country in a strong position to ride out the crisis."

Like most large economies, including the UK, Russia will see some contraction in output this year - but despite these short-term pressures, Elena believes that domestic consumption could show some resilience.

She says: "There is little doubt that the reduction in export revenues due to falling commodity prices is putting some pressure on income and employment. However, much of the windfall from last year's high oil prices was saved by the government into the reserve fund, which limited its effect on the real economy. Oil demand is relatively inelastic, and as a consequence, Russian oil export volumes have held up well - in contrast to the situation faced by some other emerging countries that are geared towards falling Western consumer demand which has led to a collapse in their exports." 

"In the meantime, there are several factors that will support domestic consumption in the medium term. Russia is an under-consuming country; car ownership, for example, is half the level in Poland. Russian households have low levels of debt, just 10% of GDP, compared to 100% in the UK, while labour costs are even more competitive than Eastern Europe, suggesting scope for incomes to rise faster in the future. Also, the government's commitment to significant infrastructure spending will help to support demand over the next few years."

Elena and her team have increased exposure to Russia across their portfolios from 30% to around 45% at the end of March 2009 due to the improved outlook, and believe that the Russian market remains cheap even after recent gains. She says: "Regional markets have started to recover, but valuations are still far from reflecting the mid-term growth potential of Eastern European economies. I believe there is a real possibility of positive surprises this year as expectations have become excessively low. The aftermath of a financial crisis can create opportunities for equity investors, as valuations are driven to unjustifiably cheap levels relative to earnings that are at the bottom of the cycle. For example, investors who bought Russian equities in the wake of the 1998 crisis saw their capital increase more than fivefold over the subsequent five years. We think that over time, fortune could continue to favour the bold."

Further information:
Elena Shaftan heads Jupiter's Emerging European Equity Team. The team manages the £295m Jupiter Emerging European Opportunities Fund (unit trust) which invests primarily in central and Eastern Europe.

The team also manages the ?49m Jupiter New Europe Fund (SICAV). This Fund has a more flexible investment policy, investing in companies in Central and Eastern Europe, Russia, Turkey and non-European former member states of the USSR. It may also invest in Western companies that are considered to benefit from exposure to these countries.

NOTE
This commentary is intended for investment professionals only and not for the benefit of private investors. Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM) are both authorised and regulated by the Financial Services Authority and their registered address is 1 Grosvenor Place London SW1X 7JJ. They are both subsidiaries of Jupiter Investment Management Group Limited and the group is collectively known as "Jupiter". The above commentary represents the views of the Fund Manager at the time of preparation and may be subject to change and this is particularly likely during periods of rapidly changing market circumstances. Their views are not necessarily those of Jupiter and should not be interpreted as investment advice. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given.