CEEing opportunities in banks

June 14, 2024

Warren Hyland and Mark Robinson discuss the key themes and topics in emerging markets and what investors should look for in the month ahead.

The big story: Banking on CEE growth

The growth backdrop for Central and Eastern Europe (CEE) is positive.¹ The region looks set to benefit from solid economic growth momentum, increasing wealth and ever-closer integration with the European Union.² This trend is already being reflected in the stability of the region’s sovereign ratings, which in some cases are comparable to Western Europe; France and the UK have the same rating as the Czech Republic (Figure 1).

Figure 1: CEE sovereign rating stability

Source: S&P ratings, Bloomberg, as of 31st May 2024. Latest available data used. For illustrative purposes only.

In recent years, several CEE countries have adopted the euro. Croatia is the latest to join³ and Bulgaria could be next.⁴ Membership of the common currency bloc reduces any FX-related volatility that used to be a defining feature of the region. Meanwhile, those that remain outside the euro indirectly benefit from the currency stability in their surrounding trading partners.

As well as these tailwinds, CEE banks are benefiting from improving regulation due to implementing the EU’s Capital Requirements Regulation, as well as oversight from the European Banking Authority (EBA) and/or the European Central Bank’s Single Supervisory Mechanism.⁵ As a result, we believe CEE banks present interesting investment opportunities across emerging and developed markets.

Sound fundamentals

CEE banks operate in less-indebted jurisdictions (Fig. 2), are often less levered than their larger Western European peers (Figure 3) and typically have stronger liquidity positions (Figure 4).

A number of these banks are subsidiaries of Western European parent banks, meaning they have inherited good-quality loan underwriting standards and solid governance controls. There is now a well-populated universe of relatively large local names, with significant domestic market share and pricing power. Their corporate lending includes exposures to significant, ‘household name’ Western European corporates (such as Volkswagen Group), which have factories or offices in Eastern Europe.

Consequently, almost all of the CEE banks we cover are investment-grade rated at the senior unsecured bond level. Some of these banks possess credit ratings that are the same as, or higher than, their Western European parents, such as Austrian banks and their Czech subsidiaries.

Due to improved governance and credit metrics, 70% of banks in our coverage universe have experienced credit rating upgrades within the past five years.

Indeed, two independent CEE banks, OTP Bank and PKO Bank Polski, were included in the European Banking Authority’s biennial stress-testing exercise and performed well under the modelled stress scenario. For investors, this provides added reassurances these banks could withstand a significant downturn.

Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy and should not be construed as investment advice or investment recommendation of those companies.

Yield pick-up

The CEE bank investment universe grew rapidly from 2022-23 due to EU regulations that required all banks to issue “bail-in” debt instruments by January 1, 2024. This meant more banks were incentivised to issue benchmark-sized bonds in euros. The outbreak of the war in Ukraine also created a de-risking tone in European markets, particularly in CEE. 

These two factors led to relatively unknown CEE banks (at least, not well-known in a wider European context) being forced to issue investment-grade senior unsecured bonds at wide spreads, and therefore high yields, despite their good underlying credit quality.

The bonds subsequently outperformed as European investors became more comfortable investing in this peer group.⁶ However, we believe CEE bank senior bonds still offer a significant yield pick-up over both senior and subordinated bonds issued by Western banks.

Past performance is not a reliable indicator of current or future results.

Insulation from regional conflict

One concern about the region is its proximity to Russia and Ukraine, and the spillover effects the ongoing conflict may have on the region’s politics, economies and energy supplies.

However, the first round of sanctions against Russia came into effect in 2014. CEE banks have already had ten years to hone their systems and controls in relation to this issue and are well-versed in avoiding sanctioned individuals and entities.

Most CEE banks we cover have little/no direct exposure to Russia. For the remainder, the European Central Bank has become more vocal in encouraging them to run-down their portfolios.⁷

The CEE bloc has also started to reduce its purchases of Russian energy. Slovenia and Bulgaria have reduced their reliance on Russian gas by more than half, to 50% and 20% of their respective net gas imports.⁸ Many former Soviet bloc countries chose to join NATO after the collapse of the USSR,⁹ and are protected from any escalation in the Ukraine conflict.

CEE banks are now more deeply integrated into Europe than ever before in healthy and growing economies. Leverage is low, and the sector has also benefited from stronger regulation and increasing trade with the rest of Europe. In our view, this positive backdrop presents a compelling opportunity for EM and DM investors.

The month in credit: Make hay in May? 

Contrary to expectations, risk assets performed well in May. Credit outperformed government bonds, and spreads tightened.¹⁰ The US government curve bull flattened, with the long end outperforming on the back of a reduction in rates volatility against a higher-for-longer narrative. Meanwhile, European government bonds underperformed the US, with yields rising across the curve as expectations of a June rate cut seemed already discounted in the market.

EM corporates outperformed their sovereign counterparts, given the weakness in the sovereign high yield (HY) universe, notably in Ecuador and Argentina. Within corporates, HY outperformed investment grade (IG), due to the very strong performance of Asia HY, led by China, which benefited from its latest policy initiatives and higher coupon and spread tightening.

Chinese authorities announced a new set of measures to address oversupply in the property market. A RMB300bn (US$41.3 billion) re-lending facility to commercial banks will be used to provide RMB 500bn for local governments and state-owned enterprises to purchase housing stock to be converted into affordable housing.¹¹ While this is below estimates of the total amount needed to bring the housing market into balance, it is a positive policy signal so soon after April’s Politburo meeting and ahead of July’s Third Plenum.

Within single Bs, the homebuilder sector (boosted by the above recent policy initiatives) prevailed, while the largest driver for BBs was Mexico’s Pemex. Longer-duration (20 years plus) IG outperformed due to the US government curve bull flattening. Consumer goods were led by strong performance from beef producers, while banks were weaker given their short duration bias.

By region, Latin America outperformed in IG, led by super long-dated Brazilian securities. Europe, Middle East and Africa (EMEA) underperformed, in line with weaker European government bonds, and due to the region’s high-quality/low-beta characteristics.

Primary issuance amounted to around US$33 billion; quasi sovereigns were the most active (38%), followed by corporate IG (33%) and HY (29%).¹²

Change afoot in South Africa

The busy election year continued with South Africa dominating news flow. The election has reshaped a political landscape dominated for three decades by the African National Congress (ANC), led to power by Nelson Mandela in 1994.

The ANC has lost its parliamentary majority for the first time, with only about 40% of the national vote.¹³ A tie up with the market-friendly Democratic Alliance would likely be seen positively by markets while coalescing with the populist MK party or Marxist EFF will likely be seen as a negative.

Against the backdrop of India’s mammoth election activity, S&P raised its sovereign credit rating outlook on the country to positive, citing the economy’s growth momentum over the next 2-3 years.¹⁴ The India election results were announced on June 4.  While the ruling BJP party led by Prime Minister Modi was victorious, it won by a smaller than expected margin, losing its parliamentary majority.

However, we expect policy continuity with an emphasis on infrastructure and a policy of attracting inward investment, particularly in the manufacturing sector.

Mexico's presidential election campaign closed with Claudia Sheinbaum becoming elected as the country’s first female president after beating her closest rival, Xóchitl Gálvez.¹⁵  Sheinbaum was elected by an overwhelming majority, which could have significant implications for Mexico.

Positive ratings activity was seen in Turkey, which was upgraded to B+ on economic rebalancing and put on a positive outlook.¹⁶ Meanwhile in Latin America, Moody’s revised its rating outlook for Brazil to positive.

With inflation concerns in emerging markets considerably less pressing than developed markets, rate-cutting activity continued with a 50bps cut by the National Bank of Hungary, bringing policy rates down to 7.5%. Chile also cut by 50bps, bringing the policy rate down to 6%. Mexico’s central bank voted unanimously to leave policy rates at 11%. 

Saudi Arabia announced plans to formally launch a secondary offering of shares in oil giant Aramco, a deal that could raise more than US$10 billion and rank among the largest of its kind in recent years.¹⁷ The UAE and Saudi Arabia both gave support to Pakistan, providing a counterweight to China.¹⁸ 

In ignoring the commonly uttered phrase “don’t fight the Fed”, the Philippines central bank warned it will intervene in the currency market after the peso dropped past the key 58-per-dollar level, following signals the central bank may begin rate cuts ahead of the US Federal Reserve. Authorities will step in “when necessary to smoothen excessive volatility and restore order during periods of stress,” said central bank governor Eli Remolona.¹⁹

Indonesia, another country impacted by the higher US rates narrative, managed to post 5.11% GDP growth in the first quarter year-on-year, up from a 5.04% expansion in the fourth quarter of 2023, driven by government and household spending.²⁰

AI euphoria continued in May in Asia. South Korea’s Hynix, a key supplier to NVIDIA of high bandwidth memory (HBM) chips used in AI chipsets, announced it had sold out its production for 2024.²¹

In Latin America, political upheaval continued in Peru, where congress rejected all three impeachment motions filed against President Dina Boluarte.²² Her approval rating fell to a new low, with only 5% of people indicating they supported the president.²³

A senior Colombian court rejected the government’s request to postpone paying back unconstitutional royalty taxes to oil and mining companies, further straining the country’s finances. The decision means the government will have to pay back the money it received, with a fiscal impact estimated at US$1.7 billion by the Finance Ministry.²⁴

Meanwhile, in Argentina, the lower house of Congress approved the omnibus bill. The bill, along with its approved labour reform counterpart, will now move for approval to the Senate.²⁵

Finally, moving to Eastern Europe, the EU Commission closed its Article 7 procedures against Poland, after confirming it has ended a long-running conflict with the country over its concerns around the rule of law in the country.²⁶

Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy and should not be construed as investment advice or investment recommendation of those companies.

EM Calendar

Source: Muzinich & co as of May 2024. For illustrative purposes only.

Credit

 

 

 

Past performance is not a reliable indicator of current or future results

Source: ICE data platform. as of 31st May 2024. EMGB - ICE BofA Emerging Markets External Sovereign Index EMCB - ICE BofA Emerging Markets Corporate Plus Index,  EMIB - ICE BofA High Grade Emerging Markets Corporate Plus Index, EMHB - ICE BofA High Yield Emerging Markets Corporate Plus Index, Q690 - ICE BofA Custom Emerging Markets Short Duration Index, EMRA - ICE BofA Asia Emerging Markets Corporate Plus Index, EMIA - ICE BofA High Grade Asia Emerging Markets Corporate Plus Index, EMHA - ICE BofA High Yield Asia Emerging Markets Corporate Plus Index , EMRL - ICE BofA Latin America Emerging Markets Corporate Plus Index, EMIL - The ICE BofA High Grade Latin America Emerging Markets Corporate Index, EMHL - ICE BofA High Yield Latin America Emerging Markets Corporate Plus, EMRE - ICE BofA EMEA Emerging Markets Corporate Plus Index, EMIE - ICE BofA High Grade EMEA Emerging Markets Corporate Plus Index, EMHE - ICE BofA High Yield EMEA Emerging Markets Corporate Plus Index,. Index performance is for illustrative purposes only. You cannot invest directly in the index. Indices selected provide best proxy for highlighting performance of emerging market corporate bonds. For illustrative purposes only. 

Yield to Worst

Past performance is not a reliable indicator of current or future results

Source: ICE data platform. as of 30th April 2024. EMGB - ICE BofA Emerging Markets External Sovereign Index EMCB - ICE BofA Emerging Markets Corporate Plus Index,  EMIB - ICE BofA High Grade Emerging Markets Corporate Plus Index, EMHB - ICE BofA High Yield Emerging Markets Corporate Plus Index, Q690 - ICE BofA Custom Emerging Markets Short Duration Index, EMRA - ICE BofA Asia Emerging Markets Corporate Plus Index, EMIA - ICE BofA High Grade Asia Emerging Markets Corporate Plus Index, EMHA - ICE BofA High Yield Asia Emerging Markets Corporate Plus Index , EMRL - ICE BofA Latin America Emerging Markets Corporate Plus Index, EMIL - The ICE BofA High Grade Latin America Emerging Markets Corporate Index, EMHL - ICE BofA High Yield Latin America Emerging Markets Corporate Plus, EMRE - ICE BofA EMEA Emerging Markets Corporate Plus Index, EMIE - ICE BofA High Grade EMEA Emerging Markets Corporate Plus Index, EMHE - ICE BofA High Yield EMEA Emerging Markets Corporate Plus Index,. Index performance is for illustrative purposes only. You cannot invest directly in the index. Indices selected provide best proxy for highlighting performance of emerging market corporate bonds. For illustrative purposes only. 

References

1.IMF World Economic Outlook, as of April 2024 International Monetary Fund regional office for Central, Eastern and Southeastern Europe,
2.Regional Economic Outlook, as of 19th April 2024.
3.European Commission, Economy and Finance, as of 1 January 2023.
4.Bloomberg, as of 11 March 2024 “Donohoe looking forward to Bulgaria joining Euro in 2025”
5.European Central Bank, Banking Supervision, List of supervised entities, as of 1st March 2024
6.Muzinich analysis, as of June 2024
7.Politico, as of 30th April 2024. “Europe’s banks retreat from Moscow, with the ECB at their heels”,
8.Eurostat energy database, data for 2023 (via UniCredit Research)
9.CEE NATO members include Albania, Bulgaria, Croatia, Czechia, Hungary, Poland, Romania, Slovak Republic, Slovenia; as well as the Baltic states.
10.ICE data platform. as of 30th April 2024. See credit tables under Market Data section for full list of indices.
11.Financial Times, as of 17th May 2024 “China unveils package to boost property sector”
12.JP Morgan, as of 4th June 2024 “EM Corporate Supply Technicals”.
13.Bloomberg UK: “South Africa’s ANC has to navigate minefield to retain power”, as of 3rd Jun 2024.
14.Reuters: “S&P upgrades outlook on India’s sovereign rating to ‘positive’”, as of May 30th 2024.

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Index Descriptions

EMGB - ICE BofA Emerging Markets External Sovereign Index tracks the performance of US dollar and euro denominated emerging markets sovereign debt publicly issued in the major domestic and eurobond markets.  Qualifying securities must have risk exposure to countries other than members of the FX-G10, all Western European countries and territories of the US and Western European countries.

EMCB - ICE BofA Emerging Markets Corporate Plus Index tracks the performance of the US dollar and euro denominated emerging markets non-sovereign debt publicly issued in the major domestic and eurobond markets. Qualifying issuers must have risk exposure to countries other than members of the FX G10, all Western European countries, and territories of the US and Western European countries.

EMIB - ICE BofA High Grade Emerging Markets Corporate Plus Index is a subset of the ICE BofA ML Emerging Markets Corporate Plus Index (EMCB) including all securities rated AAA through BBB3, inclusive.

EMHB - ICE BofA High Yield Emerging Markets Corporate Plus Index is a subset of the ICE BofA ML Emerging Markets Corporate Plus Index (EMCB) including all securities rated BB1 or lower.

Q690 - ICE BofA Custom Emerging Markets Short Duration Index tracks the performance of short-term US dollar and euro denominated emerging markets non-sovereign debt publicly issued in the major domestic and eurobond markets.

EMRA - ICE BofA Asia Emerging Markets Corporate Plus Index is the subset of the ICE BofAML Emerging Markets Corporate Plus Index, which includes only securities issued by countries associated with the region of Asia, excluding Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan, and Uzbekistan.

EMHA – The ICE BofA High Yield Asia Emerging Markets Corporate Plus Index is a subset of ICE BofA Emerging Markets Corporate Plus Index including all securities rated BB1 and lower with a country of risk within the Asia region.

EMIA -  The ICE BofA High Grade Asia Emerging Markets Corporate Plus Index is a subset of ICE BofA Emerging Markets Corporate Plus Index including all securities rated BBB3 and higher with a country of risk within the Asia region.

EMRL - ICE BofA Latin America Emerging Markets Corporate Plus Index is a subset of The ICE BofA Emerging Markets Corporate Plus Index including all securities issued by countries associated with the geographical region of Latin America.

EMIL - The ICE BofA High Grade Latin America Emerging Markets Corporate Index is a subset of ICE BofA Emerging Markets Corporate Plus Index including all securities rated BBB3 and higher with a country of risk within the Latin America region.

EMHL - ICE BofA High Yield Latin America Emerging Markets Corporate Plus is a subset of ICE BofA Emerging Markets Corporate Plus Index including all securities rated sub-investment grade based on the average of Moody's, S&P and Fitch, and with a country of risk associated with the geographical region of Latin America.

EMRE - ICE BofA EMEA Emerging Markets Corporate Plus Index is a subset of The ICE BofA Emerging Markets Corporate Plus Index including all securities issued by countries associated with the geographical region of Europe, the Middle East and Africa including Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan and Uzbekistan.

EMIE - ICE BofA High Grade EMEA Emerging Markets Corporate Plus Index is a subset of ICE BofA Emerging Markets Corporate Plus Index including all securities rated BBB3 and higher with a country of risk within the Europe, Middle East and Africa regions.

EMHE - ICE BofA High Yield EMEA Emerging Markets Corporate Plus Index is a subset of ICE BofA Emerging Markets Corporate Plus Index including all securities rated BBB3 and higher with a country of risk within the Europe, Middle East and Africa regions.

The MSCI EM Index is a free-float weighted equity index that captures large and mid cap representation across emerging market countries. The index covers approximately 85% of the free float-adjusted market capitalisation in each country.

Important Information

Muzinich and/or Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. Muzinich views and opinions.  This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall. Emerging Markets may be more risky than more developed markets for a variety of reasons, including but not limited to, increased political, social and economic instability; heightened pricing volatility and reduced market liquidity.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

This discussion material contains forward-looking statements, which give current expectations of future activities and performance. Any or all forward-looking statements in this material may turn out to be incorrect. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Although the assumptions underlying the forward-looking statements contained herein are believed to be reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurances that the forward-looking statements included in this discussion material will   prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Further, no person undertakes any obligation to revise such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

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