Beware of Booby Traps in Emerging Markets

 |  Includes: CEDC, CEE, CETV, EEB, EEM, RNE
by: Sam Subramanian

2009 has been a good one for investors in emerging markets. Since bottoming on November 20, 2008, the MSCI Barra Emerging Market Index is up 84%. Equity prices in Brazil, Russia, India, and China, or the BRIC nations, are up a higher 93%.

Of late, equity prices in Index ReturnsEastern Europe are up strongly and trying to catch up with other emerging markets. During the past three months, the MSCI Barra Eastern Europe (excluding Russia) Index is up 28%. This exceeds the 18% and 20% gains scored by equities in emerging markets and BRIC nations, respectively.

And, as emerging markets continue to rake in gains, calls for U. S. investors to invest overseas are growing louder. The underlying rationale is that prospects for economic growth in such markets are superior to those in the U. S. and such markets may be immune to the credit crisis.

However, before plunking dollars into emerging markets investors must beware that issues facing emerging economies vary significantly from one country to another. While some emerging economies are poised for strong growth others are not... at least not in the near-term. And, in some cases, emerging economies are contending with issues similar to those impacting the U. S. economy.

Eastern Europe

Eastern Europe MapTake the case of Czech, Hungary, and Poland. Here is a read of the economic situation in these Eastern European nations.

Czech. The global recession has hit Czech pretty hard. Slumping demand caused industrial output to decline over 12% for the 12-month period ending in June. The Czech National Bank expects GDP to contact 3.8% in 2009 and expand by just 0.7% in 2010.

Hungary. Hungary's economy was particularly hit hard by the global financial crisis. Hungary took nearly $30 billion in emergency loans to avoid a default. The Hungarian government expects GDP to contract 6.7% in 2009. Hungary's economy is forecasted to return to growth only in 2011.

Poland. Poland's economy has a reasonable chance of avoiding a recession in 2009. After expanding at 0.8% annual rate in 2009's first quarter, the Polish economy appears to be floundering. The Polish government is expecting 2009 GDP growth of 0.2%. Growth in 2010 is expected to accelerate just marginally to 0.5%.

Compare the above picture with China and India. China's economy is expected to grow 8% in 2009. India's finance ministry is confident that economic growth in 2009 will exceed 6% even under the worst-case scenario.

Clearly, Eastern Europe is not in the same league as China or India as far as prospects for near-term growth go.

Is Eastern Europe a Buy, Sell, or Hold?

Investment ReturnsWhile economic growth is not the only factor that determines price performance of equities, investors need to recognize that the ability of companies to grow profits in contracting economies is limited. Cost cutting can only go so far and revenue growth for many companies in such economies will prove elusive. This in turn will put a cap on how high valuation metrics can go.

The global bull-run has lifted all equities including the ones in Eastern Europe. Closed-end funds with meaningful exposure to Eastern Europe, Central Europe & Russia Fund (NYSE:CEE) and Morgan Stanley Eastern Europe Fund (NYSE:RNE) have advanced 24% and 22%, respectively during the past three months.

Open-end mutual fund Metzler-Payden European Emerging Markets (MPYMX) has done a tad better advancing 25%.

Shares of Central European Media Enterprises (NASDAQ:CETV), a TV operator in Eastern Europe, and shares of Central European Distribution Corp. (NASDAQ:CEDC), a distributor of alcoholic beverages in this region, are each up over 32%.

Investors seeking shelter in emerging markets purely for their growth prospects and 'immunity' from the credit crisis are likely to be disappointed if they choose Eastern Europe as the destination for their dollars. Given the lack of exciting near-term growth prospects in this region, investors sitting on handsome profits here should consider it prudent to at least partly cash their chips.

Disclosure: I do not have long or short positions in any of the securities discussed.