Financial Journalist

Benchmark - Performance Tracker March 1999

It wasn’t long ago that investors were failing over themselves to be invested in Eastern Europe. Predictably the fund companies launched the bulk of their products somewhere near the top of the market leaving most investors with burnt fingers. But as Feature Writer Gerry O’Kane finds, whether you are taking a paper loss on your original investment or interested in this region for the first time, Eastern Europe offers some interesting bargains for investors willing to take a long-term view.

Emerging markets have become the weakest link in the global investment business consistently showing volatility as they have become victims of what has become known as ‘contagion’.

Asia’s financial pox festered for months with only small pustules appearing in other emerging markets. Had they escaped infection? By the third quarter of 1998 the pox had erupted across Russia causing economic collapse and the government to default on its international debt. Brazil followed with a run on its currency and investor scepticism hit all the markets of Latin America and Eastern Europe.

But recent months have seen some recovery in the markets of Eastern Europe with analysts identifying its close proximity to Euroland as one reason for investor optimism. Since last October as recovery looked more obvious, Morgan Stanley’s Capital International Eastern European index rose by 47% versus a 22% rise in the emerging market general index.

But the story is not as clear-cut as it might first seem. While companies such as Templeton are currently overweight in Eastern Europe as part of their emerging markets’ strategy, outperformance is not all-pervasive.

“It’s interesting if you take a closer look at performance levels.” says lan McFarlane, emerging markets strategist with Paribas. “Since the beginning of the year the Polish index is up 8.31 per cent in US dollar terms, Hungary up 1.42 per cent but Russia is down 8.5 per cent and the Czech Republic down 5.7 per cent, ” he rattles off.

But even those better performing markets of Poland and Hungary have stimulated less interest and confidence than might first seem apparent. According to McFarlane, while Paribas is overweight in those two markets they still fall low on the emerging markets investment scale. He points to statistics from the IFC’s (International Finance Corporation) Investment Universe Index for emerging markets. In the IFC index, Eastern Europe is 1umped in with Africa, the Middle East and less developed Mediterranean economies such as Greece and Turkey.

“In terms of investment percentages, the IFC index shows Greece, Israel, Turkey and even Jordan rating higher than Poland.” he says.

Eastern European Buzz
So why is there a feeling in the international investment community that Eastern Europe is the emerging market to be in? How have some of these funds clocked better performances than might first be indicated by a breakdown of the nations? First there is sentiment. Some investors view the nations of central and Eastern Europe as upcoming battlegrounds for new European businesses. Others see it as having the opportunity to ride on the coattails of a more prosperous Europe under the Euro. Others simply say market changes such as privatisation can but boost the economies.

In terms of fund performance one of the best has been Morgan Grenfell’s Emerging Europe fund. But according to Chris Turner, the fund’s manager, one reason for its healthy performance were the returns from Mediterranean countries, such as Greece (the world’s best performing stock market last year), in which the fund also invests. This comment is worth noting because it is currently an example of one of the latest European growth theories: convergence.

And convergence is one reason that Peter Kysel, the fund manager of Govett’s European Strategic Unit Trust, Hungary Investment Company and the New European Investment Company is so gung-ho on some Eastern European markets.

“Many of the Eastern European countries are managing their affairs responsibly and in fact largely comply with what was handed down in the Maastricht Treaty - public sector borrowing requirement and debt, that sort of thing,” views Kysel.

He also points out that many of the nations have already applied for membership of the European Union, and. to eventually become successful their economies have to fall in with the rest of Europe.

It is a view heavily supported at Fleming Asset Management. Michael Hughes, the product manager on Fleming’s emerging markets desk which manages funds for Jardine Fleming, argues that this convergence dynamism was one reason why Greece’s performance over the past 18 months was so strong.

“As they prepare for membership they’re required to get their economies into shape gradually they’re seen as a safer European market, the risk premia falling, he explains.

Convergence, Convergence
To climb aboard the convergence bandwagon. these countries are cutting interest rates and also seeing inflation fall, Their eyes are on membership of the European Union (EU) and hand-in-hand with that are analysts picking up newly privatised firms inexpensively priced, in expanding markets.

“If the Portuguese and Greek examples are anything to go by convergence stimulates the equity markets and while there is no evidence of this yet in Eastern Europe there are initial convergence indicators.” explains Kysel. Apart from the advantages of foreign investment from the EU and subsidised loans, there would be about Euro80bn for developing infrastructure. On top of that are equity valuations. Both Kysel and Hughes point to price earnings ratios which stand at somewhere between eight and 10 times in Eastern Europe. In Germany and France they currently stand at about 25 times, according to Kysel. As convergence continues these PEs will move together bringing, so the theory goes, huge profits for those who bought low.

If you accept the convergence argument (it is worth bearing in mind that not all do) it also becomes apparent that not all Eastern Europe countries will have the same growth factors. Indeed there seems to have emerged a two-tier Eastern Europe investment policy. Everyone seems to love Hungary and Poland. Everyone has serious concerns over the Czech Republic, its banks and privatisation regulations, but it is on the convergence road too so thumbs up for the long-term.

But countries such as Bulgaria and Romania are less attractive even though statistics for Bulgaria show that 1998 growth was about 5.5 per cent and inflation dropped to 22% in 1998 from over 1,000% in 1997.

But all the positive news has been based upon the convergence theory. It is a view that Tumer at Morgan Grenfell does not subscribe to.

“The convergence view looks at EU membership by 2003 to start with. I talked with the guy heading Poland’s move to join the EU and even he does not expect membership until 2008 at the earliest,” reveals Turner.

His view is that too much store is put on the convergence theory and he prefers solid company fundamentals and a longer term view than the simple convergence story.

Sentiment is Key
This brings us back to sentiment. Convergence encourages foreign investment on the back of bigger markets and better and more-reliable equities. All those that BENCHMARK talked to argue that any investment in Eastern Europe has to be taken with long term intentions, with Turner expecting “bumps along the way” and Hughes warning of “hiccups”.

But both Kysel and McFarlane point out that the contagion effect has been stripped out of sentiment now and Russia has less of an impact. (Flemings, once a big fan of Russia now has less than a 3.5 per cent weighting in the country and all that is in oil stock).

But all warn that the unexpected is most likely to happen in Eastern Europe and a long-term perspective is vital. So stripping out convergence and the potluck of sentiment what other important factors affect the Eastern Europe markets?

Kysel points to the development of private pension funds. Both Hungary and Poland are heavily involved in this new policy divergence.

“These reforms push for part of the money to go into privately managed funds and naturally a bias will be for buying domestic funds and equity. Apart from a liquidity boost its impact will be to reduce foreign influence on the markets and I expect that in Poland you could see foreign institutional activity fall from 80% of market turnover to 50%. This will help reduce market volatility,” he argues.

On top of this the fund managers keep their closest watch on construction, banking and telecommunications stock and hope that political stability will last to allow better-regulated markets and full privatisation.

Should you invest in Eastern Europe? Certainly there is a solid argument that it is a good target should you want money in emerging markets. But not all of Eastern Europe shows the same promise. It is not for the faint-hearted, nor for the short-sighted and impatient. But should you even toss the convergence argument out the window, then, McFarlane’s argument is worth considering; that as the EU grows it will benefit geographically close markets, just as Asia benefited from Japan’s growth in the 80s. It is also worth remembering the maxim of buy low, sell high. Eastern Europe fails squarely into this category.

Emerging markets, investment, funds,unit trust, Eastern Europe

Financial Times Mandate March 1999

Movement in Europe but the US houses will come out topAmerican giants such as Chase and Bank of New York are biding their time but will pounce once the European action slows. Deep pockets are needed for this game. Gerry O’Kane reports

As wave after wave of fund house mergers crash down on the financial world, it has been easy to lose sight of the ongoing saga of consolidation in the custodial industry.

The game continues to be played out with European houses such as Paribas merging with Societe Generale (SocGen), Royal Bank of Scotland announcing that it is considering the sale of RBS Trust Bank and Deutsche Bank prepared to pay $10bn for Bankers Trust. But insiders say that this is nearing its end and the US money is on the US custodians and banks.

Mark Tennant, senior vice president global investor services at Chase Manhattan Bank, says: “This consolidation of the global custodians and I emphasise global has been going on for about five years but has only achieved prominence in the past two.”

Mr Tennant is not shy in claiming that Chase will be one of the global players left standing. His competitors are only too aware that the big US houses want to dominate the world business.

David Watson, director of business development at Lloyds Bank Security Services, admits that he expects Chase to end up as one of the big six. But he is also of the opinion that some markets will always warrant a subcustodian and that a number of players, such as Lloyds, will always be strong competitors in domestic markets.

The history of consolidation has been dramatic, involving the biggest names in international banking and finance. Some see the consolidation as really beginning in 1995 when National Westminster Bank sold its custody business to Lloyds.

Around the same time, Bank of New York secured the custody business of Bank of America and JP Morgan.

Within a year, another of the British banks withdrew from the market, with Barclays selling its £200bn custody arm to Morgan Stanley Trust. But even Morgan Stanley did not stay around long, with Chase Manhattan picking up its £400bn custody business soon after.

The only big British player remaining is thought to be Royal Bank of Scotland’s RBS Trust after a deal with Mercury Asset Management.

The industry has also seen Paribas and SocGen merging and, just as if to reinforce statements from Paribas that it was looking to strengthen its custodial work, the company announced a strategic alliance with Bank Austria, opening more east European markets. On top of that, Mellon Trust, one of the biggest players in the US, announced a global custody partnership with ABN Amro. But for all that movement in Europe, Mr Tennant is confident that it will be the American houses such as Bank of New York and Chase that will come out on top.

A key reason for consolidation is that custody requires enormous investment in technology, something that is ever more apparent in the new European markets. Real-time gross payments and straight-through-processing (STP) or T+0 settlement, providing the seamless link from fund manager through settlement and back to fund manager have taken on greater importance.

Players such as Bank of New York push trademarked technical solutions such as GlobalTrade, while ABN talks of BankStation.

The result has been a technological battle royal. Technology is attempting to fit into the world of standard systems. It is forced to interact with settlement and payment services, cutting times between doing the deal, confirming it and paying for it.

The future of custody seems to be dictated by information as a crucial part of the service and not only for deep collateralised pockets. Technology will provide the customer information and data warehousing is fast becoming one of the key catch phrases in the custodial industry. State Street, one of the big players in the US, bought Princeton Financial Systems in 1996.

The argument is that big money is needed to keep up with the technology game. In 1997 Chase spent more than $2bn on high-tech systems (while this figure includes all systems, custodial systems take the biggest bite of the budgetary pie).

While capital investment becomes increasingly expensive, margins are squeezed particularly in Europe. Mr Tennant puts this down to the falling risks custodians are undertaking in ever more regulated markets.

In the past, custodians received higher margins for settlement because of market risk and underfunded fund managers. “Houses are not now paying for you to take non-existent risks. The result is a decline in fee-scale,” explains Mr Tennant.

Another key factor for consolidation is the growth in the investment business. A study by Gemini Consulting suggests that European mutual funds will increase in size by 20 per cent a year over the next five years, in part as more Europeans are forced to take on responsibility for retirement funds. This is not restricted to Europe. As Mr Watson points out, one in three females in the US are now expected to live to 100. Add to that the increasing size of asset management houses through their own waves of mergers and acquisitions and there is an increasing need that the custodians themselves require larger capital bases.

With some having pulled out of the business and other players merging, many are unsure if they can survive, let alone make any money in the new custodial world. Ironically, because of the need for expertise and technology, custodians are finding it cheaper to buy these capital bases. They are buying access to high-value customers, market skills and often the latest technology. It is less expensive than building these facilities over time. Hence consolidation.

The deals of ABN and US custodian specialist Mellon, handling assets in excess of $2000bn, and Paribas and SocGen show that European houses recognise the need for a large collateral base. According to Mr Tennant, that may not be enough to handle true global custody. “In Europe we have to compete with these houses but they do not compete in the US and that is the biggest business,” he argues.

Mr Tennant estimates that Chase’s global business is worth $2000bn, while in the US it is more than $3000bn. The global business is more profitable than custody in the US, which is more of a plain vanilla service.

But this US business does bring a certain mass to bear on the market. It also explains the attraction of breaking into the custody business outside the US. This argument is, however, disingenuous. While the current value of custody is greatest in the US, that could change. The value of the new euro-denominated equity market is greater than the US markets.

British pension funds head the league table in international diversification but still have less than one-third of their assets invested abroad. For the US pensions industry this is less than one-tenth.

However, it would be fair to argue that it is only a matter of time before this changes and expertise outside the US will be vital. During the economic disintegration of Indonesia in 1997 and 1998, it was Standard Chartered’s understanding of the situation that led it to send staff to Singapore. They needed Chinese registrars and scrip after the Chinese areas of Jakarta had been torched not a good job for a computer.

Mr Tennant agrees that niche custodians will remain in existence. “There is a serious role for houses such as Bank of Bermuda to serve small and successful offshore fund companies,” he admits.

Mr Watson goes one step further. He recognises that the big boys are moving ever deeper into the market but argues that sub-custodial work will always exist. He says that Lloyds, for example, can compete in markets such as London. It might be expensive but Lloyds is, after all, a clearing bank.

Mr Watson says: “I believe that it is a fallacy to think’ that the biggest custodians can be all things to all people. Custody is a peace-of-mind business and there will be plenty of room for the niche player if his quality of service differentiates him from the competition.” While Mr Watson agrees that he might not compete on price for the volume sort of business done by the Bank of New York, for example, serving up the sort of specialised service required by London pension managers is right up his street.

Mr Watson also argues that in certain instances local knowledge and costs make sub-custodians more suitable. “The point of sale, if you like, might be global but the delivery could be local,” he advocates.

The argument of specialised services has some strength; as the larger firms handle custody as a commodity, they will receive commodity fees. The service side must-fall away. But the pro-technology houses argue that they will continue to develop ways of providing better levels of personal service. Others emphasise that technology will be important but also point out that value-added services will not fall into the high-volume, low-margin markets.

How far companies such as ABN and Deutsche Bank can compete outside Europe is the key question in whether European houses will survive in the global custodial market.

Global custodial industry