How to Approach Markets in Eastern Europe

With the euro zone mired in a debt crisis that seems to drag on towards an unpredictable end, the fragile economies of Central and Eastern Europe don't look too good now.

Antonia Oprita / CNBC.com The Czech Republic is heavily dependent on its exports to the rest of the EU, particularly to Germany.

The region, dubbed "a turbo-charged Western Europe" by an analyst, is utterly dependent on the health of the richer European Union members, which take in most of its exports. This is why, analysts said, when things will turn for the better, investors stand to gain from a faster recovery than in Western Europe.

But for the moment, things are bleak. Uncertainties over Hungary, whose policies have sparked the wrath of the European Union, have contributed to investors' jitters about the region, while in neighboring Romania a few thousand people took to the streets repeatedly, protesting against the government, and on occasions turned violent.

However, the story driving the CEE region is still convergence with the European Union and political problems are not as big as some media say they are, according to Henning Esskuchen, head of CEE Equity Markets at Austrian Erste Bank, which has a big presence in the region.

"The only political market right now is Hungary, where political problems have created substantial economic problems," Esskuchen told CNBC.com in an interview.

Hungary's right-wing Prime Minister Viktor Orban has antagonized foreign investors since he came to power in 2010 by taking measures such as nationalizing some private pensions, fixing the exchange rate for some of the foreign exchange loans taken by Hungarians during the boom and trying to curtail central bank independence.

Last week, Orban gave the first sign he was ready to back down on some of his policies to appease the EU, which launched three infringement proceedings against Hungary.

Bullish on Stocks

Hungary is in need of funding from the EU and the International Monetary Fund (IMF) as costs for it to raise finance in the markets are increasing, and the EU is likely to seize the opportunity to pressure the country into changing its policies, Esskuchen said.

"I can imagine they will keep Hungary at (the) arm's length to get what they want," he said.

A top Hungarian official said on Monday the country could get a new deal from the IMF, worth up to 20 billion euros ($26 billion), as early as March or April, sending the country's currency, the forint, to a one-month high.

The ZEW- Erste Group economic sentiment indicator for Central and Eastern Europe including Turkey - calculated as the balance of positive and negative assessments of the economic development for the next six months - worsened slightly in December.

But experts interviewed in the survey are more bullish on stocks as an asset class for this year compared with 2011 and see Central and Eastern European stocks as more attractive than those in the euro zone.

Meanwhile though, just like in the previous recession, Western banks in the region and representatives of the governments have had to come together and discuss about the banks' commitment to the area amid fears that deleveraging imposed by regulators will make them take money out of some non-core activities.

Research by Morgan Stanley showed that 80 billion euros could be at risk from deleveraging in Central and Eastern Europe, while other reports have put the figure at between 20 and 30 billion euros, according to Reuters. 

The agreement reached in 2009, called the Vienna Initiative, saw authorities promising to support banks with funds from the European Union and the International Monetary Fund and banks pledging to keep the financing lines open in Central and Eastern Europe.

This time, however, the agreement did not include any clear commitments on funds, neither from the banks nor from the EU and international financial institutions (IFIs), prompting economists at Capital Economics to call it "a damp squib."

"Compare this with 2009, when the EU and IFIs put 24.5 billion euros on the table and secured commitments from Western banks to maintain their exposure to the region," Capital Economics analysts wrote in a market note.

Other analysts dismissed this second initiative, dubbed Vienna 2.0, as "too much noise," as ING EMEA Chief Economist Simon Quijano-Evans wrote in a market note. Esskuchen said the banks no longer needed to prove their commitment to the region.

"Last time was the first time CEE was put into question. Now banks have proven they stayed in the region. For the really dedicated CEE players, they have proven that the region is important for them," he said.

Stay Neutral for Now

Erste Bank analysts forecast 1.7 percent growth for the region's gross domestic product this year, compared with 0.2 percent for the euro zone. A technical recession may take place in the fourth and first quarters but the situation will likely return to more positive developments after that, Esskuchen said.

Luis Davilla / Cover/Getty Images Poland is seen as the strongest in Central and Eastern Europe.

"Our scenario is… we have been very bearish," he said. "We looked at what happened in February 2009 when markets bottomed out. Nothing happened. The market bowed out… they had been overly bearish and then indicators started showing that we will be through [the crisis]."

Stocks in the region are undervalued, according to the Erste Bank analyst, and things may pick up quickly if the "risk-off" sentiment lifts from investors' mood and if European leaders get closer to a solution for the euro zone debt crisis.

For the moment, though, both Erste Bank and ING recommend a neutral position on stocks in the region.

Erste Bank ranked the upside potential for indexes in the region adjusted with the current view on risk. Turkey's ISE 30 is on the top spot, with an upside potential of 20 percent, followed by the Czech Republic's PX index with 19 percent and Romania's BET with 17 percent.

Austria, Poland and Croatia follow with upside potential of 11 percent, 8 percent and 1 percent.

Hungary is the last on the list, with negative potential, but Esskuchen said the country's problem was mainly political.

"If we happen to see a solution, [the stock market] will change quite quickly," he said.

In the region, the retail and distribution and healthcare sectors are trading at a premium to fair value but the insurance, banks, oil and gas, utilities and technology sectors appear to be interesting based on growth to valuation profile, according to the Erste Bank research.

Investors should go for "a mixture of defensives, telecom, oil and gas, as the price of oil is not likely to move higher but should be staying where it is," Esskuchen said.

Utilities can be a good pick, but "I'd be careful with basic resources – this really needs a strong economic recovery," he added.