July 2010

In July, the Eastern European Fund underperformed its benchmark, the MSCI Emerging Markets Europe 10/40 Index.  Czech Republic, Poland, and Turkey were the best-performing countries in the region, while Russia and Hungary lagged the index during the month.

Financials, materials, consumer discretionary and staples outperformed, while telecommunication services, utilities and energy equities generally lagged the index.

Strengths

• The improvement in relations between Russia and the United States was reflected in a marked pick up in bilateral trade.  U.S. trade in goods with Russia through the first four months of the year rose by 27.4 percent, to $8.48 billion, according to the Commerce Department.
• Higher oil prices spurred onshore drilling in Russia. Land development drilling in Russia was up 18 percent year-over-year and 10 percent month-over-month in May, according to the statistics published by Interfax.  Russian drillers are also preparing to deploy a few rigs in Southern Iraq in the near future.
• Turkish banks’ year-to-date loan growth was 15 percent, according to the regulator, driven by mortgages (+16 percent) and general consumer loans (+19 percent). In another positive trend, non performing loans declined by 4 percent year-to-date, easing the cost of risk and boosting profits.
• Domestic auto sales in Turkey rose 113 percent year-over-year in July, climbing to 339.6 units. Historically, low rates have become a major driver of auto sales, and this appears to be borne out month after month.
• Eastern European exports to Germany are largely semi-finished goods refined further for destinations outside the EU, generally making them less prone to shifts in Europe’s largest economy. A weaker euro made finished export goods more competitive, with Czech Republic, Slovakia and Hungary registering strong growth in industrial production in May.

Weaknesses

• Ukraine abandoned plans to sell its first Eurobond since 2007 as investors demanded higher yields than the government was willing to pay, according to Bloomberg.  The government has been issuing IOUs to exporters to cover unpaid value added tax (VAT) refunds.
• Russia, crippled by drought, banned all exports of grain after millions of acres of Russian wheat withered in a severe drought.  Pressure was also brought to bear by multinational grain trading companies, who, according to Bloomberg, have been lobbying for the ban so that they could declare force majeure, to escape their obligation to deliver.

Opportunities

• Russian railway cargo turnover stats for June showed 14 percent growth in building materials and 16 percent in cement year-over-year, hinting that the construction sector might finally be switching away from the crisis-induced downtrend.
• Exchange rate appreciation is the likely policy response should grain shortages drive food inflation higher in Russia. Forward contracts on the ruble were bid up to their highest level in three months, as central bank scaled back purchases of foreign currencies.
• Turkish Consumer Price Index (CPI) dropped 0.56 percent in June and annual inflation eased to 8.4 percent from 9.1 percent, prompting analysts to change their interest rate forecast call to no policy rate hikes in 2010.  A continued low interest rate environment could potentially extend the rally in financials.

Threats

• Reliance on state support is potentially risky for minority shareholders of Russian electricity distribution companies, according to JP Morgan.  Minority shareholders may face a considerable dilution if the state provides money for the capex program through additional share issuance as it did for federal transmission and hydro generation companies in 2009 -2010.
• The grain export ban could negatively affect food producers in Russia, as well as the operators of export grain terminals.  Distillers and brewers may also see their feedstock costs go higher.
• S&P is reviewing Hungary’s credit rating for possible downgrade after the collapse of International Monetary Fund (IMF) talks. Without an IMF program in place, Hungary is likely to face higher and more volatile funding costs, which could weigh on the financial sector, public finances and economic growth.

Past performance does not guarantee future results.

The MSCI Emerging Markets Europe 10/40 Index (Net Total Return) is a free float-adjusted market capitalization index that is designed to measure equity performance in the emerging market countries of Europe (Czech Republic, Hungary, Poland, Russia, and Turkey).  The index is calculated on a net return basis (i.e., reflects the minimum possible dividend reinvestment after deduction of the maximum rate withholding tax). The index is periodically rebalanced relative to the constituents' weights in the parent index.  The Consumer Price Index (CPI) is one of the most widely recognized price measures for tracking the price of a market basket of goods and services purchased by individuals.  The weights of components are based on consumer spending patterns.