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CAPITAL MARKETS

Election outcome to have positive long-term effect

Markets await reformist government
Pre-election uncertainty took its toll on the equity market over the last two weeks of September, causing the SAX to dive to a new record low of 103.88. But as a result of the election outcome, a modest upswing will occur on the equity market as investors discount the higher probability of capital market reforms and better prospects for a sound macroeconomic policy (and the resulting lower interest rates).
The longer-term full recovery of the market, however, will require concrete capital market reforms such as a well functioning securities commission, the creation of strong domestic institutional investors through reforms of the pension system, as well as investment funds legislation and privatisation of banks, the state telecom company and utilities via stock exchange listing.

Markets await reformist government

Pre-election uncertainty took its toll on the equity market over the last two weeks of September, causing the SAX to dive to a new record low of 103.88. But as a result of the election outcome, a modest upswing will occur on the equity market as investors discount the higher probability of capital market reforms and better prospects for a sound macroeconomic policy (and the resulting lower interest rates).

The longer-term full recovery of the market, however, will require concrete capital market reforms such as a well functioning securities commission, the creation of strong domestic institutional investors through reforms of the pension system, as well as investment funds legislation and privatisation of banks, the state telecom company and utilities via stock exchange listing.

Although the new administration is expected to take the necessary steps to reform capital markets the danger exists that these reforms will not be assigned top priority and that the government will be preoccupied by critical problems which are increasing the country's external and internal instability (inappropriate fiscal expansion, slow corporate and bank restructuring, etc.).

Reform package needed to rescue economy

The Slovak unemployment rate hit 13.8% in August, decreasing 0.34% from July but 100bps higher than a year ago. The total number of unemployed at the end of July went down to 385,041. The CPI decreased 0.2% M-o-M in August and rose 5.7% Y-o-Y due to a 0.9% fall in food prices. The PPI declined 0.2% M-o-M and 2.8% Y-o-Y, due to a decrease in world raw material prices, especially in oil prices.

According to preliminary estimates, the August trade deficit was Sk7.35bn (US$208.5m). The cumulative trade deficit for the first eight months of 1998 reached Sk51.3bn (US$1.47bn). The Statistical Office announced 6.1% GDP growth for the first half of 1998, which shows that economic growth continued at a robust pace.

However, the Slovak economy is in for a significant deceleration of economic growth brought about by mounting problems in the corporate and banking sectors. In our view, Slovak exporters of commodity products will be the first to suffer, but the negative effects will later spill over into other sectors as well.

The inevitable fiscal austerity that the new government is likely to impose will lead to lower domestic demand and hence will also slow economic growth. In order to return the Slovak economy into its equilibrium growth path, the new government must prepare a credible austerity and reform package, and the central bank must engineer a currency depreciation. If the actions of these two main economic policy bodies are coordinated, it will reinforce the effectivness of the reforms and reduce their costs.

Ratings put Slovakia in worst group

After Standard & Poor's placed Slovakia among the seven countries with the most fragile financial systems in the world, another rating agency - Moody's Investors Service - downgraded the rating of VÚB's financial strength to E, the lowest possible level. The stability of this institution is threatened mainly by its bad loan portfolio. The rating for Slovenská Sporiteľňa was better by only one grade. The financial strength of the two banks could be significantly improved by the entry of foreign investors.

Blue chip stocks lose lustre

Election results should result in a reduction of the risk premium assigned to Slovak equities, as the new administration is likely to take measures to reform capital markets. This should lead to investors' re-pricing of Slovak equity assets, and consequently to higher fair values of these assets.

However, international markets are not favourably disposed towards investments in emerging markets, and this negative sentiment will dampen any positive impacts on the market. Furthermore, the current stock market offers a relatively limited choice of good longer-term investments.

Slovnaft still offers good value, but its bottom-line is going to be hit by forex losses after the envisaged Slovak currency depreciation, and fears of this development will keep the stock's upside potential constrained.

Slovakofarma delivered very disappointing interim results which do not provide much fundamental support to immediate appreciation of its stock. However, the company would benefit significantly from currency depreciation, and its long-term prospects could become more rosy if it succeeds in acquiring a pharmaceutical producer in eastern Europe. In case either of these two events transpires, or expectation of their happening intensifies, investors should reconsider their exposure to Slovakofarma stock.


Valdimír Zlacký and Tomáš Kmet are equity analysts for ING Barings

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