By Jason Hovet
PRAGUE, June 2 (Reuters) - Eastern Europe has lost out on investor flows in the months-long emerging market rally and while it has benefitted from higher risk appetite, the recovery remains fragile as long as big players stay on the sidelines.
Fund trackers have seen a surge in flows to the developing world after markets hit bottom in March. But in emerging Europe there has been an outflow from equities, with investors wary of the problems still haunting the region.
Although Central and Eastern Europe's bourses have jumped 30 to 50 percent since the March lows, currencies are up 10 percent and bond yields have dropped, the surge has been rocky and marked by short-term risk taking.
"Positioning in these rallies has been modest," said Koon Chow, a strategist at Barclay's capital.
"Given that we know investors are still sceptical, they are only going for... the stories that they are super confident in, and central Europe unfortunately doesn't tick that box."
Lingering concerns over the health of banks, the possibility of a country struggling with financing, or worries of spillover if a Baltic state was forced to devalue its currency remain risks for Europe's former communist economies.
This keeps open the possibility of a swift reversal within markets experiencing low liquidity, although short of a crisis along these lines, strategists expect East and Central Europe to get pulled along in any wider rally.
NOT AS ATTRACTIVE
Fund tracker EPFR Global data shows in flows into equity funds covering Asia, ex-Japan, have risen to $6.9 billion year-to-date, jumping since April. Latin American equity fund flows have steadily risen to $3.8 billion.
But emerging Europe funds have seen outflows since the start of the year totalling $792 million, with the Czech Republic, Hungary and Poland all experiencing outflows.
The threat of systemic shocks has started to weigh on emerging Europe, with fears of spillover from a possible currency devaluation in the Baltic countries.
"Despite a continued improvement in global risk appetite, the CEE markets continue to look a bit soft," Danske Bank wrote in note on Monday.
"This probably has to be viewed in the light of increased event risk in the region."
Also, with more dependence on exports and foreign credit, Poland, the Czech Republic and Hungary have seen heavier pressure in the downturn than in some other regions, with economies slowing or shrinking, joblessness rising and fiscal deficits widening.
Other emerging markets have for the most part built economies on different market bases or control in-demand natural resources, creating more attraction now for investors.
"There are opportunities but there are other parts of the world putting their hands up and clapping, saying look at me," said Michael Power, strategist for Investec Asset Management.
"I'll give the Brazil one-liner: that in the last three months they have had net job creation. That detail alone in the current environment demands you have a look at what is going on there."
REFINANCING RISK
Recent Polish and Czech bond auctions have been strong. Hungary, with a $25 billion International Monetary Fund aid package, has restarted bond auctions after a half-year pause.
Yields, too, have fallen across the region after a spike of several percentage points following the collapse of U.S. bank Lehman, when global credit markets dried up.
However, the recovery is set to stall, especially as central European budget deficits rise past the European Union's 3 percent of gross domestic product ceiling, which has dashed hopes of fast euro adoption, while rising financing burdens for governments have turned off investors.
"The biggest challenge is refinancing of debt. That is the major risk in attracting investors," said Lars Christensen, emerging markets analyst with Danske Bank.
"We don't see investors taking long-term bets on this at the moment... They are playing risk sentiment rather than having a fundamentally good or bad story."
Currencies have also hit a plateau in a rally led by the Polish zloty, which has risen 10 percent since a February low.
The last Reuters poll from May 8 saw the zloty, Hungarian forint, Czech crown and Romania leu at weaker levels in three months, before rebounding later in the year.[ID:nL71020384]
Barclays' Chow said even though the region would track a wider rally upward, it would be restrained as long as big players stay sidelined and doubts about the region persist.
"I think we are at the beginning of a recovery. But it will be choppy. A choppy line upwards," he said. (Reporting by Jason Hovet; Editing by Toby Chopra)