Differentiation between equity investors, and so flows into regional equity markets, continues to increase, reducing price correlation between markets. Poland and Hungary are the two markets that remain most closely correlated, whereas the link between these markets and the Czech Republic and Slovakia is now much weaker. Movements in the Russian equity market continue to be dominated by Russia-specific factors. In general, the Southern European equity markets are not closely correlated with each other.

In general, return data still fails to provide support for any strong relationship between regional and developed fixed-income markets. Return data indicates a closer relationship between Polish T-bills and US short-rates than for treasury instruments in other countries, where no meaningful relationship is evident.

Fixed-income exposure to currency baskets with a high DM weighting (implicit in the case of the Czech Republic, explicit in the case of Slovakia, Hungary and Poland) are expected to show good returns in US dollar terms in the second half of 1997, as the dollar is forecast to weaken against the Deutschmark. In both Hungary and Poland, the short end of the yield curves look the most attractive as both curves are steeply inverted and are already discounting fairly aggressive monetary easing. Russian GKO yields have declined sharply and prospective returns are now only moderately attractive, while in Turkey, short dated T-bills offer good returns but with higher risk. The best opportunities appear to lie in Poland, Hungary, and to a lesser extent, Russia.

In Russia, Yeltsin has reasserted his authority since returning from an extended bout of illness, and we would agree with the sentiments of Anatoly Chubais: this is the most positive, reform-minded cabinet since the on-set of reforms. The good news in Russia is still not factored into external fixed-income prices and US dollar-denominated instruments continue to trade wide relative to credit quality, providing further scope for spreads to tighten against the rest of the market in the second half. In the short term, GKO yields seem likely to back up from the lows reached in early June before resuming their downward trend through end year. We believe there will be an additional leg to the liquidity-led rally in equities. This view is based on our expectation that Russia will be included in global investible composite benchmarks during the second half of the year. Such favourable liquidity is also supported by the fundamentals and by technical arguments and we expect the equity market to continue to outperform.

Hungarian equity and fixed-income markets should continue to perform well. Tight fiscal and monetary policies support a continued downward trend in inflation and the forint is expected to remain at the strong end of its fluctuation band.

In Poland, the September parliamentary election is already dominating the political scene. The narrow margin of victory for the government in the recent referendum reinforces our conclusion that the election will be a close-run thing. On fundamentals, prospects for zloty stability are favourable and at current levels local fixed-income yields are attractive. Despite remaining longer-term positive on the equity market, we are shifting to underweight on a three-month view.

In Bulgaria, the slump in economic activity has continued so far this year and inflation has now fallen sharply from the hyper-inflationary experience of the first quarter. Nonetheless, in economic policy terms, the second half of the year will be a hard slog.

Political uncertainty and the effect of high interest rates on corporates and banks have increased short-term risks in the Czech Republic. While privatisation and fiscal cuts are on track, the goals of moderating wage demands in the wake of rising inflation and speeding industrial restructuring to reduce wage-price pressures from low unemployment remain enormous challenges. In the aftermath of the devaluation and the recent market correction, equity investors can now find a selective number of stocks where valuations are attractive.

Romania will continue to attract investment as a result of a renewed commitment to market reforms. Fixed-income instruments offer attractive returns over a three-month horizon. The Bucharest Stock Exchange and the RASDAQ OTC market are expanding rapidly, in respect of both volumes traded and market capitalisation.

The outlook for fixed income and equities in Slovakia is expected to remain bearish. Clashes between the government and the opposition are set to heat up in the aftermath of the spoiled referendum and ambitions for early entry into EU and NATO have been shot dead. The current account deficit is unsustainable at the present level and newly imposed capital controls are only a temporary measure to prevent what looks like an inevitable koruna devaluation.

Optimism on falling inflation, political stability and convergence with the EU caused an upward re-rating of Greece by foreign investors in the first two months of 1997. However, in the short term we see a need for correction and have moved to an underweight position.

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