#18 - JRL 2006-178 - JRL Home
Russia Profile
August 7, 2006
Not For the Risk-Averse
Volatility Still Dominates the Russian Stock Market
Comment by Pavel Erochkine
One of the main debates about Russia is whether it is becoming a truly autonomous “sovereign” player on the world stage or just a clumsy “bear” stepping on the toes of its neighbors. Business reporters usually take the former perspective, while political observers usually believe the latter.
Although unbalanced, the political perceptions of Russia seem to be more stable. The 25 percent fall in the Russian stock market between May and July shows how quickly investors’ sentiment towards an emerging country like Russia can change, even as economic fundamentals continue to improve.
In 2006, Russia’s GDP will grow by 6–7 percent, industrial production by 6–8 percent, domestic inflation by 10–12 percent and inflation by 8-9 percent, which is reasonable given booming commodity prices. Russia’s “boringly bullish” fundamental strength is also being signaled by relatively tight bond spreads. At a price/earnings ratio of 9.5, Russia is definitely a “buy” in comparison with most other emerging markets, which have an average price/earnings ratio of 13.
Russian stocks are likely to remain volatile, and therefore risky, in the second half of 2006. However, sound fundamentals and significant potential upside (20-30 percent by the end of 2006) make Russia an attractive investment destination from the risk / return point of view.
It has been argued that the fundamental reason for the correction in the globaland emergingmarkets was the realization that U.S. interest rates would have to rise in order to contain the inflationary pressures spun off by the boom in commodity prices. Firstly, this explanation does not explain such a sudden and substantial correction. Secondly, it has no direct relation to either the Russian market specifically or emerging markets generally. If there was less support from domestic investors (who tend to be skilful at exploiting international volatility), Russian stocks could have fallen much lower, undermining confidence in Russia and possibly starting a self-reinforcing downward cycle in the medium term. Thus, the performance of the Russian market is inherently unpredictable, and investors, regardless of how positive they are about Russia’s prospects, should not underestimate the risks.
The liberation of Russia’s capital markets that began on Jul. 1 will re-enforce both Russia’s attractiveness and potential volatility. The ruble is still undervalued, and is almost certain to continue appreciating. Although its fair value is unknown, it is closer to 20 rubles per dollar than 30.
The Central Bank will not allow the ruble to appreciate too strongly, but appreciation in the range of 10 percent is not unrealistic. Hedge funds and other investors will not miss the opportunity to exploit this apparent undervaluation, which means that the liberalization of capital controls is likely to result in a net inflow of money into Russia.
In the past, the Russian government resisted any attempts to liberalize capital controls because of fear of massive capital flight. The current environment is favorable for investment in Russia, but easy legal ways of moving money in and out are likely to add to the market’s volatility in the longer term.
The main threats to the positive outlook are not domestic, but international. The G8 summit and Rosneft’s IPO are likely to be good for Russian equities. Rosneft shares are likely to become the new indicator by which performance of the Russian market will be judged by international observers. Foreign funds are only starting to put an increasing proportion of their money into second and third tier stocks. Rosneft is likely to attract some of the money that had been invested in smaller companies, which means that blue chips will continue to outperform second and third tier companies in the short to medium term. These smaller stocks will rally eventually, but 2006 will be the year of Russian blue chips.
On balance, Russia’s strong macroeconomic indicators, healthy and growing cashflows of Russian companies and attractive valuations should all outweigh international threats and domestic risks, which means that in the meantime, the market will be growing, or at least drifting upwards, with large swings. As much of the international volatility will continue to be caused by inflationary pressures from high commodity prices, Russia, which derives most of its export revenues from commodities, may come to be seen as a hedge.
In fact, Russia could not only been seen as a hedge against instability in the Western financial markets but also as a longer-term hedge against the rise of Asia. Asian economic growth enriches Russia, and encourages a more balanced development of its huge, and sparsely populated, territory.
Promoters of Russia often fall into the trap of trying to get investors to put too much of their money there. Russia is finding its place in portfolios of most international investors and there is a case for arguing that it is a good time for international funds to increase their exposure to Russia, both through Rosneft shares, established blue chips and lesser known second and third tier stocks.