Russia's Safe Haven

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The benchmark RTS index has dropped 16 percent since peaking at 2339.79 on Jan. 14. This sudden loss of around $160 billion in market value stands in sharp contrast to consensus expectations, which predicted around a 25 percent upside and decisive decoupling from the slowing U.S. economy this year. What is behind the sharp sell-off? Are the consensus expectations fundamentally flawed? And is the Russian economy as exposed as equity-market dynamics imply?

The answer to the first question lies on the other side of the world. Like it or not, the U.S. economy remains the world's largest. Certainly, emerging markets are catching up fast, but in recent years their growth has been outpaced by the rapid advancement of globalization. The more interlinked economies have become, the more influence the U.S. economy has exerted around the world.

For several years, this influence was benign. U.S. consumers eagerly sucked up capital from saving nations and binged sufficiently to drive one of the most impressive business cycles in modern history. But now the mood has turned, and the key U.S. indexes are off by some 15 percent, as investors increasingly price in the probability of a recession in 2008. This sharp reversal of confidence in the United States is reverberating around the world dramatically, impacting seemingly unconnected markets. It is widely believed that equities are driven by both fear and greed. At the moment, however, fear is clearly the dominating factor.

Whether this fear is merited or not is a multitrillion-dollar debate, playing out in markets all around the world. There is no conclusive answer at this stage, but for the record, I believe that the recent sell-off is overdone. Global equities are now attractively valued as the United States will likely escape with a mild recession. In the second half of the last century, the U.S. government and Federal Reserve repeatedly demonstrated the efficacy of swift and targeted policy actions to alleviate economic downturns.

More important to the local investor is whether the consensus market projections are flawed. The RTS is now down 14 percent in 2008, and the risk of another downturn remains acute. Under such circumstance, the probability of strong performance this year has clearly weakened, yet it has certainly not vanished. Russia moves fast, and emergency rate cuts in the United States appear to have halted the free-fall, at least temporarily. There is fair hope that investors will use this cool-off time to remember that the world is a large place, where opportunities are less correlated than global capital flows imply.

A rational review of Russia's macroeconomic circumstance, relative to the global environment, could easily lead to a greater inflow than the nation's capital market could safely digest. Even if this is not the case, the year-end expectations remain achievable, provided we do not find ourselves in a global growth recession.

This brings us to the question of whether the economy is as exposed as current dynamics imply. There are two ways to address such a question: by considering the threat the equity market poses toward the economy and by considering whether the economy might capitulate to a broader global slowdown.

The answer to the first point is unequivocal: The Russian equity market has minimal impact on the macro economy. It is true that more and more people are achieving sufficient savings to begin investing in equities, but a combination of the government, international investors, large corporations and wealthy individuals continues to dominate the market.

In this, Russia stands in sharp contrast to the United States, where the Federal Reserve this week cut interest rates to restore capital-market stability in order to protect consumer sentiment and the broader economic outlook.

The government rarely intervenes in equity markets, although its policies and practices often impact it, and there is little reason to assume that a year of negative market performance, in itself, would materially impact the broader economy. Thus, we can say that the fundamental economic outlook -- hence, the long-term equity-market potential -- is unlikely to be compromised by a sell-off such as that we have just experienced.

More important, the economy's macroeconomic outlook for 2008 is less exposed to the global circumstance than at any time since the financial crisis of 1998. This is not to say that the economy is a risk-free proposition; in fact, the risks are growing steadily, but the threats seem most likely to play out 1-2 years in the future. For 2008, Russia looks relatively safe. Protected by $477 billion of foreign reserves including gold, the government needs not fear a short-term drop in oil prices, which might be expected if there is a short and shallow recession in the United States.

The 2008 economic outlook remains bullish, but the long-term perspective raises concerns because of the economy's excessively high dependence on the state. Through high oil taxation, real-income spending and infrastructure investment, the state has wrestled control of the economy back into the public sector. Governments are rarely responsible or efficient economic agents, and this fact is particularly true in Russia, which ranks 143 on Transparency International's 2007 Corruption Perception Index. Inefficiencies notwithstanding, the government is determined to restore the nation's pride. In addition, billions of dollars will be spent domestically in the next decade on a whole range of infrastructure projects, and such large-scale investments will contribute significantly to short- and medium-term economic stability.

Current global economic circumstances do pose a threat. Notably, as the country closes its discount to global equity prices, lingering risks -- such as poor corporate governance -- expose the nation's high risk-return profile, but overall, Russia remains a relative safe haven. As a result, the current sell-off represents an excellent opportunity to buy.

James Beadle is the portfolio manager for Pilgrim Asset Management.