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Investor sentiment was rather mixed as we entered 2008. Bullish hopes lingered in developed markets, based on the naive assumption that 2007 credit woes would magically evaporate on New Year's Day, and emerging markets danced to the dream of decoupling. Optimism is a basic human characteristic, but on this occasion it didn't last long, as the United States traded down throughout early January and Russia soon capitulated to global risk aversion.

Down by 13.5 percent, the RTS had its worst January since 1998, although the selling was mostly a catch-up trade, closing the gap on developed markets that had been sliding more protractedly. Such a negative start set a volatile tone for the entire first half of the year.

The first six months of this year have been a testing time for all investors. Developed markets are today sending more shivers of risk aversion around the globe, primarily as investors belatedly grasp that there is no quick fix to the credit crisis and that the economic outlook is troubled. Earnings expectations are being rapidly downgraded, and equities prices are adjusting accordingly.

Meanwhile, inflation has returned globally with a vengeance. If a recession doesn't kill U.S. earnings expectations, inflation certainly will. It is an underappreciated fact that inflation causes far more harm to equities than negative growth in gross domestic product.

Nonetheless, Russia can be pleased with its overall economic performance during the first two quarters of 2008. Soaring commodity prices have again sustained the trade balance, despite the continuing growth of imports, and economic expansion has continued. Anemic equity market returns dramatically understate the relative safe haven that Russia has proved to be. Yet, as the wheels of globalization continue turning, Russia's fate becomes ever more complicated. Few doubted that the economy would withstand the U.S. credit crisis, but inflation is a far greater threat, one that is expanding by the day.

Putting aside acute episodes of the 1990s, inflation is a new phenomenon in post-Soviet Russia. Economic capacity plummeted as the Soviet Union collapsed, a depressing reality that facilitated years of rapid growth even as inflation declined. By now, though, the easy gains are over, evidenced by the sudden rebound of inflation in the last year. The problem has accelerated in 2008. Today, with the consumer price index up more than 15 percent on a 12-month basis, the population is already suffering. This is the clearest risk to all Russia investors.

Russia's inflation is a function of global demand, local demand and general economic inefficiency. Even if prices ease back globally -- a somewhat optimistic outlook -- the country's problem will not likely abate. The Central Bank is tackling the problem, but it is acting gradually.

What tactics can we expect to see in the inflation battle over the second half of the year? We can expect the ruble to continue strengthening on a relative basis, but this does not mean one should blindly buy rubles. The Central Bank is carefully using market fluctuations to contain speculation and strengthening the rate at opportunistic junctures so as not to upset the industrial lobby. Other monetary tools include mandatory reserve levels and interest rates.

The tendency to reduce the money supply is well-established and should reap inflationary rewards toward the end of the year. But the trend is clear -- Russia now faces a trade-off between growth and inflation. With this in mind, successful strategies for the second half of the year will be those that align themselves with an inflationary reality.

The rise of inflation and commodities makes investing a risky proposition. But it also reduces the need to change tactics substantially from winning first-half formulas. By midyear, investors are usually thinking about taking profits and switching to newly rising sectors, but in the current market, continuing to hold looks like the safest bet.

Inflation favors hard assets. The further up the value chain you can move, the better. Buy agriculture over food distributors and raw materials over products.

Russia's hydrocarbon sector is the nation's motor, and it is in danger of stalling. Further tax changes can be expected to stimulate hydrocarbon extraction, but the country needs to reverse declining output to sustain growth. When oil prices do plateau or decline, it will need to stimulate further output to achieve the same objective.

Which stocks, then, are less favorable? The banking sector has been hit hard during the credit crisis for no good reason. Yet, it now faces the headwind of inflation, especially if liquidity continues to decline. The same tendencies weigh against consumer stocks, which will face margin pressures from rising costs and slowing real-income growth. The tail end of the value chain is now the least attractive.

Inflation is the greatest risk that Russia's economy has faced for many years, but predominantly it is a consequence of the country's successful development. Opportunities always accompany risks, and so for the remainder of the year investors will be focusing on Russia's fundamental strengths.

James Beadle is a portfolio manager for Pilgrim Asset Management.