Political Risk Sends Stocks to New Low

Russia's MICEX Index fell to its lowest level since September 2006 on Tuesday after President Dmitry Medvedev's recognized South Ossetia's and Abkhazia's independence, and the ruble tumbled to a seven-month low against the dollar.

The falls, which were mitigated later in the day as investors seemed to recover their nerve, showed just how shaky investor sentiment has become amid a torrent of bad news over the summer, from worries over inflation to the fallout over the Mechel and TNK-BP affairs.

Both Moscow indexes plummeted immediately on Medvedev's midafternoon announcement, with the RTS falling as much as 6.1 percent since Monday close, and MICEX dropping as much as 5.8 percent.

Investors and analysts said that, as some portfolio managers ran for cover, others chose their moment to reenter the market, seeing Russia stocks as the cheapest in the emerging-markets class.

The ruble-denominated MICEX bounced back to close the day down 2.1 percent, on 1,292.92 points, while the RTS recovered to just about its level before Medvedev's comments, closing down 4.1 percent at 1,579.12 points.

The ruble sank as much as 1.3 percent against the dollar at its lowest, and was down 0.6 percent against the dollar/euro basket when the stock markets closed.

The falls also came against a backdrop of falling oil and commodity prices and a forecast from Morgan Stanley that the S&P 500 Index in New York would slump by 7.1 percent to 1,300 points by year end.

Fitch ratings agency said Tuesday that tensions with the West could damage foreign investor sentiment toward Russia but that they did not immediately threaten the country's sovereign rating.

The stronger recovery by MICEX, which is more liquid and tends to better reflect Russian investor sentiment than the dollar-denominated RTS, was indicative of a disconnect with foreign investor reaction, said Viktor Shvets, head of research at Lehman Brothers in Moscow.

"Russia has gone from being the strongest emerging-market economy to being one of the riskiest," Shvets said. "Investors are swinging from one view to another, and that's what's creating the risk."

"Some countries are more pragmatic, while others are prepared to sacrifice GDP growth for geopolitical gains," Shvets said. "Russia falls into the latter camp, but the question is: What sort of price do you want to pay -- 1 percent, 2 percent, 3 percent of GDP growth?"

James Cook, director of Aurora Russia, a longtime portfolio investor, said "investors [in such an emerging market] should expect the cycles we're seeing today."

As far as the end of the bear market, it will come only when investors believe that there is certainty and that there are no more surprises down the road, he said in e-mailed comments.

The recognition of independence for the republics had been widely expected in Russia, and would not have a significant impact on foreign capital inflows, said Natalya Orlova, chief economist at Alfa Bank.

A key concern, Orlova said, was that "Russian individuals and companies might now sell rubles for dollars," noting that this could lead the Central Bank to prop up the ruble again, depleting foreign currency reserves.

Willem Buiter, professor of European Political Economy at the London School of Economics, said that while the conflict with Georgia was bad for investor confidence, at least Russia's gas supplies to Europe were "not going to be adversely affected by the Georgian and earlier episodes."

"It will however, make the EU countries even more determined to minimize their reliance on Russia as a supplier, because the primacy of politics over economics makes Russia an inherently unreliable, even dangerous, source of energy supplies," he said in e-mailed comments.

James Fenkner, director of Red Star Asset Management, said the market slide may have reached its nadir, as further tensions were likely to be restricted to "saber-rattling" from the West as it accepts a fait accompli over Georgia, and that NATO would not likely commit troops to the Caucasus country.

"Threats to kick Russia out the Group of Eight are also without much teeth," he said.

The unknown factor could be Georgian President Mikheil Saakashvili's reaction.

"All major wars start with a match," Fenkner said.

"Saakashvili gambled once with his South Ossetia invasion," he said. "Could he gamble again? ... There's always a chance that things could get phenomenally worse quickly."