Market Suffers From Lack of Catalysts

The Russian market continued its downward trend in January, reflecting global negative sentiment, low commodity prices, continuing ruble devaluation and bleak economic data. As a result, Russia underperformed MSCI EM and BRIC countries by a wide margin.

In our opinion there are few catalysts for Russian market outperformance in February. Although the Central Bank has announced that they will be firm in defending the ruble at the pre-announced target of 41 for the bi-currency basket, CBR's resolve and ability to achieve its goal is still in doubt as further depletion of reserves will inevitably lead to rating downgrades. Russian CDS spreads are already reflecting this risk as the country spreads. In the meantime, the Russian ruble has depreciated by a further 10 percent against the basket in January despite demanded ruble liquidity due to tax payments at the end of February.

We think Russia is experiencing a managed (so far) currency crisis. However, questions still loom regarding whether the government will be able to avoid a banking crisis. As we have pointed out in our Year-Ahead for 2009, there is a vast difference in the recovery timeline, depending upon whether a country is experiencing a banking or a currency crisis (Table 3).

In our view, worrying signs also emerged about the way that the Russian government would keep the ruble stable. First, President Dmitry Medvedev named tight oversight and tracking of usage of state-granted support funds to banks and corporations as one of the key objectives of the Federal Security Services (FSB). However, Arkady Dvorkovich, economic adviser to the president, commented that the state will consider creating foreign currency "instruments" so that banks are encouraged to keep foreign currency inside the country. The comments underlined the government's concern about continuing capital flight and the prospect of capital controls (however dim) loomed on the horizon.

On a more positive note, Prime Minister Vladimir Putin struck a more conciliatory tone toward the West at the Davos forum, acknowledging Russia's vulnerability to the crisis and high commodity dependence of the economy. The change in tone, coupled with the potential end to ruble devaluation, may some day provide the necessary catalyst for outperformance. However, in the short run, we feel that sentiment will stay negative for Russian equities.

In this context, we believe that the weakness of the market will continue in February with Russian market trading in a range or trading down. In this environment we prefer to concentrate on exporters that benefit from ruble weakness as well as companies with low debt gearing and positive cash flows. Companies such as Gazprom, LUKoil and RusHydro should benefit or suffer less in the near term.