The Russian Conundrum

Cheap or not cheap enough?

By any standards the Russian market is the cheapest among emerging markets. But the lingering question is -- "is it time to invest?" While our answer is "yes," we do not expect a recovery while concerns surrounding the banking system and the oil price persist. We see hopeful signs of commodities market stabilization and expect the oil price to hover around $44/bbl Brent in the second quarter and the Russian stock market to trade in a range perpetuated by trading rallies in Q2 2009.

The prospect in 2H 2009 looks a lot brighter given our oil price projection of $60/bbl Brent. Our stress testing indicates that the price of the oil and gas majors in Russia discounts an oil price of $25 to $30, suggesting a strong rally if oil prices rebound.

Ruble devaluation on hold

When we last wrote on Russia our main call was an end to ruble devaluation, followed by a trading rally in Russia. While the consensus among our European client base was that the CBR could hold the ruble at its current level, U.S. investors were mostly skeptical. Never before, the popular investor response was, had an emerging market Central Bank held the line against a capital outflow attack on a currency. The currency inevitably overshoots. We also had the feeling that the U.S. client base was mostly underweight to neutral on Russia.

We believe that if commodity prices hold, the Russian market should experience a substantial rally by the end of the year.

By the time we traveled to London, a consensus was forming that the Central Bank had the tools (aside from foreign reserves) to hold the currency at $41 against the basket and that a trading rally was in full swing. While the London account base was mostly balanced in their views, in Frankfurt we were now accused of being too defensive on Russia and not calling the bottom more audaciously, even as the trading rally ran out of steam.

Forget defensive, its 'fallen angel' time

Even though there was no consensus on ruble devaluation, there was on equity strategy. While clients appreciated our stress testing, none wanted to play the rally through "defensive" stocks but were eager to concentrate on the stocks that have suffered most due to high leverage and the expectation of further ruble devaluation. These were essentially the stocks recommended as shorts in each industry against their stronger or export-oriented peers. Investors enquired about VimpelCom, Novatek and Evraz as opposed to MTS, Gazprom and Severstal, which were perceived to have been less buffeted by devaluation. Few brave investors even mentioned Sberbank as a high beta leveraged way to play a Russian stock market rally. The client focus on those "fallen angels" also indicated to us that they expected Russia to be a short-term trade rather than a long-term investment.

It's about oil and banks

While currency uncertainty is temporarily removed, investors quickly shifted to worries about the oil price and the state of the banking system. One concern is that a large corporate default would send ripple effects through the banking system and that an oil price plunge would unleash a chain reaction of further devaluation, increased volatility and correlation and possible further rating downgrades, rendering the Russian market uninvestible once again.

Accordingly, we do not expect a sharp rally in the Russian market in the Q2 of 2009 while commodity prices are weak and Russian macro indicators search for a bottom. Nevertheless, we believe that if commodity prices hold, the Russian market could see a substantial rally by the end of the year.

Russia is currently trading at its largest discount to MSCI EM due to its exposure to commodities, issues with corporate governance and the speed of the collapse. If oil prices are held at current levels, this discount should close, at least partially.