Tracing a V-Shaped Recovery

After the release of the 1Q 2009 GDP growth figure of -9.5 percent year-on-year, it has become apparent that the Russian economy will not be out of the recession zone in 2H 2009, as was initially expected by both government and market consensus. To us, the main negative surprise came from consumption side, which appears to have dropped significantly. As consumption is a key element of GDP (private consumption accounts for 49 percent), we now adopt a more pessimistic view on Russian economic performance in 2009-10, downgrading our forecasts to -4.9 percent in 2009 and 1.0 percent in 2010 from -2.1 percent and 2.5 percent, respectively. We also now expect to see a return to positive GDP growth only in 2Q 2010, along with a global economic recovery and positive base effect.

At the same time, from a regional perspective the collapse of the Russian economy does not look devastating. History tells us that a sudden stop of capital flows in emerging markets lasts about eight quarters and results in a V-shaped output recovery, at least initially. V-shaped recoveries are a norm even if bank lending never returns to the pre-crisis levels in a phenomenon termed "credit-less recovery." We believe that Russia is relatively well positioned in this crisis given the large upcoming fiscal stimulus, reserve funds and low external debt balance. In our view, these factors are key to understanding why the market seemingly ignores the gloomy picture created by Russian macroeconomic statistics as 2009 figures are discounted already and expected 2010 recovery is in focus.

When we wanted to trace the path of Russian recovery back in February, we created a checklist consisting of macroeconomic leading indicators, oil prices, market volatility, CDS spreads and the ruble. Since than, four out of five indicators have bottomed out and showed solid. Oil prices (probably the most important ingredient) have trended up, breaking above $65 for Brent for the first time since Nov 2008. The ruble has appreciated against the basket while both CDS spreads and realized volatility have recovered. Only our set of leading macroeconomic indicators is sending us negative signal so far. In our view, a positive change in these indicators allowed Russia to outperform the rest of emerging markets for three straight months (MSCI Russia was up 115 percent vs. MSCI EM's 68 percent).

However, with fundamentals no longer suggesting Russia is significantly undervalued, we do not expect this outperformance to continue much further. Supporting our point is the significant rise in three-month correlation between MSCI Russia and S&P 500 (94 percent as of 2 June, even higher that 93 percent against Urals), suggesting it is the global funds allocation and not fundamental factors that drive Russian market at the moment. Taking this into account, we think the best strategy at the moment would be to look for forward discount of Russian stocks to EM peers as that is likely to be decreasing regardless of whether global markets continue to rise or suffer a long-awaited correction. We currently still see these discounts in Oils, Utilities, Fertilisers and Transportation. In June, we recommend going long RusHydro, Gazprom, MMK, ENRC, Uralkali, Sollers, Globaltrans, Pharmstandard, MTS, X5 and Mirland.