Trailing After the First Half

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The Russian equity market ended 2006 in a bullish mood, the benchmark index had increased by 71 percent over the year and the outlook was rosy, with global economic strength pointing to sustained commodities prices for 2007. By mid-June, Russia was the only significant global market showing a negative performance year to date. What went wrong? And what hope is there for a brighter second half?

The negative poor first-half performance belies the bigger picture -- the world economy is on track for another stellar year as the globalizing trend continues to strengthen and outweigh protectionist tendencies. Investors are enjoying an international "Goldilocks" growth scenario -- not too hot, not too cold. Economic development is stable while inflation remains contained. Commodities prices have remained high and show no sign of collapsing. As a result, the gross domestic product has rallied again, and was up 7.9 percent in the first quarter.

The bullish global picture, fueled by continued liquidity, has justified an impressive global equities rally, which makes Russia's weak performance unique among major economies. There appear to be four primary causes for this decoupling: local traders, international and local investors and political sentiment.

Day-to-day movements in the equities market are caused by an ever-growing army of local traders who are constantly speculating and capitalizing on the market's relatively high volatility. In the absence of global capital flows, these traders rule the roost, determining short-term price movements, often within strict technical ranges. Since late 2006, local traders have priced up the market a number of times in anticipation of an inflow of new foreign money. Absent such inflows, on each occasion they have had little choice but to reverse the rallies, taking the benchmark indexes right back to where they came from.

The impact of international investors, then, has been conspicuous in its absence. Many have cited politics as the reason that Russia remains out of favor. Russia's role on the international stage has certainly played a part, but an analysis of international investors points to a broader trend. The first quarter of 2006 was characterized by a flood of international money into emerging markets, lured by globalizing tendencies. Despite the continuation of this macroeconomic theme, emerging markets have not enjoyed a repeat of that inflow so far this year.

Although less developed markets continue to provide the primary impetus of global growth in 2007, it is their more mature peers that have been in vogue. Powered by rejuvenated economies, lower relative risk and a clear upward trend, developed markets have enjoyed the bulk of investor interest, at the cost of emerging markets like Russia.

Large-scale local investors have compounded Russia's problems. Many big players have been long on the market for much of President Vladimir Putin's time in office and made huge returns. Although the details are less than transparent, it seems that several of these investors have diversified their holdings in recent months. Given the scale of profits they must have made on their home market, such tactics would certainly be justified. Russia is an interesting and healthy place to invest, but no single market, currency or asset class should dominate an investor's portfolio completely.

Diversification by investors who have been in Russia since Putin took charge (when the RTS Index stood at just 9 percent of its current level) should not be taken as a sign of impending risk, but as a responsible move toward modern asset management practice. Heavy selling has hurt the Russian market this year, but buying interest has prevented a collapse of the scale that many will recall from earlier periods. The record flow of IPOs shows that the market is getting wider, but daily volumes show that it is also getting deeper.

On the topic of IPOs, new stock performance has been hampered by broader market dynamics, and issuing companies have opted to spread their shares far and wide. New equity has certainly not helped market performance in 2007, but it does not appear to have contributed significantly to Russia's uniquely poor performance.

The final factor that has played a role in Russia's first-half performance is political activity. The Kremlin has long pursued its own interests regardless of market dynamics. In the first half of this year, the government has increased the volume and scale of those activities, which it believes demonstrate its international status, but in reality do little more than increase international perceptions of risk.

With elections looming, the government is banging ever harder on its nationalist drum. In the latter part of Putin's presidency, Russia has had spats with many of its international partners, near and far, leaving many civilians and businesses in Russia feeling a sense of international isolation during a period of unprecedented globalization. It is no coincidence that Russian companies so often feel unwelcome when looking to expand abroad.

Business expansion is, therefore, the first direct victim where political aggression has dominated in place of diplomacy and mutual respect. Portfolio investment, ergo the equity market's first-half 2007 performance, is another clear loser in this political game.

For portfolio investors, the relative stability that Putin's presidency has created has been a clear plus. Local investors likely understand that many questionable actions were necessary in a country that was so recently on the brink of collapse. But the world is changing, too, and becoming ever more integrated as diplomacy and mutually beneficial objectives become more and more commonplace.

Russia's leadership seems to have missed a beat here. Domestic circumstances merited some steps back, but international relations ought to have been maintained and advanced. The Kremlin seems committed to utilizing over-zealous nationalism to defend its popularity, and this comes at the cost of international economic participation, a fact that is directly reflected in the equity market's poor first half performance.

What, then, are the chances for the equity market going into the second half of the year? Back in December, there were clearly a number of positive global fundamentals that boded well for 2007. Halfway through the year, the international picture is meeting and exceeding the expectations these fundamentals generated. That Russia is down year to date should play to its benefit in the second half. With so much liquidity rushing around the world, Russia has become cheap relative to its peers.

Certainly the elections will cast a shadow, but Russia is now discounted enough to attract international interest. A repeat of previous outsized returns is probably too much to expect, but staying invested is the right idea at these prices. Russian indexes are still likely to close the year higher than they started. The market may not completely close the value spread that has opened in the last months, but there is every reason to believe 2007 will end positively for equity investors.

James Beadle is a portfolio manager at Pilgrim Asset Management.