The Birth of a Bubble?

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There's a telling story, not mine unfortunately, which encapsulates the feeding frenzy of the last great Russian equity bubble in 1997. An investor calls up his broker and tells him to start buying some "Irkutsk." The broker, always willing to oblige, says that he can get lots, but just needs to know whether the client would like "Irkutskenergo" or "Irkutsksvyazinform." The client pauses for a second and in some frustration replies that it really doesn't matter which, just get him some quickly. It has not entered the annals of broker history whether the order was filled or not.

On May 16 of last year, the date, perhaps not uncoincidentally, that the verdict in the case against Mikhail Khodorkovsky was read out, the Russian equity market ended a yearlong period of stagnation and began to boom. In less than 12 months, the Russian equity market has grown in value from $325 billion to $857 billion. The creation of $532 billion in value in less than a year has made Russia the best-performing large market in the world. And the appetite for equity seems as insatiable as ever. After a brief hiatus in March, the equity market is once again flying.

With the market rising by a factor of 30 in six years, and up 132 percent in the last 12 months, it is interesting to ask whether those currently charging into Russian equities aren't doing so a little belatedly. At what point does the revaluation of Russian equity move from being a story about overlooked assets in a misunderstood market to a bubble? The answer depends on whether enough new information has emerged to support the revaluation. Remarkably, enough seems to have changed for the revaluation to remain justified.

The most important trend, clearly, has been the seemingly unstoppable rise of commodity prices, particularly oil. Last year, the market raised its expectations of the longer-term oil price from around $30 to around $45 per barrel. This year, there had been an expectation that commodity prices would at least moderate. But so far those expectations have been comprehensively wrong. The oil price is 20 percent higher than at the end of last year; nickel is 32 percent higher; gas is 16 percent higher; copper is up 39 percent; and gold has risen 19 percent. Virtually all commodity prices are higher than the market expected, forcing everybody to re-examine yet again how valuable are the companies that produce them.

Next has been the growing enthusiasm for emerging markets. In the past, when global markets began to question whether enthusiasm for assets was justified, funds retreated back to the safe havens of developed markets in the United States and Europe. This time, however, the growing feeling that the world may be a more risky place is emanating from precisely those markets once considered safe. The alarming inability of the United States to control either its budget deficit or its current account deficit and the failure of Europe to implement structural reforms is an irony that will not be lost on the Russians, who were once berated by their international counterparts for precisely those failings. If during the next global credit crunch investors find it more comfortable to remain in Russia, China and India than the United States or Europe, it will mark a pivotal turning point for markets that perhaps will no longer deserve to be described somewhat disparagingly as "emerging."

Finally, there has been a financial revolution ongoing in Russia driven by extraordinary levels of liquidity. The Central Bank has been pumping out money in an attempt to maintain the competitiveness of the ruble. As a result, financial markets have been busy finding increasingly innovative ways of making this liquidity available to customers. Corporate debt, consumer finance, asset management, mortgages, derivatives and IPOs are all booming markets in Russia. By the end of this year, Russia will probably have the largest stock in the emerging-market universe (Gazprom), have done the biggest IPO in history and have daily turnover on the equity market of around $5 billion.

It would appear, then, that we are not in a bubble yet. It is far from irrational to buy companies producing hydrocarbons and metals when commodity prices are doing cartwheels. Equally, when the globe's traditional safe havens are the source of economic uncertainty, then enthusiasm for the more-secure emerging markets is sensible. Finally, the impressive inefficiency of much of Russian business and the banking sector means that there remains enormous opportunity for capital to make excess returns in Russia.

But it is equally dangerous to be complacent. It is precisely in this environment of easily justified enthusiasm and booming markets when the danger of valuations becoming separated from reality is at its highest. A market driven by demand for a generic asset class, where valuations are at least no longer cheap, in a country where the money supply is growing by 40 percent per year and the government is embarking on a spending spree, appears to be in real danger of moving from the sweet spot of global trends toward the birth of a bubble.

Roland Nash is chief strategist at Renaissance Capital.