The Cruel Mistress Returns

The Russian equity market has soared a remarkable 100 percent since January. At the same time, investors may have noticed a curious silence from the nation’s once-raucous investment management community. Considering how the RTS Index fell in 2008, this newfound discretion is welcome. What is the outlook for the market for the remainder of the year?

The silencing of the bulls is about more than simply losing face. Angry investors clawed back whatever money they could during the market rout. As a result, asset management businesses collapsed as dramatically as the market itself. Many foreign funds simply closed up shop, while domestic businesses slashed marketing costs and staffing.

Investors have every right to be furious with managers who took so much risk with their capital. But the market is a cruel mistress, and so the punishment has already been meted out. In fact, with prices having fallen so far, there are clear risks that the recent rebound will encourage a resurgence of unrealistic promises and expectations.

Those who were prudent enough to keep cash during the end of the bubble and invested it in early 2009 have been richly rewarded. Yet with the extent of economic damage unfolding, they should review their risk appetites now. To put it plainly, if such a sharp market rebound seems sustainable, then Russia investors have learned nothing.

Over the long term, it is true that Russian equities have a bright future, but prudent fund managers have approached the rally with caution. Equity market rallies may precede economic recoveries, but as New York University’s Nouriel Roubini observed recently the equity market has predicted “six of the last zero recoveries.” The difference between a bear-market rally and a new bull market may only be observable with hindsight, but there are few cases of equities performing sustainable rebounds, while the downward economic cycle is still under way.

The steepest part of the economic downturn may now have passed, but the economic and financial crises are far from finished. From 1999 through 2007, average annual gains in the Russian equity market exceeded 40 percent, so there is no need to rush in. Prudent investors with a focus on long-term wealth accumulation should now recognize a growing divergence between equity prices and the real economy. With so much excess production capacity globally, prices are unlikely to rise sharply for an extended period.

The global growth of recent years was driven by excess liquidity. That liquidity stemmed from the securitization of loans in the developed world, a practice that has now halted almost completely. Recent improvements in the interbank markets are a clear sign that the acute phase of the crisis is ending, but reducing the amount and price impact of excess borrowing (or “delevering”) the global system will take years.

Such delevering is a systematic change that will slow the rate at which developed world economies expand. So too will their internal restructuring. After years of offshoring their production capacities, developed world economies are now likely to internalize their business-value chains again, perhaps assisted by weaker currencies that reduce the attractiveness of imports. Thus, the developed world is unlikely to drive such rapid global economic improvement as the equity market has been indicating in recent weeks.

Die-hard optimists may point out that emerging market economies are already picking up the slack. Indeed, there is truth to this argument. Import demand from China has restored profitability to many commodities, and Chinese policy shifts — not least state medical aid for the wider population — point to fantastic potential.

We are talking about macroeconomic restructuring though. As many years as it will take for developed nations to reduce their imbalances, it will also take emerging markets time to encourage domestic demand. Conspicuous consumption, which Russia investors are so familiar with, is as much a function of culture as economics.

The transition to a multipolar global economy is under way, and the long-term outlook for Russian equities is inspiring. But let’s not forget the lessons of 2008. The best profits are made by investing patiently and prudently, not through greed, fear, leverage or urgency. If you have cash on hand, maintain a cool head and stick to the fundamentals. Good things sometimes take time.
 
James Beadle is chief investment strategist at Pilgrim Asset Management.