beyondbrics

By Maarten-Jan Bakkum of  ING Investment Management

The sharp correction in Russian equities of the past few weeks is nothing unique. Based on the experiences of recent years, there are few stock markets that are riskier than Russia’s.

After Brazil and South Africa,  the Russian market has been the most sensitive to increasing risk aversion among investors since the market correction of 2008. And given the rapidly deteriorating outlook for world economic growth and increasing fears that the European debt crisis will worsen, a further correction in equities is likely. At first sight, then, Russia does not appear to be an obvious investment opportunity. But things aren’t necessarily what they seem.

In fact, relative to other emerging markets, Russia could provide strong investment returns in the coming quarters. Growth rates are rapidly slowing in virtually all of the world’s emerging economies, even in relatively solid countries like India and China. Russia is a positive exception in this regard. Its growth rate will most likely be higher in the second half of the year than it was in the first.

This favourable situation is mainly due to the stringent macro-economic policy that the Russian authorities have implemented to limit inflationary pressure. Cautious expenditure in the first half of the year has also given the government greater scope to spend more in the quarters leading up to the parliamentary elections of December 2011 and the presidential election of March 2012.

All things considered, growth in the second half of this year will probably exceed 4%, approximately half a percentage point higher than in the first half, whereas growth in other emerging markets will slow by an average of at least half a percentage point in the same period.

In a world in which economic growth is becoming increasingly scarcer, the Russian growth momentum is a major argument for a positive assessment of its stock market, all the more so because of favourable valuations: with a price/earnings ratio of five, Russia is more than 40% cheaper than the average of all emerging markets.

In addition, the quality of economic policy has clearly improved since the crisis of 2008. As a result, growth is less volatile and inflation has dropped. From 10% in January 2011, inflation fell to 8% by August of the same year and is expected to be 5% for the first half of 2012. The Russian rate of inflation has never been as low since the collapse of the Soviet Union in 1991.

Given the crucial importance of oil exports to both the real economy and the stock market, it is of course important that the price of oil does not drop sharply in the coming period. The bleaker outlook for world economic growth does not help.

The weakness of the Russian market and the sharp depreciation of the rouble in the past weeks can be explained by the deteriorating prospects for energy and raw material prices. Particularly the negative sentiment surrounding China and the higher risk of a Chinese growth slowdown below 8% has pushed Russian assets clearly out of favour. In the past few years, we have seen more often that the Russian market tends to be an early indicator of oil price movements.

The upcoming parliamentary and presidential elections explain little of the recent market weakness. When prime minister Vladimir Putin and president Dmitry Medvedev announced their intentions to swap positions and the well-respected finance minister, Alexei Kudrin, resigned, the Russian equity market did not suffer.

The market has been and should continue to be driven mainly by oil price expectations. The recent correction suggests that oil prices will come down substantially. If that turns out not to be the case, Russian equities are likely to perform very well. And who knows; in a world in which major central banks are increasingly driven to printing more money and in which emerging markets are accounting for most of global GDP growth, prices of commodities and oil may turn out to surprise on the upside.

Maarten-Jan Bakkum,  is senior strategist, emerging markets equity, at ING Investment Management

Related reading:
Gideon Rachman Russia steps backwards, FT
Russia feels pain as investors take flight, FT
Kudrin quits [with video] beyondbrics
Rouble squeezed at home and abroad, beyondbrics