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Thursday, August 16, 2007

When America Stumbles, Russia Falls

As shown in the graphic above, the Russian stock market has plunged in value from a high of 2,100 on July 23rd to just 1,800 today -- a loss of nearly 15% of its value in just three weeks. Writing in the Moscow Times Chris Weafer, chief strategist at Alfa Bank, explains why Russians who cheer American economic setbacks are moronic fools dooming their own country to oblivion. It's the American stock market that's causing this crisis in Russia.

Anybody with access to the media has certainly heard of the problems caused by subprime mortgages in the United States, the growing global credit squeeze and troubled hedge funds. These are the main reasons cited for the large falls in world equity markets since mid-July and why investors around the globe are sitting today on pins and needles with one finger on the sell button. And they have every reason to be nervous and to remain so until the end of September or early October.

Despite the recent injection of cash into the financial markets by the world's central banks, confidence remains badly rattled. Stock market investors, bankers, industrialists and consumers, while relieved that the world economy did not jump off a ledge last week, will remain nervous of spending until they are convinced that recent events are not the start of a long-term downtrend.

At first glance, it would seem that there is no reason for investors, the business community and ordinary consumers in Russia to be concerned. After all, assets are still, in most instances, a lot cheaper than their counterparts in the rest of the world. The economy, which is expected to grow by 7 percent in 2007, is expanding at more than twice the global rate. The consumer sectors are rising at around 15 percent annually. And the country's budget and economy have among the strongest fiscal positions in the world.

So why should Russia care? Is not the almost 9 percent fall in its RTS stock market from the record high of July 23 a buying opportunity -- a gift from global markets? For traders willing to take on the substantial risk of uncertainty in equity markets today, cheaper assets are certainly attractive. For investors looking for more stable conditions, the time is not quite right.

Global markets are set to remain very volatile for several weeks or months. Despite the liquidity injection, investors on Chicago's options markets are betting on an increase in volatility and a second wave of selling. The Chicago Board's so-called "VIX index" -- referred to by some as the "fear index" that measures the market's expectation of volatility over the next 30 day period -- is at its highest since early 2003.

Despite the favorable domestic fundamentals, Russian equities are now firmly tied to global emerging markets and they, in turn, are linked to markets in developed economies. The price of oil no longer plays more than a supporting role to equity market trends, and it will not be until the fourth quarter, or early 2008, that investors can start to see the economic impact of the large state investment programs and consumption-based growth. Many hope that precisely these factors will drive the economy forward under the next government. At this point, I fully expected that Russian equities will once again exceed expectations by the end of this year and in 2008 as greater state-led investment leads to increased earnings and to expanded asset valuations. But in the meantime, the RTS and MICEX, Russia's other stock exchange, will move tick-for-tick with the moves in emerging markets and with Wall Street.

People looking at the instability in global financial markets will have heard the usual mix of optimistic and pessimistic assessments, each presented with equal vigor. The optimistic case is based on the fact that global market valuations are not high in a historical context, corporate earnings and economic growth numbers are continuing at a satisfactory pace and the world's financial regulators, having learned from past mistakes, are now much more adept at effective intervention. This is all true. For their part, the pessimists will argue that the fear of a change in expected growth conditions can often be enough to change the previously expected consumption and investment patterns, and this, historically, has caused recessions and equity market crashes. This is equally true. Timely liquidity injection is a major positive, but ultimately the decisive factor will be how confidence is maintained.

That is why this period of high volatility on the equity markets is likely to remain until the end of September or early October. Market participants will want to be sure that the recent problems will not affect the desired positive fundamentals. Consumer and investment activity indicators reported in September and October have a disproportionately greater importance to markets than at any other time of the year. If investors are already looking forward to a new year and if that optimism is subsequently shattered, the impact on valuations and prices can be swift and decisive. For good reason the world's major equity market crashes have occurred in the early autumn. October 1929 was the first of those and the run-up to the October 1987 crash was just as uncertain, divisive and unpleasant.

We have heard the phase many times before -- "it's different this time," which may constitute the four most expensive words in the English language. Historically, investors tend to lose the most money when they start thinking that there is a new market factor or a "new paradigm" in valuations. Investors in the dot-com era also thought it was "different this time," and, of course, it was not. That said, there are indeed some important differences this time. The speed at which Central Banks now inject liquidity is different and positive. On the other hand, how the largely nontransparent, hugely influential and leveraged hedge funds will fare in any worsened crisis is a huge unknown.

Apart from the share market volatility, the same question needs to be asked: Why should we care in Russia? Is not the economy strong and growth robust? The answer is yes to both. But just as a shift from optimism to fear can cause a major shift in global investment and consumption patterns -- thus, undermining the positive fundamentals -- any shift in global growth and cross-border investment flows will sooner rather than later have a negative impact in all emerging economies.

China's economy is the fastest growing in the world, but this could very quickly change if there is a major slowing in its major customer market, the United States. In that case, China's demand for input products, such as oil and base metals, will fall. The continuous growth in China (and other Asian economies) for raw materials is the single most important factor in the commodities boom that has earned more than $700 billion for the Russian economy during President Vladimir Putin's presidency. If that demand growth assumption is undermined, prices might revert quickly back to long-term averages, which, for oil, means about half the price that it is being sold for today. Even though growth indicators in the economy and "revitalized" domestic industries is impressive, the fact remains that more than 60 percent of the value of exports and the expected revenue into the federal budget still comes from oil, gas and the tax revenue from other commodities.

A major element of the favorable view for the Russian economy that supports my bullish view for the RTS through 2008 is based on at least a stable external environment. That will allow the government to pursue its plans to finally start more aggressively investing in such areas as downstream oil, petrochemicals, metal smelters, technology, aviation, IT and so on. But if this positive external scenario does not pan out, then it is unknown how the government will react to the undermining of revenue assumptions in its three-year budget. Will it dip into accumulated financial reserves more aggressively or will it retreat and delay plans? Either event will change the outlook for the investment case.

Russia is now simply too big in the world to remain untouched by any major global shake-out. The economy is projected to be the world's ninth largest by the end of this year and the stock market is the fourth biggest among emerging markets. The $700 billion of energy export earnings over the past seven years are largely responsible for these impressive statistics. This is exactly why the rest of the world matters.

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