RUSSIA WEEK: A PANGLOSSIAN PARADIGM

FINANCIAL ANALYSIS 

by Chris Weafer

• Moscow's bourses should open better on Monday, following another positive session in the US on Friday, a $2 p/bbl rise in the price of oil and strong gains (+4.2%) in Brazilian commodity names in New York. The weekly fund flow report from EPFR showed that investors are finally looking again at Russia as an acceptable risk in the “commodity/recovery” theme.
  
• Following a less catastrophic 1^st Qtr for earnings in the US, and Russia, than had been feared the market gains of the last few months look more secure. We retain our mid year target for the RTS in the range of 1,000. Progress from here, after a near 70% rally from late January, will be tougher but the combination of cheap valuations and light investor exposure might provide a sufficient catalyst to add the extra 20% upside.
  
• Note: at the end of this note is a table showing the % that the most liquid GDR/ADRs are currently sown from last year’s high. 26 stocks are down by more than the market average and 20 of these are off by 75%, or greater, from last year’s high. Still plenty of scope for recovery gains.  

• The main risks remain the oil price trend and the level of nonperforming loans in the banking sector. Because of that, it is too risky to broaden out too far from the most liquid blue chip names, i.e. until there is greater clarity in these two issues.
  
• This week will mark the first anniversary of the inauguration of Dmitry Medvedev as Russia’s 3^rd president and also the signing into law of the Strategic Industries legislation. See separate note early in the week.
  
• This week, i.e. between the May 1^st and 9^th holidays, is traditionally relatively quiet in Moscow with very little newsflow expected
• The main international market event this week will be the expected release of the bank stress-test report in the US. Several big banks are expected to be forced to raise additional capital. The report is now due on Thursday, the same day as the US Fed Chairman is scheduled to make a keynote speech about bank structures.
• Amongst the other news events making international headlines will be the interest rate decision of the ECB (Thursday) and several big economic reports due in the US. The most important is the nonfarm payroll and unemployment report on Friday. Investors are hoping that the trend of slight improvement, or a slower rate of decline, will also be seen in these numbers. The US Fed Chairman is scheduled to make a speech to the US Congress on Tuesday and on the bank industry Thursday.
• Investors appear to be warming to Russia risk, or at least that might be the interpretation of last week’s fund flows. Russia funds took in more money than Brazil for the first time this year, perhaps as a response to the continued out-performance of Russia relative to most other emerging markets and also because the market is, on average, considerably cheaper than peer group countries such as Brazil. But, the $127 mln received was balanced with a net withdrawal of $155 mln from the Eastern Europe fund category, within which Russia has a share of over 40%. 
• The RTS rose 0.2% in last week’s holiday shortened trade, including Thursday’s 2.2% rise. MICEX ended the week down 0.3%. Year to date, the two domestic bourses are up 32% and 49% respectively. The market is, however, broadening out beyond the liquid blue chips and beyond the international stocks. The mid cap RTS-2 Index rose 1.8% last week and market gains were led by stocks in the consumer, electricity and telecom sectors.
• International equity markets closed last week in an optimistic mood. The 0.5% gain in the S&P 500 helped that measure to a gain of 1.3% for the week. Through April, it rose 9.4%, the biggest monthly gain in almost ten years, as the rally that started on March 9^th shows no sign of easing. The S&P has gained 30% since then.
• The All-World Index rose 1.4% last week, led by 2.4% gain in European equities. The MS Emerging Markets Index rose 2.3% to bring the year to date rise to 17%.
• The value of the ruble rose 0.3% against the basket and 1.0% against the dollar last week. Investor appetite for emerging market risk is growing and the price of oil again traded above $50 p/bbl. At the close of the holiday-shortened week, the ruble-dollar rate was 32.988.
• Yen was the big faller amongst the main international currencies last week, down over 2% against the dollar and the euro. Sterling was the biggest gainer as confidence of an early end to the global recession grows. The dollar lost a marginal 0.2% against the euro, to end at $1.327, while traders wait for Thursday’s ECB decision and commentary.
• The price of WTI crude rose 3% last week to end Friday at $53.2 p/bbl and Brent closed at $52.85 p/bbl. Traders are ignoring the fact that storage in the US and Europe is near capacity and oil tankers are also near full of stored oil. Oil is again an asset class for financial investors to play the hoped for recovery in the global economy. But, if demand does not pick up, especially US gasoline usage, then oil will come under downward pressure in late May and June.
• Most industrial metals rose late last week after a report showed a positive trend in China’s Purchasing Manager’s Index. Copper also rose as stockpiles of the metal fell for a fifteenth straight day. Platinum and palladium bucked that trend and each fell almost 10% last week after the Chrysler Chapter 11 move.
  
• Gold and silver lost out last week as investors shunned the traditional haven assets. Gold lost 2.8% for the five days, ending the week at $888 per ounce. A particularly auspicious number in Asia that, perhaps, might prompt some buying on Monday. 

Investors under pressure to reduce cash. The prospect of equity and commodity prices rolling over and, at least partially, reversing the strong gains of the past few months remains dim. Assumptions voiced by advocates of an unsustainable bear market rally have been proven correct in that the economic decline is continuing across the world, corporate earnings are mainly as bad as feared and many banks will need more capital. Optimists continue to take the view that all of these events were predicted, haven’t been any worse than expected and, therefore, are priced into current valuations. For example, of the 161 companies that reported last week, 112 had results that were better than consensus but still down very sharply for the seventh straight quarter of negative earnings growth. It is of course far too early to say with any degree of assurance whether the rally is based on no more than panglossianism or whether the coordinated efforts of governments and Central Banks have succeeded in averting a “deeper for longer” recession. It was more a case that the 1^st Qtr was less of a catastrope than feared but still bad. That evidence, one way or the other, will likely only emerge in the autumn. Meantime, the 30% rally in US, EU and Asian equities (from March 9^th) looks about done but, at the same time, valuations look sustainable for now. The longer a correction in markets is avoided then the greater will be the pressure on investment funds to reduce high cash holdings. 

Still looking at RTS 1,000. We retain our forecast mid-year target for the RTS in the region of 1,000 (refer to Russia ’09: Darkness Before Dawn, dated December 1^st ’08). Without any major negative news in the US or the EU, that extra 20% hike from here could come because of the combination of relatively cheap Russian equities, i.e. to emerging market peers, and because the asset class is under-owned by international investors.  The big test for Russia will be the oil price trend and the scale of bank nonperforming loans. Both are considerable risks that should keep investors focused on the most liquid blue chips rather than venturing too far into the 2^nd tier names for now. 

See the table at the end of this note for a list of GDR/ADR shares ranked by the still biggest loss from last year’s high prices. 26 ADR/GDRs are still down my more than the RTS and 20 of these are still showing losses of 75%, or greater, from the high of last year. 

Trading this week

US payroll report will likely be decisive. There should be no major domestic news this week as, traditionally, the first week of May is a semi vacation period. Moscow’s bourses will be closed again on Monday, May 11^th. Trade activity will remain relatively light and the direction of stocks driven by international events and trends. It will be a busy week for newsflow in the US while in Europe, the ECB and Bank of England will decide on interest rates on Thursday. The ECB rate decision will affect the dollar-euro rate and will, therefore, have some knock-on effect to commodities. In the US, there will be several potentially market moving reports, with the most important coming on Friday. That is the April nonfarm payroll and unemployment rate updates. As with the other reports, investors are hoping to see some improvement in the economic trend that will allow comfort to the optimistic view that the recession is levelling off. The consensus is for a loss of 630,000 jobs, from 663,000 last time, and an unemployment rate of 8.9%. Last month it was 8.5%. Before that, there will be updates on consumer spending and pending home sales, due today, and the ISM non-manufacturing index update on Tuesday. The US Fed Chairman, Ben Bernanke, will make two keynote speeches this week; on Tuesday he will address a Joint Economic Committee in Washington and, on Thursday, he will speak at the Chicago Fed’s Conference on Bank Structures. That is the day that the Fed is expected to issue the bank stress-test report so the Chairman’s speech will likely deal with that. Otherwise, there will be several more big company 1^st Qtr results this week, albeit probably following the same pattern of the last few weeks. 

US Bank Stress Test 

Several US banks will need capital. The US Fed has postponed the release of the stress tests on the biggest U.S. banks from Monday until Thursday, May 7^th. According to weekend media reports, that is to allow time for the banks affected to negotiate proposed solutions, or next steps, with examiners.

According to those reports, the Fed wants tangible common equity equal to 4% of a bank’s assets and Tier 1 capital worth about 6%. The Fed wants common equity to be the “dominant” element in a bank’s primary capital, according to a central bank report on the test methodology released a week ago. It is expected that at least 6 of the 19 largest U.S. banks will now require additional capital. How much, and how soon, may have an impact on market sentiment, albeit the whole issue has been trashed out so much in the media that only a major surprise may raise much more than an investor’s eyebrow. 

Oil 

Still too much oil. The price of oil rose to a five week high on Friday as financial investors build up exposure to the asset class. Investors are, so far, ignoring the still bad supply-demand balance in the oil market and concentrating on the fact that oil is a very direct play on the hoped-for global growth in 2010. The weekly US Energy Dept report showed build of 4.05 million barrels in crude last week and while this was offset with a drop of 4.7 million barrels of gasoline, that was because refineries operated at only 82.7% of capacity in the period, down 0.8% from the previous week. The obvious conclusion is that gasoline demand is slowing. The other supply-demand negative last week was a comment from the head of Rotterdam port, the biggest oil terminal in Europe, that storage facilities are nearly full and tankers are queuing up to offload. 

Urals is back above $50 p/bbl. But, for now, the financial aspect is dominant and traders hope that either OPEC will again cut production, when ministers meet on May 28^th, or US gasoline usage will pick up after the Memorial Day holiday. At the close on Friday, WTI for June settlement traded up $2.08 p/bbl at $53.20 p/bbl while the equivalent Brent contract closed the up at $52.85 p/bbl, up $2.05 p/bbl. Over the past five days, WTI gained 3.2%, to bring the gain from the start of the year to 19%, and Brent gained 1.9%. Urals closed the week at $50.74 p/bbl. 

Currency

Ruble continues to edge higher. The value of the ruble rose again last week, gaining 0.3% against the basket, because the price of oil traded above the $50 p/bbl level again and also because investor appetite for risk, including emerging market currencies, is growing. The weakness of the US dollar also helps sentiment towards the ruble. It gained 1.0% against the US currency last week to close Thursday’s session at 32.988. Against the euro, the ruble gained 0.4% to end the holiday-shortened week at 43.903. The value of Russia’s foreign exchange reserves fell $4.2 bln last week, to $380.6 bln. Despite the gain in the value of the euro – which should have meant a rise in the value of dollar based reserves - the reported reason for the decline was demand for foreign currency by companies repaying foreign debt. 

Dollar remains under pressure. In the international markets, the yen and the dollar both lost out as investors moved back into sterling and the euro. The former two currencies are viewed as haven plays, and do well when equity markets fall, while the latter two are recovery plays. The yen fell the most, dropping 2.3% against the euro and 2.2% against the dollar (to 99.115) over the week. The dollar closed marginally lower against the euro, down 0.2% at $1.327, albeit the market remains more in balance until the ECB rate decision and statement on Thursday. There is a growing consensus, according to a Bloomberg survey, that the dollar euro rate may hit $1.40 before correcting. 

Trading last week: Russia 

Mid Caps gaining ground. The local markets traded for only four days last week due to the May 1^st holiday and, as is usual, activity was relatively low in the lead up. International market trends and the oil price provided the main influences rather than anything domestic. The RTS rose 0.2% by virtue of the 2.2% rise on Thursday, while MICEX ended Thursday down 0.2% and down 0.3% for the four days. The mid cap RTS 2 Index was again the better index, rising 1.8% for the week. Year to date, that measure still lags the blue chips with a gain of 16% while the RTS is up 32% and MICEX has rallied 49%. 

Domestic themes gain. The domestic themes were the better performers, i.e. rather than the commodities or banks. Again, reflecting the broadening of investor interest. The consumer sector rose by more than 4%, followed by electricity and the telecom sectors. The oil names were, on average, almost flat while metals and banks eased back a little. 

Note: the table with the best and worst performing stocks of last week is at the end of this note. 

Trading last week: International 

Optimists prevail. International markets closed out last week in a very confident mood. The S&P 500 Index rose 0.5% on Friday to bring the week’s gain to 1.5%. Through April the index gained 9.4%, the best monthly gain for almost ten years and, from the low of March 9^th, it has rallied 30%. The FT All-World Index rose 1.4% over the past five days with European and emerging market equities leading the way. The FTSE E300 Index gained 2.4%, led by the markets in the UK, and the MSCI EM Index closed the week up 2.3%. The reason for the broadly based rally was much the same for all; investor optimism that the pace of the economic decline is easing, that the problems in the financial sector have now be resolved and growth will resume in early 2010. The Purchasing Managers Index in China and several economic updates in the US all served to feed that optimism. The MSCI Asia-Pacific Index rose 1.6%, albeit the markets in Japan were closed more than open due to the Golden Week holiday. That index is also up close to 30% since the early March low point.

Commodities 

Copper bottomed recovery. The price of most industrial metals rose late last week, partly with the generally positive outlook for the global economy and also because financial investors are increasing their exposure to the asset class as a geared play on global recovery. The latest catalyst for that optimism came from the report showing that China’s Purchasing Manager’s Index rose to 53.5 in April. Above 50 indicates growth in continuing. Copper led the way higher again last week, rising 2.5% on Friday and over the week, as the China optimism was boosted with an LME report that showed another decline in stockpiles of the metal. Stocks have now fallen for fifteen straight readings. Nickel gained 3.1% and zinc closed up 4.5% last week. Platinum and palladium bucked that positive trend in base metals, falling 7.2% and 8.5% respectively, mainly due to the problems of the auto sector in the US. 

Haven loses out. Gold and silver lost out last week as investor’s avoided the traditional asset havens amidst the optimism for an early end to the financial turmoil and economic decline. The price of gold ended Friday at $888 per ounce, a very auspicious number in Asia. The metal lost 2.8% for the week while silver lost 3.4%. 

Dry weather boosts wheat price. The price of agriculture commodities jumped sharply late last week after monitoring agency, DTN Meteorlogix, said that dry weather conditions in Russia and Ukraine might curb the yield on wheat this year. That pushed the price of wheat up 2.5% on Friday and 4.9% over the five days. Corn also jumped, rising 2.1% on Friday and 7.3% over the week. Weather forecasters are predicting tough growing conditions this year and a lower yield for major crops. The slight weakness in the value of the dollar also provided some encouragement to hopes that buyers might return for these crops. 

Funds Flow: Tide Turning for Russia? 

Russia takes more than Brazil. Finally, the weekly fund flow data from EPFR Global* provides some optimism that the attitude of global investors towards Russia may be changing for the better. In the week to Wednesday, Russia dedicated funds reported inflows of $122 mln. While not a huge amount by any means, the total is more than taken into Brazil funds for the first time this year. Last week, Brazil funds took in $47 mln and India funds reported inflows of $33 mln. China funds continue to be the star attraction and again topped the list of country inflows with a reported $389 mln (including Greater China flows). 

Still lagging peers. Russia funds have now reported net positive inflows for seven straight weeks, albeit the weekly amounts until this week have been relatively modest. Year to date, and despite the fact that Russian equities have been amongst the best performing major assets within the MSCI Indices, these weekly funds have only taken in a net $178 mln. That compares with $1.5 bln each for Brazil and China funds. 

Investors worry about oil risk. Even though the dollar based MSCI Russia Index has gained as much as the Brazil index (+24% each to April 22^nd) and much more than China and India (+8% to April 22^nd), investors have preferred to use Brazil for commodities exposure. That is because Russia has a much greater vulnerability to the price of oil and because of heightened concern that the scale of nonperforming loans in the Russian banking sector may yet cause another serious blow to the economy. The fact that the Federal Statistics Service may stop issuing monthly updates for such sensitive subjects as unemployment, only serves to heighten investor suspicions and the risk premium. 

By far the cheapest. But, with oil clinging stubbornly to the $50 p/bbl level and optimism that the recession in the global economy may have, or be close to, bottoming, investor risk appetite is improving. Russian equities are, on average, trading at a 2010 forecast PE of 5.4. That compares with 8.4 for Brazil, 11.2 for India and 15.4 for China according to Bloomberg data as at April 22^nd. The big danger for investors, therefore, is that if the optimism towards global growth continues to build, and oil holds at the $50 p/bbl level, then there might easily be another spike up in equity prices in Russia, i.e. to close the valuation gap with Brazil. That would imply another 50% up for the RTS. Hence, those investors are, albeit with only a couple of weeks of evidence thus far, becoming nervous of their generally neutral to underweight position in Russia today.

GEM Funds allow for safe play. The big money flows continue to be directed to the GEM Balanced funds as a majority of investors continue to avoid country specific decisions. Last week, these funds took in $242 mln of new money to bring the April total to $3.4 bln and the year to date total to $6.9 bln. Unfortunately, while Russian equities accounted for an 11%+ share of GEM in mid 2008, by early 2009 this was cut to just over 5%. That means that Russia’s “share” of that GEM inflow was only $350 mln while the bulk of the money was allocated to China, Brazil, Taiwan, and Korea. Unfortunately, Russia is a big part of the Eastern Europe category, i.e. with a 42% weighting, and investors continue to run a mile from that exposure. Last week, the Eastern Europe Fund category reported outflows of $155 mln and year to date the total amount of redemptions now exceeds $940 mln. Russian equities will have had to fund $395 mln of that, thus more than balancing the inflows from the GEM allocation.

**Note: The weekly fund flow data from EPFR is only indicative of a trend and does not represent the total amount of money invested or withdrawn from investment funds. The more complete data, covering funds that report only month, is available with a six-week time lag. We will update those flows with a report early this week.

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