COMMENT: Local investors key to future direction of Ukraine equities

By bne IntelliNews October 27, 2009

Jathan Tucker and Danylo Spolsky of BG Capital -

As global markets recovered from their March lows, International Monetary Fund money started rolling in and the perceptions of a Ukrainian sovereign default faded into the distance, Ukrainian equity and fixed income turned into some of the best performing asset classes in emerging markets. Along with other Central and Eastern European markets, the distressed prices and recovery of commodity sectors in particular have contributed to a rapid rise.

In Ukraine's case, the rapid ascent of domestic equities was driven primarily by local market players, who replaced foreign investors as global risk aversion dominated flows into Ukraine. Domestic market participants were supported by the release of a new trading platform, the RTS Ukrainian Exchange, which, with the aid of local brokers, helped boost the liquidity of the market and subsequently attract a wider investor base. In September 2007, the PFTS saw UAH623m in trading volume; by September 2009, total volumes across the two platforms reached UAH842m, with the majority now concentrated on the Ukrainian Exchange.

Throughout the steady rise from March to October, Ukraine sharply outperformed most markets globally. Looking at index valuations, the PFTS Index's price/earnings (P/E) has skyrocketed 20 times from January 2005 to today, thanks to the significant relative undervaluation of local stocks. Meanwhile, regional index peers' P/E levels have recovered at a much slower pace - Russia's RTS has tripled and the emerging markets MSCI is up two-fold. Ukraine's closest peer, the Warsaw Stock Exchange, saw P/E levels increase 11 times.

The most significant consequence of this growth disparity is that the gap between Ukrainian and global valuations has closed significantly. Accordingly, growth on the Ukrainian market is no longer driven by a deep discount to peers, as had been the case throughout its remarkable rise between mid-2006 and the end of 2007. Ukraine now moves more closely in line with global valuations.

Looking ahead

Looking towards the end of the year, the market direction in equities will rely on the path of liquidity from local investors; the sustainability of gains in other emerging market and commodity-related economies, as the historic valuation discounts for Ukraine have disappeared; and finally, fallout from the upcoming presidential campaign, which should be hotly contested.

The story year-to-date for CEE and commodities in general has been increased demand from China, in particular for materials. That steel production, the primary driver, has bottomed out is a widely accepted fact at this point. However, as cold weather sets in and construction activity subsides, billet prices are seeing some weakness. Production and sales need to remain high for companies to continue to add to profits and operate at high capacity loads, so metals prices and bookings are the key items to watch for with regards to the Ukrainian stock market and macroeconomic flows generally.

Secondly, the path of liquidity from local investors, many of whom are new to stock investing, will help determine the growth direction of local equities. After a quiet start to the summer in terms of trading volumes on the Ukrainian Exchange, turnover has grown steadily in the months since. Total market volumes have jumped nearly 4x from June to September, and the first two weeks of October alone are setting volumes on pace to nearly double September tallies. The trend is primarily attributed to the active marketing of trading facilities on the Ukrainian Exchange. If these volumes continue to come in, the relatively low free float of the domestic market will squeeze prices higher.

Finally, fallout from the much-anticipated presidential election in January 2010 and the campaign run-up to the vote itself will be a significant factor. Outside the borders, the Ukrainian political scene is seen as the country's most glaring shortcoming, and the associated risks - perceived or real - will determine whether international investors decide to jump on the bandwagon of growing liquidity and equity market growth.

Connected to this election, the current government has been unwilling to rein in spending, fearing a backlash of public sentiment in the polling booths. Despite pleading from the IMF, the situation is unlikely to change and has changed the dynamic of the local bond market. With international bond markets effectively shut, borrowing to fund government expenditures has shifted to the local market. With yields pushed in excess of 20% and the hryvnia stable for the moment, banks now roll liquidity into these instruments given the ongoing contraction of loan portfolios. Although higher yields are damaging to borrowers in the corporate sector, the silver lining may be a real domestic bond market with banks taking down positions on their books - no longer dominated solely by the interaction between the government and the National Bank.

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