UBS in Moscow -

As the dust starts to settle in the turbulent international capital markets, a consensus is emerging that Russia has had a good crisis.

While global GDP is likely to slow as a result of the credit crunch, the fall of the dollar means that the dollar-denominated GDP growth may stay about the same as in previous years. At the same time, the increasingly domestically driven Russian growth story has given the country a measure of immunity to the external crisis.

Over the last three years, the Russian economy has received a series of slaps on the wrist from external shocks, but none of them have been hard enough to bruise the economic outlook and the sting they have left is a healthy reminder of the need to assess risks and invest into quality projects.

While the jury is still out on the severity of the current crisis - economists are predicting that liquidity conditions will remain tight for the next two months - if there is no financial train wreck in the next few months Russia's economic outlook remains bright for several years to come.

Emerging market-centred cycle has years left to run

Following the credit crisis in developed markets and the seemingly sharp slowdown of the US economy, the big question for investors into Russia is whether the end of the emerging market-centred global cycle is nigh or whether it still has at least a year to run. We are firmly in the latter camp.

The following are the key reasons, focusing on macro fundamentals first, and concurs with the views of our global colleagues:

1) Domestic demand is strong in many emerging markets (EMs) and, critically, this is underpinned by strong balance of payment positions, including for many (China, Russia, Brazil included) current account surpluses. Capital accounts are almost ubiquitously positive too. (The other way to put this is that currencies are broadly undervalued.) The likely domestic slowdown / recession in the US will hurt EM export growth, but US imports are already down on year so that pillar of growth in EMs has already gone (in other words, the data we currently see is not dependent on that). And given the current account surpluses, we will not have the usual domestic follow-through into EMs as domestic demand is easily financed from their own sources.

2) The US slowdown will likely lead to both a weaker dollar - invariably good for EMs - and lower US rates, which is again good for EMs. These two factors combined should see more capital stay in and flow to EMs, suggesting continued capital account surpluses and so supporting EM domestic demand growth.

3) This suggests that while global real GDP growth might slow somewhat, global dollar GDP growth might well stay as robust as it has been (up to 10% annually) given the weaker dollar.

High commodity prices have largely been driven by EM growth (with China most important) and so this outlook for EM suggests these nominal prices will remain broadly buoyed, helped by the softening dollar (the currency they are quoted in). On the margin, they might soften some - metals prices likely being the most vulnerable - but all-important oil continues to look very strong (that it has rallied to all-time highs during this capital-market crisis speaks volumes, and seems to negate the view that its surge has been driven notably by financial factors).

Russia stacks up well in this outlook. It will continue to have current account and budget surpluses. Domestic demand is very strong and should remain so.

How long can this last? A couple of years looks realistic, we think, though crucial will be how long China continues to power ahead-signs that the country's authorities are getting more uncomfortable about their rapid growth is a concern. Put another way, China's progress is probably notably more important for Russia, given its central role in commodity consumption, than that of the US.

What does this mean for the outlook for asset prices in EMs?

1) Shorter-term, the tightening of credit and consequent risk reduction and de-leveraging will likely result in less buoyed asset prices and put some cap on multiples. But with underlying profitability growth still strong-especially in depreciating dollars-stocks should continue to do fairly decently.

2) Mid-term, once markets stabilize and get used to the new risk environment, the possibility of a full-blown bubble across much of EM remains possible. Growth will have remained strong and impressive in these countries boosting optimism; capital will have been flowing in with liquidity conditions still positive (lower US rates will mean that dollar GDP in these countries will remain notably faster than prevailing interest rates-suggesting still notably negative real rates); and these stories will be "the only show in town" versus a soft developed world.

3) A useful comparison, though these should be taken with a large pinch of salt in terms of their powers of prediction, is the 1990s when the US (US tech in particular) was the centre of the global cycle. Capital flowed into the US, the dollar and rates rose, putting pressure on exposed EMs (due to notable current account deficits) that had their crises (1994 Mexico, 1997/1998 Asia and Russia, 1999/2000 Latam), but the US kept going (until spring 2000).

This time around, the situations are reversed: capital is flowing increasingly to EMs and the US (with its big current account deficit) is struggling with the resulting higher rates. This then suggests swapping the outlook of the 1990s for the current scenario, with the US then being EMs now and the EMs then being the US and the rest of the developed world now (Anglo-Saxon in particular). Using this comparison, August 2007 looks equivalent to October 1997... and the cycle would still have two-to-three years to run, with a big bubble in EM to look forward to.

What does this all mean for the broad investment strategy?

1) The most obvious point is that risks have increased while most asset prices (especially equities) have not moved that much, suggesting that a general degree of caution is in order. Put another way, there is notably less certainty around the outlook now than there has been for a while - and specifically this still-bullish view on EM growth relies on a "decoupling" from the US that has not been common, as well as the scale of the US slowdown being unclear with notable downside risk appearing. With asset prices off not so much and still largely discounting continued good times, the risk-reward looks less exciting than it has in a long while. This all suggests reasonably cautious positioning: limited if any leverage; cash levels higher; quality stories.

2) The changed shorter-term outlook, suggests concentrating on quality companies, be that balance sheet, cashflows (dividends particularly), margin, franchise or growth strength.

3) Assuming our still-bullish call on EMs is broadly right, the big upside risk mid-term would come from a bubble-type scenario: never something one wants to stake the house on and something that one has to "trade" more than being blind outright long on. Generally, it seems safe to presume it will be more of a trading market-more volatility- than the more linear market it has been these last years. Also, we think a decent entry point to EM could well appear later this year.

4) The relative call for EMs over developed (except companies concentrated on EM markets) remains a strong one though.

Russian macro: a good crisis for Russia

Calling any crisis "good" is a little radical. However that is what this global crisis is proving for Russia, to-date at least. The reason? It has helped the central bank achieve some monetary tightening - and so dampen significant inflationary pressure, the one black mark on the Russian macro story - without having to resort to allowing the ruble to appreciate significantly as it has been loathe to do.

The Russian macro picture is extremely buoyant. The one problem was that the combination of big current account and capital account surpluses, combining to create a balance of payments surplus of almost 20% of GDP in the first half, was leading to extremely strong money and credit growth, as the central bank held down the currency by intervening heavily to buy dollars and euros and sell new rubles. And the result of this has been an acceleration in inflation that threatens to breach its 8% year-end target.

The one real policy tool the central bank has - letting the ruble appreciate - it has been reluctant to use because a) it does not want to put pressure on domestic industry as it gains competitiveness; and b) because, short-term in previously heady markets at least, it was sceptical it would work as it would likely have attracted in yet more money as more market players moved to take ruble exposure so adding further to money supply and exacerbating the problem. In other words, in an environment of heady global liquidity, the one real tool open to the central bank was blunted.

This crisis though, with its consequent outflow of dollars ($10bn went out in the first three weeks of August) as investors cut risk and de-levered, allowed the central bank to tighten up (money market rates and other local debt yields have increased noticeably while the ruble has remained broadly flat. (That the CBR allowed the ruble to depreciate by 1% against the basket at the height of the outflows, we believe, was just to send the markets the signal that being long the ruble does carry risk: it is not just a one-way bet.) Combined with the on-going tightness of credit markets, this should help to curtail the money and credit growth that has been fuelling the inflation, and so help the central bank to both meet its inflation objectives and reduce the risks of an over-heating boom followed by a bust - what was (and we still think remains) the one real macro risk to the economy in the mid-term, short of a significant fall in oil prices.

What then is the likely short-term outlook? The unexpected turnaround in credit conditions plus what is going on in the rest of the world, means we see fewer inflows in the second half than we did previously, and this, combined with the consequent higher short-term rates, means we see less reason for the central bank to need to let the ruble appreciate: we cut our year-end Rb/$ forecast to 25.0 from 24.5. We do not think inflation will meet the 8% target though, leaving our 8.5% year-end CPI forecast, though we note the risks are now more evenly distributed around it rather than being skewed to the upside as before.

One thought to take note of, however: the central bank might well be more willing to see a ruble appreciation in an environment of limited capital inflows than in the conditions that prevailed earlier this year, as they (rightly, we believe) would see it as less likely to attract in more money. So it is possible we will see more ruble appreciation this year, during these times of tighter markets, than we currently forecast.

On the real economy, though, we see things similarly to our previous forecast - while the tighter capital markets might dampen slightly domestic demand, we think this is relatively marginal and only means that the upside risk we previously saw to our growth forecasts has evolved to being less pronounced.

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