Roland Nash of Renaissance Capital -
The divergence between financial markets and the real economy in Russia is startling. The recovery in debt and equity markets in the first half stands in stark contrast to the collapse in economic activity and the stubborn absence of green shoots. In the second half, something has to give. Either the economy will start to recover, or asset markets will move lower to reflect the deep recession in the real economy.
In our view it is economic recovery that will come through in the second half, driven by the re-engagement of financial markets with Russian credits. While the situation is clearly fragile, we believe that the dangers are exaggerated. Russia has had nine months to prepare for a new round of the global financial crisis. Massive government intervention has put Russia in a stronger position to deal with any further fallout. Corporates and banks have built up around $100bn of dollar assets, more than enough to compensate for debt repayments of $60bn. We do not subscribe to the popular thesis of the second wave hitting Russia. The ability to repay, together with loosening credit conditions globally, are contributing to the first cautious signs that markets are again opening up to Russian credits. In the second quarter, $500m was raised in equity markets for oil and gas exploration companies, and it seems that new money is being raised for the real estate sector. That risk appetite exists for some of the most beaten sectors of Russian industry bodes well for the market as a whole.
More importantly, domestic markets are becoming increasingly active. An appreciating ruble, rising reserves and falling interest rates are encouraging demand for ruble debt. We estimate that Russian corporates will issue around RUB400bn ($13bn) in the second half. Equally, the government is both encouraging and demanding banks to start lending. Well-publicised plans are in place to provide at least RUB460bn ($14bn) of new capital into the banking sector over the next 12 months. At the same time, the central bannk will likely cut interest rates by another 150 bps by year-end. These measures, together with the recovering value of collateral, as proxied by asset markets, should increase the willingness of banks to begin lending again.
Finally, the fiscal stimulus planned in response to the crisis should start having an impact in the second half. Despite a fall in revenues from 22% of GDP to 18% in 2009, expenditures are expected to rise from 16% of GDP to 22%. The shift in the central government's budget position from an 8% of GDP budget surplus in the first nine months of 2008 to a planned deficit of 8% in 2009 is arguably the biggest government stimulus package globally.
The opening up of credit markets, looser monetary policy and fiscal stimulus all suggest that economic growth can resume more strongly than current expectations would imply. After seasonal adjustment, we expect quarter-on-quarter growth to resume in the third quarter and expect GDP in the second half to be 4% higher than in the first. While this would still imply an annual GDP decline of 8% on 2008, we think that year-on-year growth will resume in the first quarter next year at an annual rate of 4%. Our forecast for growth in 2010 is 3.5%. A resumption of growth will likely result in a further decline in weighted average cost of capital (WACC), and an increase in target prices. As we move into the second half, we therefore view any pullback below our end-2009 RTS target of 1,200 as an opportunity to buy into Russian equity.
Of course, it goes without saying that the oil price remains a major risk. Oil inventories are close to all-time highs and utilised capacity is historically low. Financial demand clearly makes economic sense as a hedge against dollar depreciation, but at some point the stuff has to be burnt. As in Russia, the resumption of economic activity globally is a necessary condition for continued appreciation. Equally, Russian politics has a nasty habit of flaring up over the summer, and there are uncomfortable signs of growing tension between the two heads of Russian power. Interpretation of the closed world of Russian politics is as much an art as a science, but any concrete signs of instability creeping into Russia's power-vertical will inevitably spook the market.
But using an average WACC of 14% (down from 16% in the second quarter), and with a price of $55 per barrel of oil estimated in 2009, rising to a long-term average of $80 in 2011, our discounted cash flow fair value for the RTS has increased to 1,350 (average upside potential of 40%). If economic recovery gets under way, it is not unrealistic to expect the RTS to move back towards 1,600 in 2010.
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