Roland Nash of Renaissance Capital -
Peering into the fourth quarter and out into 2008, clarity is emerging on a number of fronts. While global credit remains a threat, assurances of liquidity from Russia's monetary authorities are helping calm fears. In politics, the Kremlin seems focused on managing most of the major political decisions before the elections - a neat trick if it can be accomplished constitutionally. At a corporate level, companies are beginning, again, to tap equity capital markets. While risk therefore remains elevated, we believe it has receded enough to leave Russian equity offering value at current levels. We expect an end-of-year rally to drive the equity market towards our revamped RTS target of 2,500.
As with the last two quarters, the biggest risk facing Russian equity in the fourth quarter remains liquidity. Roughly $10bn of planned issuance has been cancelled since the end of July. Up to a further $20bn is planned in the final quarter. Poorly capitalised banks and badly positioned corporates will struggle to meet obligations while international capital markets remain reluctant to provide financing. We anticipate that Russia might see a forced consolidation of parts of its banking sector. Similarly, we would not be surprised to see the first post-1998 bond default.
But we view these risks as limited in both scope and duration. In better times, if capital markets were not so spooked, a minor default would probably be considered the healthy credit differentiation of a market which has arguably expanded too quickly. Moreover, while liquidity risk exists for Russia, economic risk is minor. From a fundamental perspective, Russia really does offer a safe haven. While financial markets have successfully integrated globally in the past few years, the Russian economy remains safely autarchic. US economic slowdown would have very little impact on Russian equity if commodity prices remained strong. As we explain in the strategy section below, once the market can see through the liquidity risk, Russia does not look vulnerable to the longer-term risk of a US economic slowdown.
Politics, on the other hand, remains a uniquely Russian risk.
Capacity to surprise
The announcement of the largely unknown Viktor Zubkov as prime minister in September illustrated well the capacity of Russian politics to surprise. Vladimir Putin's suggestion that he may remain in power as prime minister (something this strategist thinks unlikely) demonstrated that the Kremlin is determined to maintain presidential authority by keeping everybody guessing.
Nonetheless, it has been our view since the beginning of the year that the change in prime minister at about this stage ahead of the parliamentary elections would mark the beginning of the end of the political uncertainty surrounding the 2008 regime change. The new government, the personality of the prime minister and the rumours of personnel change in the natural monopolies, all suggest that the chief concern for Putin is to maintain continuity through the presidential handover. While risk certainly remains, we hold to our view that a pre-election rally will begin in the final quarter of 2007.
Finally, the fiscal focus on infrastructure investment is gathering pace. The process of "21st Century perestroika" across both the public and private spheres is accelerating, despite the global uncertainty.
Over the longer term, we leave our recommendations largely unchanged. Infrastructure exposure through steels, pipes, real estate, cement and transport look to us the safest way to maintain exposure to the main trends in the Russian economy at a reasonable price. However, in the short term, in the final quarter of this year, we believe hydrocarbons should react to the surprise in the higher oil price and catch up some of the underperformance of the past 12 months. In particular, we would highlight Gazprom and Transneft as two companies that combine exposure to the oil price, relatively unchallenging valuations and most potential gain from political clarification and a possible change in management. Gazprom in particular, is gaining momentum and is our liquid equity of choice.
The longer-term trade-off for Russian equity remains between the fiscal and investment boost that the economy is likely to receive over the next few years and the resulting implications for rising cost pressure. In the meantime, however, and despite the global liquidity risk, the next leg-up in the Russian equity market may well prove to be a wave of international and domestic capital seeking the next big investment theme.
Indeed, it is quite plausible to imagine that a combination of new liquidity pushed out from the Fed in an attempt to keep the US from entering recession together with weakened demand for developed market assets could result in a new wave of capital entering the Russian markets. We start the fourth quarter in a still potentially destabilising situation of tight global liquidity. We could find as we move into 2008 that the longer-term problem for Russia might actually prove to be too much money trying to get into Russian assets.
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