Roland Nash of Renaissance Capital -
One day before the ninth anniversary of the great August 1998 crisis when devaluation, default and banking meltdown wiped out 90% of the value of the equity market, Russias equity markets are again in freefall. And that is where the similarity ends. Apart from the temporal coincidence, the current sell-off could not be more different. Russian assets are being sold to raise financing for losses in developed markets. Contagion has reversed.
Nonetheless, however "unfair" it might seem relative to Russia's fundamentals, the current global meltdown is proving to be highly detrimental to Russian asset prices. The answer to the question in the subject line is that "we dont know." Indeed, the most worrying aspect of the current weakness is that we cannot know how bad it can get because Russian asset markets today are not being driven by anything fundamental in Russia, but rather by the unwinding of some very large imbalances in global financial markets. However, precisely because "we don't know" how far Russian equity can fall, it remains our view to get out and wait on the sidelines.
On July 26, when the RTS was at 2050, we sent around a note entitled "Ten reasons to be worried about Russian equities in the current global credit environment" and suggested selling Russian equity. The feedback received was pretty consistent Russia was fundamentally sound and therefore should be immune to fallout emanating from credit markets in the US. The irony of the situation today is that the same argument against selling Russian equities still applies, but at valuations which are now 10% lower.
There remains little doubt for us that Russia, from a fundamental perspective, remains very well placed to weather the building financial storm. With the oil price still above $70, earnings in the sector should positively surprise for second- and third-quarter results (Surgut's Q2 numbers emphasise the point). The money supply in Russia is rising in excess of 50% per annum, providing one of the most supportive domestic liquidity environments globally. Economic growth is proving very strong (latest figures show growth in excess of 7% per annum), and is being driven now by booming domestic investment (investment is growing at nearly 25% per annum). Indeed, perhaps the most encouraging comment that I have heard in some time was from our domestic sales desk that clients saw the biggest opportunities in investing into the real economy rather than in financial markets. It continues very much to be our view that Russia is just embarking on a large and still very under-estimated investment boom.
Unfortunately, in the current market environment, the fundamentals demonstrably dont really count for much. The flip side of the globalization which has so benefited all asset classes over the last decade is that immunity from a change in risk perception is illusory. Global financial markets are going through a fundamental rethinking of the pricing of risk. What global markets are experiencing is not fallout from the relatively esoteric US subprime mortgage market. This is fallout from the last decade of unprecedented credit creation and asset price appreciation.
Below we give 10 more reasons why we continue to think it prudent to sell Russian equity and get into cash.
Hedge funds look vulnerable to redemptions. While there has been a rush to cash, it is simply unknown as yet how much money could be pulled out of hedge funds given the lags implied by tie-in clauses. Given the leverage that many funds have used over the last five years to maintain returns as asset markets become more expensive, redemptions act like increased capital requirements at banks there is a multiplier effect.
"Black-box" technical funds may not deal well with large price swings. While the level of sophistication of these funds tends to follow Moore's Law on computing power, they still tend to rely on some derivation of the principle of reversion to mean. They dont deal well with "unexpectedly" large swings in asset prices.
Financial organisations globally are being squeezed from both sides of their balance sheets. Funding costs have grown as global volatility has risen, leaving weaker credits susceptible to a liquidity squeeze. As asset markets now sell off, the value of collateral is also falling. In other words, margin calls will become both more frequent and more difficult to finance. Financial institutions have already suffered. In globalised financial markets, ring-fencing poor credits has become more difficult.
The sell-off in the equity market is becoming more than a correction. The graphic below shows the performance of the Russian equity market over the last four years. As it shows, and in line with most other equity markets, Russia has been enjoying a well defined (and well deserved) bull run.
However, illustrating the fear in the market, it is now trading through long-term support levels. So far, the equity market has been well supported (volume has been high see graphic below). But as the market weakens, fear may well cause the buyers to stay away.
Russian risk premium rises. Spreads for Russian benchmark foreign currency debt remain low. However, they have widened by 60 basis points over the last month. At 150 bps over Treasuries, EMBI+ Russian risk is measured at its highest level for two years.
Domestic liquidity becomes more expensive. Perhaps the most worrying change in recent days is that, despite the superb longer-term liquidity environment for the ruble, the price of short-term money in Russia spiked. Two months ago, overnight money cost between 1 and 2%. Over the last month, rates have been stable at around 3%. On Wednesday, August 15, overnight rates jumped to 6%. International banks in particular are selling ruble positions and cutting ruble funding lines. Similarly, ruble bonds have sold off in recent trading sessions.
Bond placements are being pulled. In the last three weeks, at least nine benchmark size ($500m-plus) Eurobond issuances have been postponed by CIS credits.
The oil price could come under pressure. So far, hydrocarbon prices have been supported by hurricane season in the US. But at least part of the strength in commodity markets in recent years has been from leverage financed commodity funds. The increase in the cost of leverage for these funds could well mean weakness in commodities, and oil.
Credit Default Swaps in even the best credits are widening rapidly. The graph below shows how CDSs have widened out for Gazprom, VTB and Russia. While each of these entities is very well protected from a fundamental perspective, once again the price of risk associated with them has been rising rapidly. So far, the re-rating of risk shows no sign of improving.
CDS for poorer credits are ballooning. If CDSs have widened out for the better credits, they have ballooned elsewhere. For Turan-Alem bank in Kazakhstan, spreads have widened from 300 bps to 600 bps over the last month. The market clearly believes that there is genuine risk for the financing of some of the weaker credits in the CIS. Should one of these institutions face a sharp liquidity event, it is likely to cause a further shock to the financial sector across the region.
While Russia's financial system in general is very well supported because of the superb liquidity environment, there are probably some blind spots. The financial sector in Russia has been growing very rapidly over the last few years. Growth has been from a small base, and therefore leverage in the economy as a whole remains low. Nonetheless, the speed of growth could have led to a number of structural weaknesses. While ruble costs remained low, any weaknesses would be camouflaged. With financing costs rising, any structural weaknesses will be revealed.
Once again, to re-emphasise the point, from a fundamental perspective, Russia continues to look strong. Indeed, perhaps a longer-term impact of the current financial crisis will be to remove the somewhat outdated "emerging" from the phrase used to describe the world's newer markets. Perhaps the worlds current relative safe havens should at last be considered to have emerged.
However, just as the innovation in, and development of, financial markets have been incredibly powerful in stimulating change in the real world economy over the last decade, so the undermining of those same financial markets will inevitably have a real-world impact, including on Russian equity.
So what is the conclusion? Markets currently are in carnage mode. It is more difficult to recommend selling when there is so much weakness around already, particularly when, from a fundamental perspective, we see upside in the market (our fair value target for the RTS remains 2100). However, our conclusions from July 26 remain valid. There is a lot of risk around currently, and it would seem to remain the prudent course to move into cash and wait for the better buying opportunity.
Roland Nash is head of research at Renaissance Capital in Moscow
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