Roland Nash of Renaissance Capital -
Whatever we believe about the longer-term trends in the Russian market, clearly the big short-term question leading into the third quarter is, when will the market have overshot to the downside? The answer in our view is that the buying opportunity will emerge when the market has fully digested the poor earnings among the hydrocarbon companies for the final quarter of 2006, and will begin pricing the better outlook for earnings in the first quarter and, in particular, the second.
A combination of higher oil prices and lower lagged taxes should mean positive earnings surprises among those companies that have underperformed most obviously in the recent downturn. While second-quarter earnings are not expected until late summer, analysts will be upgrading forecasts ahead of those numbers, and the market may well move more quickly still.
Nonetheless, weakness for Russian equity over the last few months is not something that we feel can be simply dismissed a market inefficient anomaly. There are important changes taking place in the underlying equity market and it is the pricing of these changes that is causing the current underperformance relative to emerging market peers. Short-term market movement aside, the underlying trend changes are what will determine performance in the medium-term. There are three we consider to be particularly important, and are the major focus in this Outlook.
First, the ongoing decrease in the economy-wide subsidy implicitly given to Russian companies, particularly the exporters. Rising wage costs, a strengthening rouble, lower commodity prices, higher tax collection and much higher investment requirements are all, in one way or another, a shift back towards an equilibrium that, while possibly proving positive for longer-term economic efficiency, is also resulting in lower earnings prospects for companies.
Second, the rebuilding of the Russian economy. Demand for capital in Russia has never been higher, with everything from real estate to railroads facing tremendous investment requirements. The allocation of capital to meet that demand will prove the biggest determinant of medium term relative performance, in our view. Our last two "Outlooks" have focused in detail on this theme. In the current quarterly, we look at the issue less from an equity standpoint, and more at the economics. In the economics section, we examine the impact on investment, inflation and sectoral growth. We note, for instance, the 14% and 10% growth rate in construction and financial services against the 2% growth in mineral extraction.
Third, an increase in risk perception ahead of the parliamentary and presidential elections. We have argued that virtually all major political and economic decisions are now being made with one eye on the regime change scheduled for the first quarter of next year. On the domestic front, this has resulted in asset reallocation decisions ranging from the YUKOS auctions to the sale of assets owned by oligarchs to the ongoing squabble over Kovykta. On the international side, diplomacy is becoming less restrained as politicians perform for the domestic audience. Kosovo, Estonia, threats to sue the Bank of New York and Polish missile defence systems are all adding to tail-spinning Russia-Western relations. Last, but not least, the G8 summit in Germany put Putin firmly on the world stage. Despite some astute manoeuvring from Putin and some positive signs of dialogue, there was little sign of hostilities drawing to a close. As we argue in the "Politics" section, while none of this is particularly new, it is encouraging a belated, but necessary (in our view) increase in the risk premium associated with Russian equity.
As always, underpinning these domestic trends, global imbalances and the oil price continue to be the two major unknowns internationally. Chinas attempt to finesse the deflation of its over-priced equity market without popping the bubble is probably the single biggest threat to Russias equity markets. While a bounce for the Russian index seems overdue after its recent underperformance, market confidence remains low. Any increase in global risk perception will hit Russia hard, in our view.
So looking into the third quarter, we follow consensus in expecting to see a bounce in the hydrocarbon sector. Recent underperformance and current valuations clearly suggest a reversal is due. However, in the medium-term, we stick with our fundamental view that (assuming stable oil prices) it is the infrastructure plays and exposure to real appreciation that will continue to outperform. Steel, pipes, real estate and mobiles have been our preferred exposure for the last three quarters, and remain so over the medium term. Finally, we would note that along with the catch-up in under-valued oils, we would expect some of the more expensive stocks on a 2007 P/E basis to sell-off, particularly among the retail companies.
Roland Nash is Head of Research at Renaissance Capital in Moscow
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