Ben Aris in Berlin -
Russia just put in one of its best years on record and looks set for a straight seventh year of strong economic growth. The year-end results are not in yet, but GDP growth over the first 11 months of the year was 6.8%, according to the Economic Development and Trade Ministry, and the full-year figure will almost certainly top 7%.
Inflation was in single digits for the first time in modern history and inside the government's self-imposed target of 9%. Fixed investment surged and is poised to become the main economic driver for 2007. And despite a wicked sell-off of equities in May, which wiped a quarter off the value of the Russian equity markets in a week, the leading RTS index still ended the year up almost 70% and just shy of the 2000 mark (before selling off hard in the first week of trading in 2007), making Russia one of the best performing markets in the world in 2006.
RTS end-of-year targets
Reviewing Russia's leading investment bank 2007 strategy papers, mostly issued in December, the broad consensus emerges that "the easy money is gone." This year returns-on-equity will be a more modest 25-30% and there is the possibility of some major hiccups in the first half of the year, depending on how fast the US economy cools.
Deutsche UFG says: "Russian equities have not had a single down year since the beginning of the millennium, with 2006 being the sixth consecutive year of positive returns for the key Russian indices (although 2004 was almost pushed into negative territory by the Yukos affair). Moreover, it became the fourth year out of six with returns in excess of 50%."
All the reports were ebullient about Russia's prospects over the whole year and agree the RTS will finish 2007 at about 2,250-2,300, which still leaves stocks at a 20% discount to their global emerging market peers, according to Alfa Bank. And they all agreed it is hard to see what can go wrong with the domestic growth story; all the dangers to growth and continued rises in stock values are now external.
However, this relatively modest gain by Russian standards masks the frenetic action below the surface. Oil, gas and metal stocks dominate the RTS capitalisation and, as most of these companies have already caught up with their emerging market peers, the index is not expected to double in the way it has done in the last two years.
Peter Westin, chief economist with MDM Bank, says: "The aggregate [price-to-earnings] for the Russian market remains in the middle of the consensus range for emerging market peers. Similarly, on a growth-adjusted basis, Russian valuations are close to peers valuation trends."
However, going down the ladder a rung or two and it is still possible to find 100% returns another theme that emerges from the reports is investors can no longer just buy blue chips and sit on them; they have to work harder to find fast growing companies in vibrant sectors.
Alfa Bank argues that the RTS is weaning its self off its oil addiction. In the past the performance of the market was closely correlated to the price of oil, but increasingly the index is driven by the overall performance of emerging markets around the world.
"Since 2000 the best correlation that the RTS has shown is with the trend in the emerging market asset class. Of course, short-term price dips and spikes in the oil price have an immediate knee-jerk reaction in the market because of the heavy weighting of the oil majors, but increasingly it is the direction of the Global Emerging Markets (GEM) asset class that is driving the market. The main reason is because while local investors now dominate daily market activity, the base direction of net buying or net selling comes from the main holders of the free float in the equity market, i.e. international funds," says Alfa.
Russia's economy has surprised the investment banks on the upside nearly every year for the last six years. Part of this is clearly due to analysts' natural aversion to being overly optimistic; no one will blame an analyst for understating growth, but you can loose your job for badly overestimating it.
But they get it wrong every year as they consistently underestimate the pace of reform. In the past, this oversight had little impact on the value of companies' stock. However, several banks pointed out for the first time this year the effectiveness of reform and the speed of its implementation are major factors in determining a stock's price. For example, once it was clear that the reforms to the power sector were finally going ahead in 2006, the value of United Energy System's shares doubled over the course of 2006.
While the Kremlin is slated on a daily basis in editorials around the world for its backsliding on creating democratic institutions and oppression of the nascent civil society, it has clearly got its act together when it comes to pushing through financial reforms, which in turn have already had wide-ranging consequences. Banks' loans are burgeoning and sending their value skywards. Fixed investment surged in the middle of the year as companies began tooling up to replace over-extended capacity. And consumer credit has fuelled a retail-driven bonanza amongst the companies orientated to the domestic market.
UBS Brunswick said in its 2007 strategy paper: "We see real GDP growth accelerating slightly to 7.5% from 2006 estimated growth of 7%, driven by investment and construction as, flush with cash, Russia becomes one big building site."
This year marks a big change in the "Russia recovers" story, says Alfa Bank. Most of the fast growth of the last decade has been simple "catch-up," growth due to doing simple things like filling all the empty seats on a production line. However, as almost all industries are approaching maximum capacity utilization, government policy and how it chooses to spend its enormous accumulated wealth to promote economic diversification will be increasingly important from now on.
"With valuations now approaching the GEM peer group average in most sectors, the cheap assets phase has now all but passed and investors will want to see where the future growth is to come from. Without that clarity, it will be difficult to justify pushing Russian equities to a premium over the valuation ratings of similar stocks in emerging markets, especially China, India and Brazil, where the growth drivers are a lot clearer," says Chris Weafer, chief strategist at Alfa Bank.
While everyone agrees it will be "more of the same in 2007" as far as economic growth is concerned, investment is the new dynamic in Russia's economy, say the banks. Domestic investment had begun to gather steam in 2003 when the Yukos affair effectively stopped it dead. Now the brouhaha about the crushing of Yukos is almost over, investment is poised to be the factor that allows Russia's economy to surprise on the upside once again.
"The impetus for this acceleration comes from the boost to fixed investment. Having taken the backseat to consumption over the last three years, investment leaped strongly in autumn 2006: year-on-year fixed investment growth was above 15% for three consecutive months," says Deutsche Bank UFG economists Yaroslav Lissovolik and Irina Lebedeva in their paper arguing that Russia is moving into a new investment-driven cycle of growth. "Thus, we expect to see a virtuous cycle of investment and demand growth emerging, which will greatly enhance the quality of Russias economic growth. The stories most closely tied to the new capex cycle paradigm are rapid financial deepening and domestic energy reform."
After stalling in the aftermath of the Yukos affair, Russia's oligarchs are spending on their companies again as they chase more growth. For example, Russian Aluminum upped its spending plans this summer from $8bn-10bn to $16.7bn by 2013, with most of the extra going on either buying or building power stations.
UBS said: "In many ways 2007 looks set to be very similar to the past few years However, in one important sense next year will be somewhat different: 2007 will be the year in which domestic investment was seen to have taken off and, probably, as an extended period when strong, investment-led growth commenced.
"What makes us confident of this? Capacity constraints are being hit in all sectors; both domestic and international funds are readily available; asset prices are no longer dirt cheap, so gains must come from growth; and confidence is abundant. We conclude that Russia is on the threshold of a construction and investment boom."
With $300bn in the bank thanks to the flood of petrodollars, everyone agrees it will be hard to screw up this year. However, there are a few domestic risks that have to be considered. For once domestic politics seems to be the least threatening of these, the banks say.
While fighting ahead of the Duma and presidential elections represent a real political risk, hardly any of Russia's investment banks expect any changes to the status quo.
This is a key year for politics with Duma elections in December and President Vladimir Putin is likely to introduce his anointed successor to the public in the second half of this year, probably by replacing Prime Minister Mikhail Fradkov with his intended successor.
At this point the presidential candidate is a matter of pure speculation. Dmitri Medvedev, the current the frontrunner, is the obvious candidate, but all the banks agree a dark horse emerging after the summer as Putin's chosen replacement is not only possible, but likely.
UBS said: "Theoretically, with both the executive and the legislature up for grabs, there should be the potential for a change in regime. However, we, like the bulk of analysts, see the chances of a real change as being close to zero: with Putins popularity still sky-high and democracy 'managed', the questions are more second-order ones about who is promoted and whether there is any modest change in effectiveness and style."
The Duma election will be a little more exciting but not much. The poll will almost certainly return the pro-Putin Party of Power United Russia with a majority, with the only unknown being the exact size of its majority.
The only drama in the elections will all come from the tail-end of the race, seeing which of the "also rans" can muster 7% of the vote needed to get into the Duma.
Battling it out for second will be the newly formed left-leaning (and Kremlin-backed) "A Just Russia, set up in August to steal votes from the Communists. Currently the party has only a 4% approval rating, but most of the banks agree that with the Kremlin's resources behind it, this is certain to rise.
After almost a decade of loyally serving the Kremlin's interest (and providing Russia-watchers with a lot of entertainment), Nationalist Vladimir Zhirinovskys LDPR will struggle to get over the 7% hurdle, as will the liberal parties on the right, who look like a spent political force.
The major themes of the election look set to be social equality and nationalism, suggesting the big policy question will be the extent to which policy drifts in this direction in 2008, says UBS.
However, Alfa Bank thinks that the election campaign could produce some fireworks in the form of an anti-corruption drive something that is high on almost all Russian's list of gripes.
"The election theme is expected to be an increasingly high-profile campaign against corruption in state agencies and amongst law enforcement officials. It is possible that we may see some very high profile anti-corruption event in 2007 as the government looks to address the countrys poor investment image and reflect voter concerns," says Alfa Bank.
Russia's robust fundamentals mean that it was able to shrug off the May sell-off and go back to growth, but the stock market remains very sensitive to the amount of liquidity in the market and the possibility of a sharp contraction in liquidity is a real danger that would cause the relentless rise in the RTS index to stall.
The two factors will affect the amount of liquidity available to traders in 2007: oil prices and the strength of the ruble. The availability and cost of accessing liquidity for domestic traders has a major effect on market volatility, says Alfa Bank.
"We saw through 2006 that when liquidity conditions tighten in Russia, the rising cost of borrowing slows market activity and generally hurts prices as traders are forced to close positions. The major driver of liquidity in 2007 will be budget revenues based on oil flows and the Finance Ministrys actions to balance sanitizing flows to the Stabilization Fund and increase the monetary base," Alfa Bank said.
Alfa Bank's chief economist, Natalia Orlova, worked through the relation between oil and liquidity in a note in October and concluded that oil prices are increasingly important for the volatility of the market.
Orlova said without some flexibility to the governments policy of paying in excess revenues to the Stabilization Fund, should the oil price average $50 per barrel in 2007 rather than $60 per barrel, then the Central Bank of Russia's (CBR) reserves would only rise by $40bn rather than the expected $100bn. In that case, the Stabilization Fund would only receive an extra $40bn rather than the expected $60bn.
"That would also mean zero allocation to the monetary base and a severe liquidity squeeze. The fiscal growth that has sustained economic growth through the last several years would disappear," Alfa Bank says in its note.
The second factor determining liquidity is the strength of the currency, also likely to be heavily influenced by the oil price in 2007. A strong ruble, especially relative to the dollar, will result in higher speculative inflows. That will increase the amount of liquidity in the banking system and reduce the cost of borrowing. If the ruble were to weaken, then the opposite would happen.
"We expect that the generally strong ruble will attract increased (and speculative) capital flows into the country, and that should provide a good base for liquidity to support market activity. But the oil price is again the key," says Alfa. "The ruble is more likely to establish a closer correlation with the price of oil in 2007 than it has in the past. The reason is that starting from January global foreign exchange traders will be able to settle ruble trades via the Euroclear system. The fact that this has not been an option historically is one of the reasons why the global FX market has had relatively little influence on the direction of the ruble."
The $39bn worth of IPOs slated to appear this year almost double the volume of Russian shares floated in 2006 will also significantly squeeze liquidity. While the $10.4bn IPO of Rosneft in June had little impact on liquidity, as most of the issue was bought by strategic investors strong-armed into participating by the Kremlin rather than institutional and portfolio investors, this year's round of IPOs could lead to some investors cashing out profits in stocks in their portfolio to buy into the new issues.
However, the tightening due to the upcoming IPOs will be offset to some extent by the inflows of new money. For emerging markets 2005 was a record for allocation of new money with $20.3bn flowing into this asset class. In the period from January 1 to mid-May 2006 the total received was almost $30bn.
But because of fears of interest rate hikes in the US, just over half of this was withdrawn through the summer months of 2006: from mid-May to July investors pulled $16.9bn out of emerging market funds, followed by only $1.4bn in new inflows between August and December 2006.
Since May, the fund-flow data shows that money is returning to emerging markets, however, the bulk of this net flow is going to China and China regional funds which took in $7.5bn of new money in 2006, according to Emerging Portfolio Fund Research.
Thanks to the inclusion of Gazprom in the widely followed MSCI index in 2006, Russia has significantly increased its weighting in the index and so can expect more money to be allocated to the market. However, Aton Capital says this rebalancing could be worth as little as $1bn-2bn, which is, "an important contribution, but hardly a major market driving force for the trillion-dollar Russian equity market."
If liquidity is thin, then the already volatile Russian market could get more volatile. The immaturity of the Russian market makes it very sensitive to smaller changes in liquidity than many of its emerging market peers.
If the external environment is positive or at least benign, then the local traders tend to push prices higher aggressively. If there are any negative events or perceived external selling, then the local traders quickly push prices lower, and with relatively few natural long holders in Russia the market can fall very sharply.
A sudden fall in oil prices remains the biggest danger for the Russian economy. Predictions for the average price of oil in 2007 are understandably confused, but the possibility for a spike in the prices is possible in the first half of this year, says Weafer.
"OPEC is targeting an oil price average for 2007 of $60-65 per barrel. The risk of a spike above this level is high in the first half of the year because of the Nigerian elections and a possible confrontation with Iran," says Weafer, who is also a former advisor to OPEC.
Oil prices averaged $67 over 2006, but the consensus for 2007 is that prices will almost certainly fall. UBS has a long-term average price of $41, while Alfa predicts and average oil price of $61 for this year. OPEC is striving to maintain a floor of $55 a barrel for the price of oil, although an unseasonably warm winter has already seen prices fall below this level in the first week of trading this year leading OPEC to suggest production cuts. Russia under Putin has also constrained production gains, which were rising in double digits in the last two years of Yeltsin's administration.
If oil sticks to the long-term average of $60 a barrel that it has traded at over the last year, then UBS says the RTS could end 2007 at a stunning 3,200. A fall to $40 would be painful, but would not knock the apple cart over.
UBS said: "While we see the economy robust for all oil prices above $40 barrel, with 75% of the market oil and gas stocks the price of oil is key. If it were to fall to $40 or below, the market would hurt. If though something like our house $67 per barrel average occurs, we could see long-term oil-price expectations rise. With $60 long-term we see end-2007 RTS fair value of 3,200."
Happily, the downside is not as scary as it used to be when a dramatic fall in prices in 1997 plunged Russia into a financial meltdown. With hard currency reserves passing $300bn in the first week of this year and the budget balanced at oil prices as low as $39 a barrel, the chances of an oil-induced crisis seem remote. Also, oil's importance continues to diminish as consumer spending grows and will be further reduced if investment grows strongly this year as predicted.
Aton Capital says: "Contrary to conventional wisdom, the Russian economy is increasingly consumer driven and less reliant on global oil prices to sustain and accelerate its growth. Consumption now accounts for about 55% of Russian GDP (exports 15-20%). We estimate that a $10 per barrel change in the oil price would change Russian GDP growth by about 0.5-0.6%, which means that even if the Urals price averages $51 per barrel in 2007 (versus the current forecast of $61 per barrel), the resulting GDP growth rate of 5.5-6% would still be fairly impressive."
Regulatory and reform risk
A new risk has emerged for Russian investors: regulation and reform. Over the last two years the state has emerged as the biggest investor in the Russia stock market and much of the performance of the market in the next years will depend on how far and fast it pushes reforms to improve the lot of these companies.
Aton Capital says: "The financial and business outlook of an increasing number of companies and sectors, especially those with substantial state shareholdings or influence, depends on the successful implementation of various regulatory reforms and corporate restructuring plans. The clearest examples are UES and all the listed electric utilities, fixed-line telecom firms, Gazprom, Novatek, Sberbank, Transneft and various others. In most of these cases, our financial and fair value estimates depend, to a very substantial degree, on our assumptions regarding the pace and scale of market liberalization and corporate reorganization, as well as our expectations as to the quality and timing of the execution of the planned reforms."
Another big fear is that the US economy will slow rapidly this year and so drag down global growth prospects with it. Deutsche Bank UFG shrugs off these worries, saying most of the slowdown will come in the first half of this year, while the prospects for the second half of the year look much rosier.
Deutsche Bank UFG says: "Deutsche Banks Global Economics team sees the baseline scenario for the world economy in 2007 as one of a modest mid-cycle slowdown rather than an end-of-cycle recession. The worlds real GDP growth is forecasted to decline from 5% in 2006 to 4.1% in 2007, principally driven by a significant deceleration in the US, where recession in the construction sector has steadily been gaining pace over recent quarters. An additional, albeit smaller, source of drag on global growth may be next years fiscal tightening in the Eurozone, for example Germanys VAT hike."
Moreover, Deutsche Bank's Asian economists argue that Asian consumer spending is playing an increasingly important role in the global economy; while Asian demand is not yet big enough to outweigh a US recession, it is enough to keep commodity prices in the mid-cycle range, says the bank, which would do much to bolster Russia's position.
Other Themes and events
With a global slowdown in prospect and fears of US interest rate hikes lingering, investors switched en masse out of commodity stocks during last summer and into listed Russian companies with exposure to consumer consumption, which would, in theory, be insulated from events in the global economy.
"The switch was dramatic and probably overdone," says Ian Hague, co-manager of Firebird Management that has $2.8bn under management. However, in 2007 the investment banks believe that the domestic-exposure bias will continue and expand, partly as so many more companies from this segment of the economy are expected to IPO this year. The total planned volume of IPOs slated for this year is $30bn against the $17.5bn that Russian companies raised in 2006.
At the same time, as the traditional blue-chips all approach fair value (and in several cases, pass it), banks are also recommending investors go down into what Eric Kraus, manager of the Nikitsky Russia/CIS Opportunities Fund, dubs "the great unpronounceables" the companies of the second and third tiers.
Even though oil, gas and metal companies account for three quarters of the value of the Russian stock market, thanks to the increasing flood of IPOs the market is already diversifying; two years ago the 10 largest names accounted for 85% of the value of the market. Currently the 10 largest names account for 69%. The top 15 names accounted for 94% of the total market value at end-2004, while currently they account for 76%.
Alfa Bank says: "Our major portfolio bets for 2007 are to favour stocks that are exposed to a domestic theme over those that are vulnerable to earnings from commodity exports, to recommend an underweight in Gazprom, and to increase the model portfolio exposure to mid- and small-cap names in emerging industries."
The bank is typical in decreasing its weighting of blue-chips in its model portfolio from 60% to 50% and increased its weighting of mid-cap companies to 40% from 30%, while maintaining the small-cap, low-liquidity companies share at 10%.
Aton Capital adds a new tack to the strategy by highlighting the potential of infrastructure as the Kremlin begins dealing with the transport bottlenecks and rebuilding the physical underpinnings of the economy.
"We believe the next several years will witness large-scale investments in Russian infrastructure assets, as the country effectively needs to rebuild itself in order to sustain the economic growth of recent years," says Aton.
On the corporate reform front the privatisation of state-owned telecom operator Svyazinvest and the power sector will be the main events.
"Energy reform is increasingly becoming one of the key agenda items for the government. Both the electricity and gas industries have to substantially increase their capital expenditures over the next few years in order to modernize existing infrastructure and add new capacity," says Alfa Bank. "It is now clear that without this spending there will be increasing incidents of capacity shortages for both electricity and gas. Both UES and Gazprom have laid out extensive expenditure programs, but to fund these they both need to see a substantial hike in domestic prices."
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