CHART 1

CHART 2

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CHART 4

CHART 5

Keynotes

• Represented by RTS Index, Russia market was the world’s top-performing benchmark equity index and jumped 128.6% in 2009. However, we still believe the market has significant upside after the strong gains. Investors are advised to stay invested and catch further upturn profits.
• The third quarter GDP rose by 13.8% quarter-on-quarter, further confirming the country is officially out of recession.
• A positive oil outlook, coupled with easing monetary policies and compelling valuations, will continue to support the equity market in 2010.
• Financials will be a bright spot in the Russia market.
• Major risks in 2010 include the country’s excessive reliance on oil, foreign debts, political uncertainties, market interventions and a larger-than-expected inflation risks.
• Russia’s valuation is quite attractive amongst BRIC countries based on the comparison of their excess yields and Price Earnings ratios.

A sharp turnaround

If 2008 was “the year of crisis”, then 2009 would be “the year of recovery”. Russian Trading System (RTS) Index was one of the worst-performing benchmark equity indices and plummeted by 72% in 2008, followed by the collapse of the oil price. After the worst year in record, the dollar-measured RTS Index became the world’s top-performing equity index and jumped 128.6% in 2009. Investors are now facing a dilemma - will the market extend its strong rally in 2010 or is an overdue correction approaching? We advise investors to include Russia equities in your portfolios for a couple of reasons.

Table 1: Top-performing Benchmark Equity Indices
Indices	2009 Returns (% in local currencies)
Russian Trading Systems^	128.6
Argentina Merval	115.0
China Shenzhen Composite	117.1
Peru Lima General	101.0
Turkey ISE National 100	96.6
Source: Bloomberg and iFAST Compilations ^RTS traded in USD

The worst-ever recession is over!

On the economic front, Russian GDP fell by 8.9% year-on-year in the third quarter last year but grew by 13.8% when compared to the last quarter, the second straight quarterly gain. Since Russian economy contracted drastically in the first three quarters last year, we expect a sharp year-on-year economic expansion in 2010, due to the low-base effect and the rebound in oil price. In this regard, we can now conclude that the worst is behind us.

Admittedly, the recovery witnessed so far has been mainly oil-driven and the domestic economy remains fragile. Oil is an important source of government revenue and GDP. According to Merrill Lynch, a dollar increase in oil price will bring USD 1.8 billion to the Russian Government revenue. Along with the global recovery, the strong oil price (we will take a closer look in the next section) is likely to lift up corporate spending, asset prices and consumer confidence, leading to a multiplier effect. Consequently, after the recovery of energy and material sectors, we expect consumers and banking to be the next sectors to pick up in the coming months. Because of these positive effects, the Russian central bank delivered a favourable economic outlook by raising the 2010 GDP forecast from 3.1% to 5%.

A closer tie with Asia

Because of the crucial role of oil, Russia has been working hard to diversify its oil exports to countries outside Europe due to constant political tension with the European Union, its leading trade partner. As of the first six months of 2009, exports to EU countries accounted for over 39% of total while exports to Asia only took up 15%. The relations between Russia and East Asia moved a step forward when a new Pacific oil terminal was launched recently. The under-construction pipeline, with a capacity of 300,000 barrels of oil per day, will divert some Siberian crude to China.

Still more upside on Equities

Investors may perceive that a strong correlation between the RTS index and oil price means the higher the oil price, the better is Russian equities. However, the above assumption is not completely accurate. Let’s take a closer look at the correlation through regression analysis as illustrated below.

The optimal oil price for the Russian equity market

As displayed in Chart 1, using the data between 1999 and 2008 - the last oil bull run, the relationship between the oil price and the index level can be modeled by a linear best-fit line (long-term trend) with a R2 of 82%, indicating that 82% of the index movement can be explained by the oil price. It is interesting to note that the oil price and the RTS Index have been moving along a similar path since 2009, which further confirms the predictive power of this model.

The model reveals that the oil price may have different impacts on Russia’s equity market under different price ranges. When the oil price stays under US$50 a barrel, the dots in the chart appear to fall closely to the best-fit line, indicating that the index is moving parallel to the long-term trend. When the oil price falls between US$50-100 a barrel, the index stays above the long-term trend, suggesting the range is optimal for the equity market. However, when the oil price moves above US$100 a barrel, it seems there will be detrimental effects on the economy. Therefore, as long as the oil price remains in the optimal range, even there’s no further increase in the price in 2010 (the oil now stands at US$77.62 a barrel as of 21 January 2010), the index will continue to keep its upward momentum.

Oil Price Movement in 2010

According to our estimation, the gain in oil price last year is unlikely to repeat this year. As displayed in Chart 2, the spread between the long-term and short-term contracts has remained flat since September 2009. Despite of the recent slight widening of the spread, the magnitude is still insignificant when compared to the spread observed in January 2010. Taking these factors into consideration, we expect oil to trade at a range between US$75 and US$95 a barrel this year as the global demand will likely to pick up at a moderate pace. As argued above, such optimal range will drive the RTS Index to move above the long-term trend, thereby potentially generating a further upside in 2010.

Exit Strategy and Monetary tightening are Not Yet a Near Concern

The market generally perceives 2010 as the year of “exit strategy” and “policy tightening” because policymakers start to unwind the effects caused by the massive stimulus packages and to remove the excess liquidity. This is particularly a great concern for the fast-recovering emerging markets as inflation fears grow.

For instance, the People’s Bank of China raised the required reserve ratio for commercial banks by 50 basis points on 18 January, 2010, followed by the massive new loan growth in the first week of January. The Reserve Bank of India increased the Statutory Liquidity Ratio to curb liquidity in the financial system on 27 October 2009. No explicit tightening actions were carried out in Brazil for the time being, but government interventions(e.g. IOF tax) were seen as a tool to stop the huge inflow of foreign capital. Brazilian Central Bank, which has already kept the key interest rate unchanged at 8.75% since July 2009, is forecasted to hike rate in the first half of 2010 as the robust domestic demand and the rising commodity prices may cause inflation to exceed the target range.

On the contrary, Russia’s Central bank has cut the key interest rate for ten consecutive times and the rate is now at its lowest level in the history, thanks to the easing inflation. Moreover, historical data reveals that Russian equities moved inversely to the interest rate (Chart 2). Since Russian economy remains fragile, it is not a good time for the central Bank to hike rates. Hence, more rates cut is yet to come in the future. A lower interest rate environment together with a more manageable inflation will bolster corporate investment and consumer spending.

More earnings revisions in 2010

The earnings upgrades of Russian equities have not occurred until September last year, which appear to fall behind the re-ratings of global equities. Chart 4 shows the consensus earnings forecasts, rebased to 100 on 1st April 2009, over the course of the year. Since September, the expected earnings integer in 2010 has climbed by 23%. Better yet, some re-ratings were attributed from non-energy sectors. For instance, the 2010 consensus earnings of Sberbank, the largest bank in Russia, have been revised upwards by over 100% since September. This demonstrates a full earnings recovery of Russian corporations.

On the bright side, if the strength of the global recovery is greater than expected, energy and commodity prices are likely to be lifted up further, leading to more earnings upgrade. Even if the pace of earnings upgrade has peaked, the bottom line is that the current earnings forecasts are well-supported by fundamentals and the valuation is still attractive.

Key Risks in 2010

Investing in emerging markets is generally riskier than investing in developed markets. In addition to the two major risks (i.e. excessive reliance on oil and foreign debts) which we have addressed in the previous article, investor should also keep a close eye on the following risks in 2010.

The government may intervene to halt the appreciation of Ruble

As investors’ risk appetite pick up again in 2010, hot money tends to flow to high-yield currencies. Bank of Russia may intervene in the appreciation of Ruble as a strong Ruble will depress the exports and undermine the pace of the economic recovery.

Political instability may give a discount on valuations

Political disputes between Russia and the West may continue to have negative impacts on exports.. For instance, the Georgia-Russia conflict undermined investor confidence significantly and amplified the equity market sell-off in August 2008. These disputes are also some of the reasons that have prohibited the country from being accepted into the World Trade Organization (WTO).

Interest rate hike may happen earlier than expected

We have highlighted earlier that Russia is one of the very few markets that is not overwhelmed by the monetary tightening fears for the time being. Russia’s inflation risk, in our view, is the result of the output gap and the rising commodity price.

Russia was hit the hardest in the global crisis. We only expect the economy to recover slowly from the recession. In our opinion, the risk output gap inflation is far less than the risk of commodity-driven inflation. PMI rose to 52.0 in September but subsequently dropped to 48.8 in December last year, indicating that the manufacturing sector in Russia has not yet fully recovered. Moreover, if the commodity prices continue to surge in 2010 as the global demand picks up, the producer price will be expected to increase, thereby inducing a rising pressure to consumer price. However, this risk remains insignificant at the moment.

On the base case scenario, we think that under such slow recovery and easing inflation environment, the central bank seems more inclined to lower the benchmark interest rate (currently 9%, at a record low level) which could bolster corporate borrowing and investment spending as well as lessen the pressure of the Ruble appreciation.

Valuations remain attractive

As of 12 January 2009, Russian equity market traded at 9.2X (Chart 5) which is marginally below the five-year average of 9.53X during 2005 - 2009. The substantial gains in 2009, in our view, were the effect of a mean reversion. In the fourth quarter of 2008, the market feared the potential outbreak of Eastern European financial crisis and consequently the RTS Index traded merely at 4.16X at the end of 2008 amid the panic sell-off, and became the cheapest global equity market at that time. Today, even though the valuation appears less appealing as compared to 2008, Russia is still one of the few equity markets that are still trading below their historical average. Moreover, as shown in Chart 5, Russia is expected to see the largest earnings growth which approximately is twice the growth of the other three BRIC members. Also, under the model of the excess yield, Russia appears to be quite attractive amongst BRIC.

Conclusion: A market that is too attractive to ignore

Given the uncertainties brought by the exit strategies, global markets are expected to see a bumpy year in 2010. Russian equity market, however, is one of the very few markets that are not overwhelmed by the tightening fears. As valuations remain attractive, we predict a bright outlook for the Russian market in 2010.

Related Equity Funds

Alliance Advantage GEM Treasures Fund
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