Russia: Beware the Bear

Recent contrarian calls I've published on Seeking Alpha on the dollar (short Euro), equities (long financials and pharma) and commodities (short oil and copper) have proved highly profitable.

The CRB index has just had its worst 4 week period in 50 years, losing 16% as the speculative bubble that I've described many times on this blog popped with a vengeance. Nickel is down 46% from the highs, Wheat 41%, and Natural Gas 40%; copper and oil have just entered bear territory, both down 20% so far but copper may easily halve from the peak (see Copper and China post).

The flip side of the commodity slump has been the resurgence in the unloved dollar; I suggested on 27 July in Has the Dollar Bottomed? that a major reversal was imminent, but its magnitude and speed has been surprisingly dramatic; last week was the best for the dollar since the Euro's inception in 1999.

In these markets, records tumble by the day. Also as discussed in previous posts, emerging markets are underperforming developed (with Russia and China particularly weak while India is bottoming) and Japan is the weakest of the developed markets.

Crucially in the US, policy responses to the credit crunch are finally gaining traction just as Europe and Asia slow markedly. The combination of a cheap currency, a positive yield curve, and the recapitalization of bank balance sheets are now speeding the recovery process for US equities.

Overall, I see no reason as yet to change investment tack, although I'm closing most of my oil short until the implications of the Russian invasion of Georgia (and it is a de facto invasion) are clear. While I was in France, much local media attention focused on the outrageous sum of $750m paid by a Russian oligarch for a prime mansion on the Cote d'Azur, in a macho bidding war with his equally spendthrift Moscow peers, whose idea of sophisticated entertainment is burning bundles of 500 Euro notes in front of the hired staff (not all of whom work on their feet).

Apart from reflecting the corrupt pillage of the Soviet resource economy by a handful of well-placed insiders in the 1990s, this is the kind of grotesque financial excess that has previously marked major turning points in economic history. Indeed, the last time Russian buyers displayed such shameless decadence in France was among the aristocratic elite just before the fall of the Tsar nearly a century ago. Meanwhile, Putin (reputed to be an offshore billionaire himself by some sources; political power in Russia guarantees you serious purchasing power) is encouraging loose talk of basing Russian bombers in Cuba, and sending the tax police heavies to shake down any corporate that incurs his wrath Yukos style. It all smacks of reckless hubris.

A commodity crash would have dire implications for the dysfunctional Russian economy, beset by demographic decline, low productivity, 15% inflation and a fragile consumer boom that is vulnerable to a reversal in commodity export prices (resources generate 75% of export revenues; at prices much below $110 the state budget will be back in deficit). I have been bearish of the Russian market for some time (the RTS is 70% weighted in resources and is down 30% since the May peak) given the arbitrary lawlessness that makes long-term investing there a spin of the roulette wheel.

The increasingly belligerent attitude to foreign investors, immigrants, and neighbouring countries, combined with the endemic corruption and decay now affecting every state institution under the Putin regime, may soon make Russia a bigger geopolitical risk factor for global investors than Iran. Despite the military posturing, army conscripts remain an emaciated drug addled rabble, the defence industry is largely a shambles, and the rusting nuclear deterrent is becoming more of a danger to Russians than to any adversary. Russia is still the Potemkin village that flatters to deceive.

In particular, the Kremlin is not the monolithic power it appears, but referees a shifting coalition of clans, from energy barons to the security services and regional bureaucrats, whose sometimes violent rivalries have so far remained misunderstood by many naive foreign observers. Nonetheless, current events in the fragile Caucasus region bear close watching as they risk spiralling out of control with implications for everything from the US election outcome (good for McCain) to the dollar (supportive of current rally) and oil price (may help put a short term floor around $110).

It's 10 years since a default crisis in Russia spread shock waves though emerging markets globally. Although the nature of any upheaval will be different this time given the huge foreign reserves now accumulated, the potential for Russia to export chaos along with crude remains high.

Comments

[TRUE:]

Whe i'm reading this article, i'm smiling. This is absolutely non-professional approach to understand the situation. You have to think, before you read american propaganda press. And you probably do not strain themselves reflections.

Yesterday’s (12 Aug) developments appear to have put an end to the military conflict between Russia and Georgia. First, President Dmitry Medvedev ordered a stop to military operations. Later in the day, France’s President Nicolas Sarkozy travelled to Moscow and Tbilisi to negotiate a solution to the conflict in South Ossetia. Sarkozy and Medvedev agreed on six principles: 1) to stop the use of armed forces; 2) to halt all military action; 3) to provide access to humanitarian aid; 4) Georgian troops are to return to their permanent military bases; 5) Russia’s forces are to return to positions occupied before hostilities began and Russia’s peacekeepers are to remain in the disputed territories until international mechanisms are in place; and 6) the status of South Ossetia and Abkhazia is to be discussed internationally. In Tbilisi, Sarkozy agreed on five of the principles with Mikheil Saakshvili (Georgia did not agree to international discussion of the status of South Ossetia and Abkhazia). Further discussions will be held today (13 Aug) at a meeting of EU foreign ministers; any resolution will then be presented to the UN Security Council.

We believe that despite the very possible violation of the ceasefire, attention will now focus on internationally brokered negotiations on the status of the disputed territories, as well as an investigation into the possibility of crimes against humanity committed during the conflict. The situation in the area will remain a source of tension in the medium term, but we think that the worst is behind us.

2008 Aug 13 08:33 AM

[TRUE:]

Russian market is a very undervalueable market.

2008 Aug 13 08:36 AM

[Nick Gogerty:]

I think the analysis is spot on. Dangers are lurking in a fragile and corrupt regime. The easy money will wash out and nationalism in economic and political form will take over. the next 3 years are dangerous especially for former satelites.

2008 Aug 13 09:59 AM

[TRUE:]

We have a strong authority and strong political regime. It is too mutch attention to the sitiation with MECHEL and TNK BP.

What is even worse for Russia is the fact that the situation in South Ossetia followed
a chain of other political events that also negatively affected the market, such as the
conflict between BP and TNK in which state authorities also took part, the Mechel
story and Russia’s position on Zimbabwe in the UN Security Council. Almost no
positive news has come from the political arena in recent months, such that until
recently, the Russian market had been falling more or less in line with global trends,
and even a strong macroeconomic performance was unable to pull it back up.
Needless to say, on this front, it looks much better in Russian these days in relative
terms than in the matured economies; the country’s growth of around 8% looks
more impressive than the 1.2% seen in the US and the Eurozone.

Meanwhile, we have to remind that little has changed in Russia itself. The same people keep
governing the country, its diplomacy is the same as a year or two ago, institutions are also in the
same condition, and the economy keeps growing as fast as in previous years on average. If this
(currently) regional conflict does not spread into a greater geopolitical standoff between Russia
and the West, the Russian market should start gradually rebounding at some point.

2008 Aug 13 11:18 AM

[TRUE:]

Even though the market looks undervalued, with such a low P/E of
below 7.0, investors do yet not see it as a strong buying opportunity. Many have
decided to reassess political risks, though we do not think much has changed; these
risks have been largely ignored in the past.

2008 Aug 13 11:21 AM

[Alex Filonov:]

'long-term investing there a spin of the roulette wheel'

More like spin of revolver drum in Russian Roulette.

2008 Aug 13 04:18 PM

[Darrell:]

Yuri gas made some valid points, but what he did not discuss is the fact that Russia, like the US, started an unjust war; when they allowed Georgia to become an independent country they gave up their rights to impose their will on a free country.

They should have used diplomacy, not violence, to address the concerns of the minority populations in Georgia.

Economically, I think Russia will thrive and become an economic power; but it remains to be seen if they will become a moral force in a globilized economy. Over the years Russia has produced some great spiritual leaders, including Father Arseny, and I pray that a new generation of spiritual leadership will take control; it is obvious that the current leadership has not taken up the touch.

2008 Aug 20 02:00 AM