With the equity market up by about 125 percent, 2009 has been an excellent year for Russia investors. Anyone willing to forget that the RTS Index lost $140 billion of market capitalization in 2008 will be more than happy with the $70 billion that it has gained this year. Blessed with short memories, investment management professionals feel able to look their clients in the eye once more and talk about more profits to come.
The general consensus among optimists is that strong earnings, economic growth and a new market-oriented approach will bring healthy gains in 2010. Benchmark indexes may not return to their highs, but they will put in healthy, double-digit gains. Even the more skeptical and pragmatic of investment managers are positive about prospects for the coming year.
The upside case has two distinct themes. The first is macro-based. Oil will remain at healthy levels, the economy will recover, inflation will retreat, and capital will pour back into ruble assets. The second is domestic change. Shocked by the economy’s failure, the Kremlin has learned its lesson and will adopt a reformist strategy, as propagated by President Dmitry Medvedev. The combination of an investor-friendly attitude and a large resource-backed economy will lure capital inflows, Russia will finally join the World Trade Organization, corruption will actually fall, and economic reform will move the nation away from commodity dependency.
But since old Russia hands need little reminding of the nation’s upside potential, let’s take a closer look at the downside threats. Since Russia is first and foremost a global macro play, the international outlook remains every investor’s primary concern. Russia cannot out-perform without a benign global backdrop, and this is the largest risk for the country.
This year’s recovery in asset prices is tied directly to monetary policy in the West. Although government stimulus is certainly contributing to the fragile economic growth today, it was the slashing of real interest rates to protect household net worth by forcing money back into risky assets that really pulled markets out of the abyss.
This policy represents the biggest economic experiment in capitalist history. If asset prices can go high enough and stay there long enough, then consumption will return. There is a long way to go, but so far the central banks are rightly pleased with their progress, and asset prices have responded positively, as expected.
But economic recoveries remain fragile and are notably dependent on fiscal support. The problem is that these levels of government spending cannot be sustained, and so far there is little sign that private sectors are ready to take up the slack. Indeed, the West appears to be heading for a frugal Christmas.
This great capitalist experiment will continue throughout 2010. But today, the dichotomy between asset prices and economic fundamentals is wide. Despite the tightness of real interest rates, there is a significant risk of asset prices sliding back toward economic fundamentals in the coming months. Such a correction would most likely be a buying opportunity as loose monetary policy will ultimately prevail. But prudent investors would be well advised not to chase overbought assets in the near term.
Surprisingly for a nation so renowned for investor risk, Russia’s domestic outlook is more stable for 2010. What real improvements will we see? Sales of state assets will mark an end to government expansion into the private sector, if not notably reducing its size. Sales of debt on international markets will encourage a longer-term awareness of investor interests and concerns. There is also a real chance of WTO accession, which will prove a game-changer for many inefficient outdated sectors as foreign investment incentives will soar and red tape will get sliced.
After years of arrogant commodity-fueled wealth, the political elite finally seem to understand that Russia’s economy lacks the diversity and openness necessary for sustainable growth. The president’s team is reassuringly liberal — in the Russian sense of the term “liberal,” meaning at a minimum that it recognizes that Russia needs to integrate with the global economy. After years of anti-Western and abrasive economic policy, the potential for progress is genuine. Russia cannot easily do worse than it has in recent years, and small changes will mean real improvements.
But investors focused on this theme would do well to remember Russia’s history. Repeated efforts at reform over the centuries have fallen short of expectation. Just like in the global economy, there is a danger that optimistic expectations will exceed real world change. The government’s pro-market investment story will gloss over key issues. It is true that the legal framework can be greatly improved, but the real problem is implementation. Over the last eight years, the bureaucracy has re-emerged from the chaos of the 1990s and again dominates the economic system. Its stranglehold will not easily be shaken.
Prime Minister Vladimir Putin’s policies have empowered too many vested interests. Midlevel bureaucrats will be unwilling to cede power unless the political elite lighten their hold as well, and that is clearly against the leadership’s most basic interests. Looking at the judiciary, the police, the bureaucracy and many other branches of government, the chances of achieving fundamental reforms that decisively break away from the destructive path of recent years are very weak. Medvedev is wisely pursuing a gradualist grassroots approach, encouraging awareness of basic civil society. This strategy has the potential to feed long-term change, but it will not deliver anything substantial in the coming year.
Nonetheless, the risk that investors will be overambitious in pricing in reform is greater than the risk that we will see no reform in 2010. There are excellent gains to be made before the divergence between expectation and reality once again rears its head. Unusually for Russia, the domestic outlook is attractive in 2010, and it is on the global level that the near-term threats remain most elevated.
James Beadle is an independent global and emerging markets investment strategist.