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A new dawn

27 July 2015

The Russian economy is showing signs of recovery after sanctions and falling oil prices put progress in reverse.

The Russian economy has had a dismal 18 months. It was already labouring under the impact of Western sanctions – imposed in March 2014 because of the Russian government’s actions in Ukraine – when it was hit by a second blow; the price of oil halved in a little over six months. Meanwhile, the rouble lost around 40% of its value against the dollar and Russia’s central bank reacted by pushing up interest rates, which peaked at 17% in December and prompted international investors to withdraw their funds – $70 billion in the fourth quarter of 2014 alone, according to Capital Economics.

It’s a stark contrast to the heady days at the start of the century when it was a core member of the BRIC club – along with Brazil, India and China it was seen as one of the major emerging markets of the world. Back then, the country was enjoying rapid growth, spurred by factors such as its huge commodity resources (it also has large stocks of coal and timber), a move towards free-market principles after the long era of communism, and an emerging middle class. As the commodity boom turned to bust, so its growth rate fell. Sanctions and falling oil prices have dealt its status as a fast-growing emerging economy a further blow.

Yet there are signs that the worst may be over. Oil bounced back from its lows at the start of the year, albeit some way off last year’s highs, which helped the rouble to recover some of its value against the dollar. Economic growth in the first quarter of the year was down 1.9%1, although the Economy Ministry of Russia is predicting that the contraction this year will be much lower than expected. Investors have been encouraged by the better news and Russia’s stock market performed strongly at the start of the year, though admittedly this is in recovery from a dismal few years.

Following one of its regular visits to the country in May, IMF officials predicted a 3.4% decline in GDP in the current year ‘driven by a contraction in domestic demand weighed down by falling real wages, higher cost of capital and weakened confidence’. But it went on to say that the rouble’s depreciation would boost exports.‘Due to the authorities’ policy response and higher oil prices, growth should resume in 2016 while inflation is expected to decline further to single digits.’ However, the recovery is ‘unlikely to be strong’, says the IMF, as factors limiting expansion ‘will take time to be addressed, leading to medium-term growth of 1.5% per year2’.

A lifting of the international sanctions could also help sentiment, although that is not yet on the horizon. A communique after the G7 summit in April reiterated the need for Russia to respect Ukraine’s sovereignty and to fulfil the requirements of the ceasefire agreement before they are lifted.

Russia’s recession has reinforced the need for fundamental economic reforms. Liza Ermolenko, an emerging market analyst at Capital Economics, says that growth in the past few years has been driven primarily by consumption.‘Investment has been very low and has been one of the main constraints on growth,’ she says. That has made it hard for domestic companies to increase sales of their products to take the place of the imports which Russia has blocked in retaliation for Western sanctions. ‘Capacity utilisation is already high and there is a need for more investment,’ says Ermolenko. ‘But that is difficult because of the economic uncertainty.’

Even in such unpromising circumstances, there can be investment opportunities.

Richard Oldfield, of Oldfield Partners, manager of the St. James’s Place High Octane fund, says there are areas of ‘overwhelmingly attractive’ value among Russian companies. Among the companies he owns is Lukoil, which is the biggest privately owned Russian oil producer.

Oldfield focuses on companies and does not make projections about economies, but he says that investors naturally need to take account of the macro and political climate in which they are investing. Lukoil’s sales are calculated in dollars and its costs are in roubles, insulating it from the currency’s weakness. While some Russian oil companies have been susceptible to political interference, Lukoil has not – the government does not own any of it. Lukoil’s board contains Mark Mobius, the renowned Templeton fund manager, and Ivan Pictet of the Swiss banking family, as well as former executives of Western oil companies such as Chevron and Eni, while its two founders control more than 30% of the shares. ‘We look at probabilities,’ says Oldfield. ‘We try to estimate the risks – the US could make it difficult for US investors to own Russian companies, the government could expropriate a company’s assets, or much tighter sanctions could be imposed.’

Oldfield has been investing in Russia since 1997, when he said what he describes as one of the silliest things he has ever said about investment: that it was safer to invest in Russia than in Coca-Cola. The Russian market promptly fell 90% in dollar terms. But it recovered; and since the time of his comment in 1997, the Russian stock market has outperformed the soft drinks company. ‘It’s a lesson, in a rather extreme way, about volatility and the long term,’ says Oldfield. Equity investment requires at least a ten-year time horizon; investment in volatile markets like Russia should have an even longer-term view.

Other fund managers are less enthusiastic. Tom Prew is an emerging markets fund manager at First State, which also invests in good companies, regardless of their location, rather than taking a view on individual economies. Its St. James’s Place fund does not currently hold any Russian companies, although it has some exposure to the country via local divisions of global businesses – such as the local bottler of Coca-Cola or representatives of Unilever’s businesses.

Prew cites corporate governance concerns as the key issue, with many Russian companies ultimately owned either by the state or oligarchs who may not always act in the best interests of outside investors.

Whatever the long-term outlook, for most retail investors direct investment into Russian companies is too risky. Exposure to Russia can also be gained through a global or regional fund, where the manager will determine the appropriate allocation to the country.

Russia has many natural advantages, which make it an interesting economy over the long term, but the investment case will always be tempered by political uncertainty.

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice.


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