After a very strong start to the year, the Russian equity market has given up this performance in recent weeks.
A positive return of 19.6% from the MSCI Russia 10/40 Index in the first three months of the year has been followed by a series of sharp declines. Year to date, the market return is now -1.0% in US dollar terms.*
In our view, the ongoing problems in the Eurozone have contributed to this. Investors are back in "risk off" mode, and emerging markets are out of favour for the moment. In the case of Russia, the strong performance of the market at the start of the year has made it a source of funds for investors looking to reduce emerging exposure, while political developments and concerns over the reform agenda have brought additional uncertainty.
One example of this was seen recently, when the market was not prepared for newsflow regarding the taxation of gas producers, and the loss of the private sector's more favourable tax treatment. While the initial negative reaction was understandable given the unpredictable behaviour of legislative bodies in Russia and the need to reduce the earnings outlook for companies under the new regime, we believe that a unified, more transparent tax environment will ultimately be interpreted positively by overseas investors. Potentially, it creates a fair competitive environment and could be the precursor to opening the lucrative pipeline export market to the private sector.
Economically, we would highlight that most of the domestic growth indicators are holding up very well in Russia, particularly on the consumer spending side. Car sales, for example, are at record levels, and continue to rise at an annual rate of around 15%. Judging by the latest numbers on lending growth and credit creation, domestic activity is poised to remain strong as we go into the Summer, and we believe the current consensus estimate for GDP growth of 3.30% is too conservative.
Even growth of 3.30% is likely to compare favourably with the low or even negative economic growth likely to be seen in parts of developed Europe this year, in our view. In fact, the ongoing European sovereign debt crisis highlights one of Russia's main competitive advantages. Not only is the Russian state virtually debt free, but levels of borrowing remain very low across the household sector, which should help to fuel continued consumption growth.
We believe the Russian equity market will stay focused on political developments as President Putin reshuffles federal government and provincial governors. The Kremlin is very aware of the need to deliver reforms before the nascent opposition movement can gather meaningful momentum, and there are a number of changes which could be implemented relatively easily. Investors are likely to follow this closely, and significant progress could trigger a renewed flow of investment into the Russian market. Additionally, and just as importantly, Russian companies continue to improve their corporate governance, a trend that is confirmed by increasing dividend payout ratios.
Against the context of undemanding share price valuations for Russia, with the market currently trading at little more than 5 times 2012 earnings, we continue to believe that the long term prospects for the Russian economy and market are attractive.
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