15.12.08

Expect 2009 to be a mirror image of 2008 - a bad market environment for the 1st half leading to a stronger market in the 2nd half.

The RTS will remain very volatile over the next two quarters with a wide trading range driven by a combination of external market trends, the price of oil and domestic economic news. Momentum for ruble devaluation is building despite senior government assurances that it will be avoided. The main catalysts will be where the price of oil trades and the pace of slowing in the economy. We expect an average price for Brent of $70 p/bbl for the coming year but assume that the price will remain very weak in the 1st half (especially 1st Qtr) before recovery in the 2nd half.

Forced selling by foreign investors is almost complete. Russia’s equities are, in most instances, very oversold. But we do not see any major catalyst for buying until there is recovery in commodity prices and a general improvement in global market sentiment in the 3rd Qtr.

The trading range for the RTS over the 1st half is expected to be between the recent lows (550) and 1,200 with an end June target closer to the upper end of that band. For the 2nd half, the trend in the global economy, in oil and metals plus investor perception of Russia risk, will determine where the index closes the year.

Equity issuance, originally expected to total around $40 bln in 2008, will not exceed the $2.6 bln already raised this year. The outlook for 2009, originally set at $50 bln, is that a maximum of $10 bln may be raised and that only if the investment climate improves in late 3rd Qtr or 4th Qtr.

The main driver of the more positive investment sentiment in the 2nd half is expected to a strong rally in commodities as the huge injection of cash by the world’s Central Banks, the incoming US Administration in particular, leads to an inflation spike in commodities and better hopes of a recovery in the global economy from late 2009.

The domestic economic environment will get worse in the 1st Qtr with recovery not expected before the 3rd Qtr. How bad the economic downturn gets will depend on whether credit and other loan facilities can be made available to the country’s SMEs and consumers. Right now, a shortage of cash and credit, as well as confidence, is grinding commerce to a halt. Unless this is addressed then our forecast for 4% GDP growth in 2009 will be far too optimistic.

The next sectors to go into steeper decline will be the consumer, services and manufacturing industries. The consumer boom of the last five years is coming to an end.

We do not expect any major (i.e. High Street) bank failures but do expect industry consolidation to continue and the number of banks to shrink. We see zero risk of sovereign debt default and also amongst the country’s biggest enterprises. Defaults are already taking place amongst 2nd and 3rd tier ruble bond issuers. This will leave a legacy of higher investment risk for this asset category way beyond the recovery elsewhere.

The economy cannot escape a severe slowdown in the 1st half and that will also pull earnings to single digit growth for the first time since 1999. But Russia is in much better shape to weather the storm than other economies. Partly that is because of the high level of financial reserves and partly because the slow development of the economy to date means that it is not greatly exposed to the slowing global economy, i.e. other than in terms of commodity exports. If this crisis were to hit in three or four years then the damage would be much more destructive.

We set out two recommended stock portfolios to reflect the different investment backdrop expected between the 1st half and 2nd half of 2009. The “Defensive” portfolio is comprised of stocks that we believe are best placed to withstand the deteriorating economic conditions in the early part of 2009. They should perform relative better than the average and are well placed for absolute gains. The 2nd list is the “Phoenix Rising” portfolio. It is comprised of the Defensive stocks plus others that we believe are the best to hold for strong absolute price gains when the market rallies in the 2nd half.

The Defensive portfolio is (alphabetical): Comstar, Federal Grid Co, Gazprom, Gazprom Neft, Magnit, OGK-4, MTS, Polyus Gold, Raspadskaya, Raven Russia, RusHydro, Silvinit Common and Preference, Sistema and TMK.

The Phoenix Rising portfolio is (in additional to the Defensive stocks): DIXY Group, Evraz, LSR Group, LUKoil, Mechel, Norilsk Nickel, PIK Group, Sberbank, TNK-BP, Vimpelcom, VTB and X5 Retail.

The main international assumptions for 2009 are:

• Negative global growth until the 3rd Qtr with very evident recovery in the 4th Qtr
• Inflation to rise on the back of massive liquidity injections and state spending in US and EU
• US dollar to weaken considerably from late 1st Qtr
• Price of oil to continue weaken into early 1st Qtr as production cuts chase collapsing demand. But we expect recovery later in the year and assume an average of $70 p/bbl for the next two years
• Gold to rise to a new record in 2009 as a haven against the currency uncertainty and general financial market uncertainty in the 1st half of 2009
• Metal prices to stay weak in the 1st half year but rising strongly in the 2nd half on the back of a) weak dollar, b) less product availability as current production cuts are extended and c) some evidence of demand recovery in late year.

The main domestic assumptions are:

• Zero sovereign default risk and zero risk of default from the state controlled enterprises or other major companies
• Defaults to continue amongst 2nd and 3rd tier bond issuers
• No high street bank defaults but consolidation and bail-outs to continue
• Consumer activity will slow considerably over the nest six months
• Real-Estate prices will continue to fall very sharply
• Inflation not to fall below 10% before 2011
• The ruble rate will depend on the oil price trend but with negative momentum continuing
• Oil production is expected to slow between 2% and 5% by end 2009. That means a reduction of between 200,000 and 500,000 barrels per day, all of which withdrawn from the export market.

The main risks include:

• Economic growth may decline even more and for longer if business continues to be starved of cash and credit and if the price of oil falls further for longer
• Rising unemployment and a deteriorating economy leading to a loss of public confidence in the government
• Non-performing loans and bad debts grow to a high level in the banking system
• Chinese growth may slow, leading to internal instability and a big fall in demand for commodities. That would delay the expected rally in metals and oil
• Corporate governance standards have already fallen in some instances. If that trend extends then investment risk will increase and hurt asset valuation recovery
• Czech EU presidency. The Czech Republic takes over the rotating presidency of the EU from January 1st. That may create a backdrop where progress on trade and investment talks between the EU and Russia slows or runs into problems.

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Source: Prime-Tass