The Russian economy, fueled by energy and commodity exports, registered impressive growth of 8.1% in 2007 and is on its way to over 7% this year and probably in 2009 as well. The Russian stock market as measured by the DAX Global Russia Index (DXRPUS) advanced by 40% in 2007, and as recently as June it looked set to outperform global markets again this year. We were reluctant to invest in a country under an autocratic and unpredictable government and a market with continued evident shortcomings in corporate governance and in the equitable application of laws and regulations. Yet with Russia accounting for some 11% of the emerging markets, staying out of this booming market was becoming a drag on portfolio performance relative to the emerging market benchmark, the MSCI Emerging Market Index. And, the “election” of Dmitry Medvedev as president and the move of Vladimir Putin to prime minister early this year held promise for political stability and continued improvements in economic prosperity.
Finally, in February we decided – while holding our nose – to include a position in Russia in our international and global ETF portfolios, using the Van Eck Global ETF Market Vectors Russia ETF, symbol RSX, which seeks to track the DXRPUS Index. The sector distribution of the holdings of this ETF is dominated by a 39.1% position in oil and gas companies (Lukoil, Rosneft, and Gazprom) and a 24.45% in iron and steel companies.
As global energy and materials prices surged in April and May, the Russian stock market also performed strongly. In June the first headwinds hit that market in the form of the shareholder fight at TNK-BP, coupled with administrative pressure (visa and work permit problems, regulatory investigations) and then in late July a verbal attack by Putin on steelmaker Mechel – both developments raising the political risk premium for Russian equities in the eyes of foreign investors. A reversal in prices in the international oil and materials markets in July added downward pressure on Russian equities. While we were not sure how long-lived the decline in oil prices would be, we were seriously considering reducing our Russian exposure.
Then came the entry of Russian armored and motorized infantry forces into the Republic of Georgia (a vocal US ally), along with air power, the morning of August 8th, which marked an important turning point in the geopolitics of Euroasia. While Georgia’s president, Mikheil Saakasvili, seriously miscalculated when he moved Georgian forces into South Ossetia, a secessionist region of Georgia, the night of August 7th, the military response of Russia on the 8th and in subsequent days was greatly disproportionate. The indiscriminate pounding of civilian as well as military targets well within Georgia sent a chilling message across Europe about both the nature and the relative power of the present Russian state. The US, with its military assets (and interests) tied up in the Middle East, and the Europeans were shown to be unable and/or unwilling to react other than with words. All the new democracies along the periphery of Russia have been sent a message – as have foreign investors.