Russia Enters Georgia – Cumberland Exits Russian Stocks

Author: Bill Witherell, Post Date: August 13, 2008

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.

For Cumberland, this event raised the political risk premium of the Russian market far above an acceptable level. We rapidly sold our positions in the Russian ETF, RSX, even though this meant booking some losses on those investments. Because our positions were in an ETF traded on the US market, we were able to accomplish this in minutes while the market was open on August 8th. Had our position been a diversified portfolio of stocks in individual Russian companies, the process would have taken far longer. Or if it had been in a mutual fund, the transactions would have had to take place at the closing prices on Friday. This was a good example of the relative flexibility and efficiency of ETFs.

While at the time of writing the Russian market has recovered somewhat, as an end to the six-day battle appears to have been successfully brokered by French President Sarkozy, we are not about to return to this market in the foreseeable future. While Russia’s wealth of natural resources will continue to underpin the economy, Russia’s relations with Europe, its most important trading partner, have been dealt a serious blow, the effects of which have yet to be seen. The US has cancelled planned joint military exercises with Russia and secretary of state, Condoleezza Rice, has stated”… what role Russia can play in the international community is very much at stake here.”

In Europe, the Baltic States have called on the European Union to suspend its efforts to strengthen relations with Russia; and the Presidents of Latvia, Lithuania, and Estonia, together with Poland, issued a statement warning that the Georgian conflict was a “litmus test” for NATO and the EU. The Baltic States, indeed most countries of Europe, are heavily dependent on Russia for energy supplies. In response, the Russian ambassador to Latvia warned that the stance of these countries will “have to be paid for a long time afterwards.” The already great unease of many Europeans about this vulnerability of their energy supplies surely has increased.  This will affect future investment decisions. My colleague David Kotok will have a good opportunity to explore the situation in the Baltics first-hand when he participates in Tallinn, Estonia, next week at a Global Interdependence Conference on Nordic-Baltic Energy Issues. Look for his Commentaries from Tallinn.

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