Should the BRussiaICs Become the BICs?

Author: Bill Witherell, Post Date: July 7, 2009

At Cumberland Advisors, our answer, from the perspective of a global portfolio manager, is a strong “Yes.”  As we write, President Obama is in Moscow for his first Russian-American summit with his counterpart, President Dmitri Medvedev, along with Prime Minister Vladimir Putin.  The stated objective of both sides is to “reset” American-Russian relations. The agreements reached on slashing nuclear arsenals and military cooperation are certainly positive developments. But we have not seen anything that would make us more willing to invest our clients’ funds in the Russian economy and equity market. Below we summarize the various reasons behind our negative evaluation of Russian equities in comparison with those of China, Brazil, and India.

In 2001 Goldman Sachs coined the acronym BRIC to refer to the large and rapidly developing economies of Brazil, Russia, India, and China. The equity markets of these four economies have indeed outperformed others in the emerging-market asset class. The MSCI BRIC Index, through the end of the first half of this year, advanced at an average annual rate of 20.4% over the past 5 years in comparison with the 12% average annual increase for the MSCI Emerging Market Index. This outperformance was maintained over the past 10 years as well, with the corresponding annual rates being 11.6% versus 6.3%.  And in the first half of the current year the BRICs continued to lead, registering a 45.76% increase, as compared with a 34.26% increase for the emerging markets index.

Ever since Russia’s invasion of Georgia, and particularly in the past month, strong doubts have arisen as to whether Russia should continue to be considered to be in the front rank of emerging market economies along with China, Brazil, and India. The Russian equity market has become increasingly decoupled from the other BRICs and emerging markets. From a peak on June 3, the Russian Trading System Index (RTSI$: IND) tumbled 21% by June 23, as investor confidence in the economy weakened and the upward advance in oil prices encountered headwinds. The Russian economy is facing a steep decline this year.  The economy plunged by 10.2% in the first 5 months of 2009.  A decline of 8.5% for the full year is projected by the Russian Economic Development Ministry (we had been expecting a 7% drop).  In marked contrast, the decline for Brazil is likely to be only 1.5%, while the Indian economy should advance by 8% and the Chinese economy looks to be on track for annual growth approaching 9%.

Unlike the diverse Chinese, Brazilian, and Indian economies, that of Russia is heavily dependent on the oil and gas sector and other raw materials.  This is evident from the sector composition of the DAX Global Russia Index, which is tracked by the Market Vectors Russia ETF, RSX. Oil and Gas account for 38.5%, Other Energy 6.9%, and Iron and Steel 18%.  We particularly do not like the dominant position of Gazprom, the leading holding of RSX, accounting for 12.6% of the ETF’s holdings.  Granted, investors in Gazprom have done well.  But this firm, majority-owned by the Russian state, has a quasipolitical profile and is spending its dwindling cash flow excessively. This spending is focused on expansion abroad, while huge domestic investment requirements remain unmet.  Other major positions are in Surgutneftegaz, 8%, Rosneft Oil Co., 7.8%, and LUKOIL 7.8%.  An investment in this ETF is essential a play on the global oil price. We would prefer to do this in a way that avoids the country risk presented by Russia.

One of the factors behind the steeper fall of the Russian economy compared with the other BRICs is a huge debt restructuring problem. Russian companies and banks face a $200 billion refinancing requirement over the next 12 months. The Russian Central Bank is seeking to recapitalize a banking sector that has all but ceased to lend. The steep recession is moving this year into a substantial deficit, amounting to more than 8% of GDP.

We were pleased to see President Medvedev signal a new initiative to “strengthen the rule of law” in Russia and call corruption a threat to national security, but we remain skeptical that meaningful steps to reform serious deficiencies in this area will be taken. A new trial with strong political overtones – of Mikhail Khodorsky, the former head of Yukos Oil Co., once Russia’s richest man and political opponent to Putin, along with his former business partner Platon Lebedev, has been underway since March. As the Economist magazine said in its July 2, 2009 issue, Russia is “courting disaster” with its “dismal investment climate.”  The CFA Institute’s report, “Shareholder Rights Across the Markets,” summarizes the situation in Russia as follows:  “Shareholders face various challenges to their rights in Russia.  Inconsistent law enforcement, growing state intervention in business, and challenges in corporate transparency are among the obstacles to stronger shareholder rights in the Russian market.”  IKEA has announced that it is suspending its operations in Russia because of the “unpredictable character of administrative procedures.”  This is not surprising when one refers to the 2008 Corruption Perception Index, calculated by Transparency International. Russia ranks 147, just one place above Syria and one below Kenya.  In contrast, China ranks 72, Brazil, 80, and India, 85.

In sum, we are continuing to invest our International, Emerging Market, and Global Multi-Asset Class portfolios in the three BIC markets (Brazil, India, and China). We sold our Russian holdings when Russia invaded Georgia and do not expect to invest our clients’ assets in such a market until conditions there improve.


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