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Calling Russia's Bluff

Written By Briton Ryle

Posted August 28, 2014

Investors are getting excited over Russia, of all places. Despite increased sanctions against it by western governments, investors have been piling money into Russian ETFs – most notably the largest of them all, the Market Vectors Russia ETF (NYSE: RSX), managing some $1.7 billion in assets.saint basils cathedral moscow russia

In just the month of August alone, the RSX has seen nearly $200 million of inflows (11.7% of current assets) on the expectation that Russia’s conflict with Ukraine will end peacefully. This comes after an even larger flood of inflows reaching $573 million earlier this spring (33.7% of current assets) after Russia annexed the Ukrainian province of Crimea.

“Investors are cautiously optimistic as there are talks and there have been no new sanctions on Russia,” Alexander Antipov, head of sales at Veles Capital LLC in Moscow, explained investors’ changed sentiments. “Russian equities are very cheap and long-term investors who buy these days expect to make serious profits when the Ukraine crisis is solved and things are back to normal.”

But will they really? Any inflows into Russian funds on the expectation of easing tensions are being proved grossly premature. Just this morning the fighting between Ukraine and rebel forces intensified, with numerous rebels identified as Russian soldiers. Now we understand why the Russian government was so keen on sending those “humanitarian” supplies last week, just before sending in its troops.

To get an idea whether we should be opting into the Russia story, let’s put this year’s RSX inflows into perspective by examining the fund’s trend looking backward, as well as examining the Russian economy’s expectations looking forward.

The RSX Trend

The RSX’s surge in price from around $23.10 on August 6th to $25.12 as of yesterday’s close for an impressive 8.74% gain over 3 weeks, or 151.5% annualized, may seem promising. But zooming out a little shows it to be just a little upward splash from a cascading waterfall on its way down from dizzying heights.

As the chart below shows, the largest Russian ETF soared out of the gate at the bottom of the global financial crisis in the spring of 2009, rising 220% in value by the spring of 2011, far surpassing the S&P 500’s gain of just 80% over the first two years of the global recovery.

RSX ETF Russia


Yet that surge upward abruptly turned into a downtrend. Why? Because the first sectors out of a recession are always commodities and materials, since these are at the base of the production chain, and are always the first to be bought up when production ramps up again.

Since Russia’s economy is predominantly commodity-based, it was to be expected that it would be one of the first out of the gate when the global recovery began. Unfortunately, manufacturing didn’t follow suit. Suddenly there appeared a glut of materials and commodities with still not much of a market for them. Oversupply killed commodity prices, and wounded commodity-based economies like Russia’s.

Hence we see the long downtrend in the RSX which is already well over three years long, as noted by the red trendlines of lower highs and lower lows. Throughout this period the S&P 500 (beige) has been steadily rising, since it includes a broader range of sectors including banking, manufacturing and retail, while Russia still remains predominantly commodity-based.

Adding this year’s RSX inflows (blue and green) onto the chart gives us a better idea of what’s going on. These two buying reactions come after two selling over-reactions leading up the annexation of Crimea and the more recent incursion into eastern Ukraine. They seem to be merely upward corrections to downward over-corrections, and can hardly be considered the beginning of a new trend. As far as the charts are concerned, the RSX is still trending down.

Why the Downtrend Persists

Remember that glut of commodities and materials that began affecting commodity prices in 2011? Economists are still pretty dumbfounded that three years later the glut still remains. Although mines from based metals to precious metals have scaled back production, global manufacturing has not grown fast enough to eat up all the stockpiles worldwide.

But why? Aren’t five years since the recovery began in 2009 enough time to get manufacturing going again? After a normal recession, sure, five years would be plenty. But the 2008-09 crisis was not a normal recession. This one was characterized by illiquidity, a lack of capital as mortgages, swaps and other paper investments evaporated overnight. Capital simply vanished, leaving bank vaults almost empty and seizing the gears of the global economy.

Hence, for the past five years central banks the world over have been creating money and pumping it back into the system. But not directly into the economy itself; rather, to the banks first, through such programs as TARP, Quantitative Easing, and monthly purchases of the banks’ mortgage-back securities.

The idea here is that once the banks’ stores of capital are replenished, they would be able to increase their lending, and money would then work its way into the economy. But only after the banks are replenished. The banks get the money first; the economy gets it second.

This is why the recovery has taken so long, because central banks are still not finished replenishing all the capital that was lost during the crisis. They are still guiding banks through the process of recapitalization.

Russian Economy Looking Forward

Thus, commodity-based economies like Russia’s are still waiting for other economies to be recapitalized, for lending to improve, for manufacturing to pick up, and for the demand for their commodities to increase once again.

But that can take a few more years to accomplish. The U.S. may have had a head-start recapitalizing its banks, but Europe and Asia are still lagging. Europe, for instance, has only recently realized that austerity doesn’t work, after losing valuable time. Despite recent stimulus programs in Japan and Europe, global manufacturing is still not where it needs to be to absorb the world’s commodity stockpiles.

In the meantime, the Russian economy is slowing. “The Russian economy shrank 0.3 percent quarter-on-quarter in the first three months of 2014… as production in nearly all main sectors of the economy decreased,” informs Trading Economics on the most recent numbers out of Russia.

“On a quarter-on-quarter seasonally adjusted basis, agriculture and wholesale and retail trade shrank the most (-1.9 percent each). The construction sector contracted 1.5 percent; fishing activities fell 1 percent, manufacturing dropped 0.6 percent and mining and quarrying decreased 0.5 percent. In contrast, financial activities recorded the highest growth rate (5.5 percent), followed by real estate activities (2.5 percent),” the research firm added. “Year-on-year, the economy advanced 0.9 percent.”

Russian Economy Chart


Russia’s GDP is once again below zero and contracting, with only modest growth projected going forward:

• GDP quarterly growth rate: +0.27% (Q3), +0.15% (Q4), +0.18% (Q1-2015)

• GDP annual growth rate: +1.08% (Q3), +1.37% (Q4), +1.07% (Q1-2015), +2% (2015)

Inflation has also surged this year, mostly on account of sanctions, rising from 6% in February to 7.8% in July.

Among the greatest contributors to rising inflation have been food and non-alcoholic beverages (+9.5 percent). To combat inflation, the Russian government has lowered the cost of electricity, gas and other fuels, mainly by capping regulated utility fees. As a result, the government was successful in decreasing the annual inflation rate to 7.5% this month.

However, inflation for 2015 is still projected to be high, at around 6.45%. This means that any investments into Russian companies or ETFs would have to increase by 6.45% just to break even. Inflation rates must be factored into any ETF that tracks foreign economies. Think of the inflation rate as an expense that cuts into your investment’s returns.

Russia’s PMIs (Purchasing Manager’s Index, based on new orders, inventory levels, production, supplier deliveries and the employment environment) are themselves projected to be stagnant to contractive (where readings over 50 denote expansion, and under 50 denote contraction).

• Manufacturing PMI: 51.23 (Q3), 51.31 (Q4), 51.32 (Q1-2015), 51.3 (2015)

• Services PMI: 48.07 (Q3), 49.5 (Q4), 47.1 (Q1-2015), 49.11 (2015)

With such projections, even a rapid end to the conflict in Ukraine would still mean several years of stagnation for the Russian economy going forward. Until the world as a whole starts consuming commodities like it once used to, investments into Russia’s economy will continue to stagnate as well.

For investors, a safer bet exists in U.S. markets, which as mentioned above have had a head-start on the rest of the world in fixing the liquidity problem that triggered the last crisis. The recent inflows into the RSX and other Russian funds are simply short-term upward corrections to previously overdone downward corrections. But the overall trajectory for Russia is still down.

Joseph Cafariello