Clear and Present DangerPosted by Chris Weafer on Monday, 28 February 2011 03:42 | Published in Chris Weafer's Investor Notes
The issue of greatest concern to investors in all markets is that the rising price of oil may soon lead to a reversal of the current rate of economic recovery and send the global economy back into recession. The evidence says that we are far from that event today but the fear of the trend is dominating market activity and has added higher volatility to most asset classes. This week, the battle between risk and economic reward will step up a gear when all major economies release their most important monthly activity indicators while the events in Libya – and the risk of a greater loss of oil export supply – continue to deteriorate.
Russia is still well placed to continue to perform in absolute and relative terms. But, is the economic indicators are weaker than expected while the Libyan threat worsens, all markets including Russia will fall. If, on the other hand, positive economic indicators restore investor confidence then we should see a global markets rally and recovery in the non-oil and gas Russian names, especially in steel and the banks. That “either-or” scenario is why most investors are staying on the sidelines and building cash for now.
Many publications, including the weekend FT under a title “Oil price spikes set grim precedents” (with a useful graphic) highlight the historic trend when, since the 1974 oil price spike, a sharp % rise in oil has always led to a period of recession in the US. It happened in 1974/75, in 1981/83, in 1990, in 2001 and, arguably the sharp gain in oil that occurred after Hurricane Katrina was a contributory factor in the 2008/’09 slowdown. The historical precedent, and the current threat, is very clear.
China slightly revised down its medium term growth outlook to an annual average of 7.0% for the period 2011-15. That is down on the target average of 7.5% set for 2006-’10, albeit actual growth was much higher than that in recent years. A 7% average growth rate provides a strong backdrop for commodity prices and for Russia’s producers.
Against that backdrop Russia is one of the few assets, in either developed or developing markets, which offers investors a haven or a hedge against increasing global uncertainties. While the MSCI EM and World indices fell 2.0% and 1.6% respectively last week, the RTS and MICEX both added 3.4% and the IOD index of GDRs gained 5.4%. Year to date, while the MSCI EM index is down 4.5%, the RTS is up 9.2% and the IOD Index is 11.1% ahead. MICEX is lagging the other bourses with a gain of only 3.5%. That is because of the strength of the ruble, which adds an extra boost to dollar denominated prices.
The main driver of the market was again the oil and gas sector shares. The RTS Oil & Gas Sector index rose 5.8% for the five days while Banks (-0.4%), Telecoms (-0.4%), Electricity (-0.8%) and Consumers (-1.4%) all closed lower. The gold/silver stocks also staged a rally with the recovering price of the metal and Polyus Gold was the week’s best performer with a gain of 13%.
The ruble is much more likely to add to last week’s gain against the dollar during this week, i.e. while the currencies in other big emerging markets are weakening. Russia’s Central Bank unexpectedly raised its benchmark rate by 25 basis points, to 8.0%, on Friday. It is only a token move in the battle against inflation (our full year CPI forecast is 9.5%) as high street banks are flush with cash and borrowing demand is still modest. But the action may start to attract speculative capital inflows to ruble deposits, especially with the price of Urals crude over $110 p/bbl and climbing. Last week the ruble added 1.0% gain against the dollar to close Friday’s MICEX session below 29.0 at 28.932. Against the euro the ruble lost 0.5% to end at 39.829. That is the wrong way for Russia as a weaker dollar hurts the value of imports and export tax revenue, while the stronger euro adds to inflation pressure because imported food is a major driver.
The price of crude continued to rally last week as fears increase that a prolonged and extended conflict in Libya will lead to greater oil export disruption. On Thursday both the IEA and Saudi Arabia said that they would make up the shortfall from Libya and that pulled the price of crude back towards $110 p/bbl. But, on Friday, it was widely acknowledged that the grade of Libyan crude will not be easily replaced with other oil qualities and shortages in some locations is inevitable. That helped add almost $1 p/bbl to oil by Friday’s close. One-month Brent closed at $112.14 p/bbl, up 9% last week and 18.5% YTD, Urals crude closed at $110.03 p/bbl and WTI ended at $97.88 p/bbl.
Commodity prices were as volatile as equity markets last week with news from Libya also being the dominant factor. The slight weakening of the US dollar helped provide some support and facilitated the bounce in most prices on Friday. Copper bounced 2.6% on Friday to cut the loss for the week to 0.9% and bring the year to date price move marginally back to positive (+0.2%).
The price of gold rose for most of the week but partially reversed that on Friday with the greater optimism in global markets. The price fell 0.5% on Friday to cut the week’s gain to 1.0%. It closed the week at $1,409.3 per ounce. The record high price was $1,432.5 per ounce set on December 7th. Year to date gold is down 0.9%. Silver fell 0.8% on Friday and was off 0.5% for the five days.
Agriculture commodities were the most volatile last week as traders took advantage of the general lack of conviction in all asset classes to bounce prices day-by-day. Wheat and corn each rose 3.7% on Friday and, over the five days, respectively ended down 5.2% and up 7.2%.
The weekly funds flow report from EPFR Global shows that investors continue to retreat from emerging market (EM) funds in preference for developed market (DM) equity funds, albeit at a slower pace than in previous weeks. For the week to Wednesday, a total of $1.9 bln was redeemed from all EM funds, the fifth consecutive week of losses.
Amongst the major country specific funds, Russia again attracted relatively strong inflows for a thirteenth straight week. The total last week was $162 mln, slightly down from the previous week’s inflow of $169 mln. But on only 27% of those flows were from ETF funds, down from almost 80% the previous week, as longer-term investors add more Russia exposure.
EPFR Global has also updated the country weights of the global and regional EM funds as at end January. At January 31st, Russian equities accounted for a 7.5% share of EM Global Balanced funds, up from 6.8% at end December. Russia’s share of Emerging Europe funds rose to 50.8% from 49.6% at end December.
Kovykta auction. The auction of the Kovykta gas deposit, delayed from February 14th, is scheduled for Tuesday. The main contenders areGazprom and Rosneft, the latter being particularly keen to build a significant gas business. The other contenders are Novatek or the state’s energy holding company, Rosneftegaz. Novatek is fast growing, very well “connected” and getting the licence would be another positive game-changer for the stock. Whichever company wins the licence will likely create a JV with BP (the previous operator) and with CNPC to develop the project as the source of the China gas contract – and perhaps with China money up front to pay for it.
AAR-BP. The next deadline for this dispute is March 8thwhen both sides are scheduled to come before the arbitration court in Stockholm. It still seems most unlikely that the dispute will end up in that court so we may hear some compromise by the end of this week. The board of TNK-BP is scheduled to meet for an extra-ordinary meeting on Friday and that is likely to be the major showdown between AAR and BP over this dispute. However, TNK-BP minorities are more likely to gain from any deal.
Mechel. Our analysts have upgraded the target price of Mechel ADRs to $36.0, i.e. upside of 26% and retain a target price of $13.5 for the Prefs. Mechel is the main beneficiary of any recovery in global market confidence, which may come this week if the important macro updates in the US and China show steady recovery.
VTB. The weighting of VTB shares in the MSCI Russia Index will be increased on Tuesday to reflect the expanded free-float after the state’s successful placement of 10% of the equity. Index linked funds will only buy with that event and are not allowed anticipate it.
PIK Group. Now that PIK Group has reached a deal to repay its dent to Nomus Bank the suspension of the GDRs should be removed very soon. PIK is then expected to proceed with the long-awaited SPO to clean up its balance sheet and that will be taken very positively by investors. Both PIK Group and LSR Group are very well placed to benefit from the additional stimulus planned for the mortgage market this year.
Sistema/MTS. A non-controversial alternative to Vimpelcom. 83% upside to our target price and a 2011 EV/EBITDA of less than 4.0 times. Very defensive in such troubled markets. Investors are playing this defensive theme increasingly through Sistema where there is also an oil play pickup.
CTC Media CTC Media will release its 4th Qtr results on Tuesday. The quarter is the most important for the company so the numbers will drive the stock.
Utilities The Prime Minister’s comment that utility tariffs have risen too fast, and may be revised downwards as part of the inflation control strategy, weighed on the sector last week and will likely continue to do so over the medium term. Our preference is for the best-placed Gencos, which are OGK-4, OGK-5 and TGK-1. Best to stay away from the distribution companies for now, as they are most in the “inflation” firing line.
Aeroflot In global equity markets, the airline stocks have taken the biggest hit with the dual threat of higher fuel costs and the threat of a cut in travel if economic recovery does slow. The sector will remain under pressure until these concerns ease.
This Week: Important global macro indicators
After a week of watching the expanding risk premium in global markets and worrying that the rising price of oil may derail global recovery, this week investors will refocus on hard economic data. The first week of each month brings the most important macro updates for all major economies, by the end of which, investors will have a clearer picture of whether growth is has been affected by the events in North Africa and the Gulf and whether higher oil is starting to have an impact. Positive numbers will help re-focus attention on the domestic and global trade sectors that had been leading most markets, including Russia, up to late January.
The most important numbers will come on Tuesday, the start of the new month. The Purchasing Managers Index in China will show whether the last round of tightening has had a negative effect on growth or not and the answer will be reflected in, e.g., how Russia’s steel sector names will trade. The ISM manufacturing update in the US later on Tuesday is one of the most important market drivers each month. Fed Chairman Bernanke will address the Senate Banking Committee meeting over two days from Tuesday and may give some clarity on the bank’s position concerning interest rates. Especially after several EU countries have signalled that they may support a rate rise by the 3rd Qtr.
The focus will return to the EU on Thursday as the ECB meets to review its interest rate strategy. As usual, the ECB president’s comments at the post meeting conference will be closely scrutinized by the market and will have an impact on where the euro-dollar ends this week. The EU will also update retail sales and 4th Qtr GDP on Thursday.
Friday is also a big day for investors as the monthly US nonfarm payroll and unemployment rate updates will be published. Last month’s number was disappointing but investors rationalized that down to the bad weather in January. That implies a big pick up through February.
In Russia, apart from the specific corporate events highlighted earlier, the weekly inflation report is of increasing importance to the currency market and, later as inflation rises, it will be to those stocks and sectors most exposed to either regulatory price pressure or outright political pressure. The 2010 FDI report is now due and, as we heard from the Finance Minister last week, will show a big drop in the level of direct FDI over the previous year to a level ($12-$14 bln) that is also about half that of the pre-crisis FDI. The need for higher investment is very clear and is one of the main issues highlighted both the government.
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