One of the reasons to hope that markets will rally into the year end is because Japan seems set to follow the US with additional QE spending. That may set up problems in 2011 but it can provide a medium term boost. It is possible that other members of the G20 may also follow the example of the US and Japan and make additional stimulus available ahead of the G20 summit in mid November.

Investment flows into Russian equities have almost come to a standstill since the beginning of July. Investors view Russia as a derivative of the global market to a much greater extent than they do for other big emerging markets. So, while the MSCI EM Index last week closed at a 14th-month high, the Russian market is still some 12% off its mid April high. The valuation discount remains above 25%. The good news is that, as we saw in the period up to mid April this year, when global market investors become more confident, Russia is the best way to play that. In that period, Russian equities rallied 14.5% while the MS EM index gained 6%.

The recent evidence is that global markets are starting to settle. Fewer investors now expect a double-dip recession, especially after the US Fed indicated that it is ready for additional easing to ensure growth remains positive. For sure, most are also looking at a long period of low growth in developed economies rather than the hoped for steep bounce, but no reversal. More a square-root pattern than a "V" or a "W"

That backdrop, plus the support that a weak US dollar gives to commodities, commodity economies and to high yield assets, provides a favourable backdrop for Russian equities. In the vacuum created by a lack of international market momentum and little investor interest, domestic concerns are disproportionate. In reality, whether 2010 GDP grows at 3.8% or 4.8% doesn't matter much for equity investors. What does matter is the trend in US equities. If that can remain positive then equity investors in Russia can look forward to a strong year-end rally.

Critical 3 weeks ahead

The next 2 or 3 weeks will be critical for that. This week brings a raft of important economic indicators in the US and the eurozone. The most important will be on Friday with current month industrial activity indicators for all counties, including China. The sentiment influencing US payroll report will come on Friday week. The week after that will see the start of the 3rd quarter earnings report from Wall Street banks and other big companies. If these reports add sustenance to the majority that now believe in the "square-root" recovery then Russian equities, and the ruble, will lead the charge into December.

Over the next three weeks it is more likely a case of the same sort of trading pattern that we have had for the past few months. Good US data sending Russian equities higher, led by the high-beta steels, miners and banks, while bad numbers will send all down and increase the preference for defensive names.


Stocks & Themes to look at this week;

Ruble & Banks: While most other emerging market currencies have rallied in recent weeks, the ruble continues to lag. The reason is a combination of economics and technical factors. With oil and other commodities holding strong and appetite for risk assets also rising, I expect the ruble to rally from last week’s lows, albeit not strongly just yet. There is still a lot of residual nervousness that will take a few weeks to dissipate. In particular, the deteriorating trend in the balance of payments and current account is a cause of concern. Lower growth forecasts for 2010 and rising inflation are also weighing on the currency. But, the ruble depreciation is overdone. The technical factors, in particular, are close to being resolved. There was a large buyer of foreign currency in recent weeks that is unlikely to remain. Whether it was to fund the purchase of the LUKoil stake, or the transfer of wealth by a nervous Moscow billionaire or perhaps linked to the closure of Russia’s independent Bureau de Change offices. This latter point could certainly be playing a part in the current ruble weakness. There are thousands of these offices spread across the country and, from October 1st, they will start to close. It is unknown exactly how much money the offices handle but it is at least in the tens of billions of dollars worth. Owners of these businesses may well be preparing for their retirement.

The bank sector shares are the best way to play a rally in the ruble over the next couple of weeks.

Bashneft: It has been announced that only Bashneft’s application to acquire the development rights for the Trebs and Titov oil deposits is without error. Not much of a surprise there as, with Rosneft having withdrawn, Bashneft is favourite to acquire at least one of the deposits. Bashneft, now that it is part of the well connected Sistema group, is making rapid progress from the 2nd division of Russian oil producers to the premier league. Bashneft share liquidity is low so the best way to play this theme is via Sistema.

Novorossiisk Seaport; the share price is off almost 20% since the news of the deal with Transneft was announced. The initial reaction was negative due to worries about the terms of the deal (yet to be disclosed) and because Transneft may drive down the tariffs after it gets control. Last week, it was disclosed that the state may sell its 20% stake in the company and Russian railways has already said that it is keen to acquire it. Russian Railways already has a 5% stake and tried to acquire the additional 20% at the time of the IPO.

I believe that the government will have a direct influence in how the proposed deal with Transneft is concluded and will be keen to ensure that minority interests are protected. To do otherwise would undermine the president’s efforts to improve the perception of the investment climate in Russia and to attract a greater volume of foreign investment. If Russian Railways were to acquire the 20% state block, thus controlling a 25% blocking stake, I believe that would be positive. It would provide a better balance to Transneft’s influence and would lead to a major investment in the port by Russian Railways. The opportunity for the investment has recently been created with the deal to build an oil pipeline by-passing the Bosphorus that will substantially cut the number of oil tankers using the channel. .

Retailers & Inflation; Food retail shares came under some pressure last week and that is more likely to continue. As inflation creeps up (0.2% per week currently) the government is looking for ways to contain the increase. There is already plenty of anecdotal evidence that state agencies have increase the number of, e.g. anti-monopoly reviews. The risk is that prices will be forced lower in food producers, food retailers, pharmaceutical companies, fuel retailers, etc as part of the state’s efforts to restrain price growth ahead of, and into, election year. That raises the risk of profit contraction.

Rosneft, Gazprom & China; as the week starts, President Medvedev is in China with a large entourage of Russian businesses (see Thursday’s note “President Medvedev and Rosneft go to China”). Several new agreements and understandings have already been announced but nothing exception or, nothing unexpected. The gas talks are still on the table and Gazprom is saying a deal is likely in 2011. At the same time, Rosneft is trying to ensure it remains the energy partner with China. Rosneft is also pushing for a major entry into the gas sector. The 2+2 analysis suggests that Rosneft is angling for the China gas contract, possibly with BP as its strategic partner in Kovykta, but so far the situation remains as opaque as ever. The only thing less inscrutable than trying to analyse political-business relations in either China or Russia is to try and unravel political-business relations involving both.


Surgutneftegaz & MOL; The Hungarian government last week confirmed that it is in talks with the Russian government about the sale of Surgutneftegaz’s over 20% equity stake in MOL. The official clearly stated that the Hungarians are not talking to Surgutneftegaz management as there was no point. That deal looks likely in the coming weeks and it will add to Surgut’s cash pile. So, what does it do with it? Increased dividend is the least likely option. It may do nothing of course or, it may buy an equity stake in Rosneft – a long standing rumour that, whether with substance of not, is due another outing and will have an impact on both shares. Positive for Rosneft, less so for Surgutneftegaz shares.

LUKoil & Conoco stake; The deal whereby LUKoil, and a group of un-named investors, acquired an additional stake from Conoco, adds some comfort in that it almost resolves the issue. But, traders that have been buying in the hope that the whole block might have been sold to a new strategic partner have been disappointed. There is still an overhang of over 6% of LUKoil equity and the 5% block acquired this weekend will also be sold in the future. A very neutral result for now but provides no reason to buy.

Uralkali, Silvinit and Potash; It is reported on Bloomberg that China’s Sinochem Group may p the bid for Potash Corp. BHP has already tabled a bid of $40 bln. A higher offer from Sinochem would boost sentiment, and valuations, for other major producers. Of course neither Uralkali nor Silvinit should have a bid premium. But the UN conference about food production last week made it very clear that farming will have to become much more efficient and that means more soil enrichment. Very positive long term outlook for potash demand.


Trading last week: Russia

Moscow’s bourses closed higher on Friday as the US market reacted positively to the latest economic reports. It was a quiet week for the domestic markets, both in terms of volatility and trade volume, as most of the 2nd Qtr earnings reports from the biggest companies have now been published. The RTS gained 1.7% for the week, a move that was in line with the EM Index. MICEX was a little shy of that with a gain of 1.3%. The better ruble-dollar rate helped the former. Year to date, the RTS is up 3.0% while MICEX is up 4.8%. In London, the IOB Index of GDRs rose 1.5%.

The best performing sector was the Gold stocks. Highland rose by over 11% and Severstal, also up over 11% last week, gained because of its announcement that it intends floating off its gold assets. Polymetal, one of the best performing stocks this year (+72%) also rose with the gain in precious metals. It closed 7.5% better. Polyus Gold continues to be excluded from the rally in the theme as investors avoid the stock until there is a resolution in Kazakhstan. LUKoil rose 6.4% on the back of speculation about the fate of the remaining Conoco shares. The option to acquire the block expired this weekend.

Chris Weafer is the Chief Strategist of UralSib Group