WASHINGTON, April 2 (UPI) -- When something seems too good to be true, it probably is. Following that maxim over the last 15 months, my firm twice advised clients to take profits in Russian equities, and thus missed about a quarter of what proved to be a 100 percent runup in the Moscow Times Index.
What happened? Well, on the bright side, when the goblet is one-fourth empty, it's three-quarters full. But we didn't get to enjoy the full banquet because we were squinting at our bowl of ministrone, rubbing the silverware, and double-checking the waiter's fingernails. We kept looking for a fly in the soup -- and when we couldn't see one, figured it must be hiding in there somewhere.
In recent months, as "bottom line" regulars know, we've been enthusiastically in, and Russian stock prices, through the landslide re-election of Vladimir Putin, have rewarded investors with yet another impressive surge of more than 30 percent in dollar terms since December 1.
That surge in the markets, and a general encomia from financial reporters and investment banking houses, has us thinking again. When J.P. Morgan, Merrill Lynch, Moody's, and Prudential all agree, there must be a bug in the mix somewhere.
Here, then, at least for consideration, are several arguments to take profits (again) in Russia and be on the sidelines for a time.
1. Putin's ambiguous mandate
The former KGB spy chief is no less opaque than many Russian leaders past, and probably more so. His massive re-election margin, and his party's victory in parliament, are now over, putting the best phase of a re-election bull market -- which tends to pause after the election -- are behind him.
Ahead, for Russia, is the problem that he won so easily that he never engaged -- there was not a single presidential debate, for example. His intentions for a second term are vague and unclear. As investment is about the future, these are troubling trends.
The problem is, Putin's intentions are not vague. He promised continued tax reform in his second term and has outlined a solid program for it, centered on keeping the top income tax at a relatively low 35 percent combined effective rate -- 13 percent "paid by individuals" and about 25 percent "paid by corporations," which, as anyone who has ever met "FICA" knows, winds up coming out of Boris's paycheck one way or the other.
Putin won't touch the 13 percent rate, which is rivalled only by Hong Kong in the developed world. His reform, though, aims to bring down the massive 25 percent Social Security rate by 3-4 percentage points next year. Some of the "lost revenue" -- under the first Putin cuts, revenues actually surged -- will be paid for by economic growth. The rest will be recaptured by bumping up Russia's tax on exported oil. This latter is an intelligent move on its own terms, designed to make the country less dependent on its oil economy -- diversifying its national output.
Likewise, Putin has put forward a plan for phasing in a convertible ruble beginning this summer. This move will not only help the economy directly, but will have positive political feedbacks -- removing one more barrier to Russia's entry into the World Trade Organization.
2. Putin's slow start
In recent months, Putin fired much of his cabinet and eliminated a number of departments, and he's reducing the central staffs of what's left by 20 percent. These moves initially took investors and voters aback, and created a sense of confusion -- or a fear of a reversal of course in his second term.
The opposite has been the case. The new cabinet is more focused on economic growth than ever, and being leaner, it is proving more vigorous. Here are just some of the initiatives Putin has launched, not in his first 100 days since re-election, but in the first two weeks:
-- more tax cuts and a new convertible ruble, mentioned above.
-- spending restraint. Russia's rate of domestic spending growth is less than half that of the U.S. over the last three years, despite the upward spike in revenues. Defense spending is flat -- and note, Russia has its own domestic terror threat to deal with. The cuts in central government agencies and staff are aimed, as much as anything else, at setting a tone and an example for the rest of the central government, not to mention Russia's flabby regional governments.
-- intellectual property reform. Chief Trade Inspector Nadezhda Nadina recognizes that for Russia to be a true center of technological research and innovation, foreign companies and countries must trust it not to pirate the fruits of their IP investments. A good first step: Putin's team is pushing Russian pharmaceutical companies to adopt the Good Manufacturer Practice international standards by early 2005.
-- renewed WTO push. Putin recently upbraided several of his ministers for failing to bring Russian accounting standards, IP protection, monetary policy, financial transparency, and tariff practices into line with WTO requirements. When several ministers proposed a 2-3 year timetable for the effort, Putin reportedly scolded, "Russia needs to join the world economy now, not in 2007." An organization that includes Haiti, Egypt, Zimbabwe, China, Cuba, and "the Democratic Republic of Congo," a source at the U.S. Trade Representative's office notes, may be able to add a seat for Russia.
-- privatization and stock-market upgrades. Despite comparable growth rates, Russia has lagged China, India, and a number of other countries in international IPO and corporate bond offerings, state-enterprize selloffs, and making its stock market accessible to foreign investors. No more. The recent announcement that J.P. Morgan will offer a Russian stock index and corporate bond fund is only the first of many. The administration plans 13,000 privatiation offerings in its second term.
3. Putin's hubris
Putin's success might go to his head, producing a Russian Caesar. Given his massive majority in the duma, and tight hold on much of the country's press, as The Economist noted recently in an intelligent review, Mr. Putin is now in the unhealthy position of having few or no effective checks and balances on or in his government.
This is a more serious concern -- and here there are some early warning flags. The rapid duma passage of a bill limiting public assembly was one. The continued crackdown on critical journalists, and unnecessary fawning of the state and pro-Putin media -- which together dominate the Russian press -- is another. Still another is the government's use of anti-corruption efforts, which are legitimate in themselves, in a very focused way -- i.e., to jail prominent opponents.
Each of these developments, however, comes with mitigating circumstances. The bill limiting free-assembly focuses mainly on state buildings and foreign embassies. Putin has his own war on terror to fight. The strange need to dominate the news media is more troubling, but in the age of the internet, and a truly global press, Russians still have access to critical information. Anti-corruption efforts have had a biased application, but then again, Al Capone was an enemy of Herbert Hoover. If some of your opponents are crooks, should they get off scot free?
These trends should not be dismissed. A free press and democratic institutions are a vital part of economic liberalism -- as American's learned during the corporate scandals in recent years. But Russia shows no signs of annointing Putin as a tsar; he's just a powerful elected official -- Russia's FDR.
Boris Fedorov, chairman of the Russian Economic Society and a voice of social and political moderation, put the fears of a Putin authoritarianism in perspective in a recent article for the International Herald-Tribune. "Actually, Russia is not doing too badly," he wrote. While not dismissing the concerns of civil libertarians in the West, he makes the case that Putin's sometimes "selective" crackdown on corruption has hardly become a Stalinesque purge. Indeed, he concludes: "Even more state intervention can be acceptable if it is limited to punishing guilty oligarchs and introducing more law and order."
4. Putin's war on poverty: JFK or LBJ?
Another area for concern is Putin's recent rhetoric about a war on poverty. Wars on poverty are good if they are fought with growth and prosperity, as with the Clinton-Gingrich welfare reform of the 1990s. They're less helpful, as the U.S. learned in the 1960s, if they lead to vast new transfer payment programs -- and thus, disincentives to work, higher unemployment, and more poverty.
Putin, though, seems to have a John F. Kennedy "rising tide" model in mind more than a Lyndon Johnson spending binge. In fact, his only major move on entitlement programs (cc: George Bush, Jacques Chirac) has been to suggest the utility of raising the retirement age and keeping more of Russia's talented 55-65 year old men and women in the work force.
Putin's thinking on reducing Russia's estimated 20 percent poverty level became clear at a recent cabinet meeting when one of his ministers asked him what programs he had in mind. "Economic growth, first of all," Putin said. Economics Minister German Gref did a quick calculation that at 5 percent economic growth levels, Russia's economy should grow by 70 percent over the next decade, bringing poverty rates down better than a point a year.
"Well then, 5 percent growth is not good enough," Putin replied. "We need to shoot for 7 percent. We must set more ambitious goals; then we will be certain to achieve more modest ones." Putin's goal is to double Russian output by 2014.
Everywhere you look, there are still more good reasons to pull out of Russia. The problem is, when you look closely, none of the reasons is true.
5. Russia's oil economy
The price of oil, for example, is critical to Russia's economy. Last year, Russian output surged by 8 percent, and the budget moved into a 1 percent surplus. But about 75 percent of the gain in revenues, and more than half the GDP gains, were due to high-flying world energy prices. "Russia," as a colleague puts it, "is an oil stock."
Oil prices, though, show little sign of dropping below $35 a barrel any time soon. One of EMG's premature Russian sell signals took place last spring, when we figured the war in Iraq, stabilization in Venezuela, slow European growth, and other factors would bring a sag in world oil prices.
It's worth noting that the Russian budget for 2004-2005 conservatively assumes an oil price of $26-$27 a barrel. If instead, a level of $30 to $45 is what occurs, Russia's economy will boom even without the Putin initiatives.
FINALLY, THERE's the very surge in stock prices noted above. Market momentum, as investors re-learned in recent years, is only good as long as it's up -- or you're short. The Moscow Times index, which the foresighted bought in the low 700s in 1999, shows no signs of slowing as it nears 9000, and appears set to break 10,000 by the summer. The strong ruble -- ! -- is at a three-year high. Phrases like "speculative bubble" and "50 percent retracement" come to mind.
With emerging markets and true growth stocks, however, runs of 10 and even 20 years are not unusual. Take a look at a chart of Microsoft in the 1980s and 1990s, or the Japanese stock market from the Kennedy through the Reagan Administrations. Price-earnings ratios on most Russian companies are still below 10-1 -- hardly suggesting there's need for a correction in value terms, even considering the vagaries of emerging markets.
(Caveat: Russian earnings reports leave something to be desired. Then again, so do earnings statements from Turkey, Indonesia, and Mexico. And Chinese financial reporting might be the Enron of 2004-2005, as we will report in the coming weeks.)
The bottom line: lert investors will want to eye Putin closely for any signs of aggressive de-glasnosting, which would not just "not be nice," but would hurt confidence and Russia's financial markets. The oil price is always worth watching too -- or hedging.
This being said, we've tried to be unenthusiastic about Russia a third time. It's just hard to find a real fly in there. We're still in.
Gregory Fossedal manages international investements for Emerging Markets Group in Washington, DC. His clients may (and usually do) hold long and short positions in many of the investment securities and opportunities mentioned in his reports. "The bottom line" is compiled from sources we believe to be reliable, but no representation is made that they are necessarily accurate or complete. Investors should perform their own due diligence and consult their own investment professional before buying or selling any securities. Mr. Fossedal's opinions are entirely his own, and are not necessarily those of UPI or EMG.
