OREANDA-NEWS. September 30, 2011. Despite current instability on financial markets, Russia remains in good economic shape. Unfortunately, however, investors do not view the country as a safe haven, and continue to lump it together with other EMs. This was confirmed in the August sell-off following the US downgrade; expectations of a global economic downturn strengthened such that tremendous pressure was exerted on risky asset prices. In this report we assess the possible implications of short-term internal and external influences on the Russian bond market and suggest investment strategies to address potential market developments.

Some Factors are Positive

Economic slowdown not a great risk. Despite negative expectations and downgrades, 2011 economic data show that Russia’s economy remains robust. Our view is that it is too early to expect a rough landing.

Inflation risk is lowering. Given the Central Bank of Russia’s (CBR) prudent policy, a decline in food price growth and capital outflows, alongside expectations of an economic slowdown we do not expect any harsh tightening of key rates in 4Q11.

Though there are Serious Risks:

Structural problems in the developed world: European debt crisis and US economic slowdown in the US. While these problems originate in developed countries, in times of financial turmoil investors withdraw from emerging markets, including Russia

Threat to rouble liquidity. While we anticipate that liquidity conditions will ease at the end of the year with the seasonal increase in budget expenditures, we believe most of 4Q11 is likely to be difficult. Liquidity will be constrained for three main reasons: the federal budget’s positive balance (more taxes paid), changes on the forex market forcing the CBR to buy roubles, and capital outflows via corporations and (particularly foreign-owned) banks.

Increased peril to stock market from an oil-price decline. The Russian Ministry of Finance (MinFin) used USD 93/bbl as the break-even point for what it views as a reasonable budget deficit (3% of GDP). As the oil price drops, investors’ perception of Russia’s risk increases. We have therefore tried to quantify this risk perception in order to forecast possible capital outflows. Our calculations show that an oil price drop by even 10% from the current level (USD 113/bbl to USD 102/bbl) changes investors’ Russian risk perception by USD 4.6bn. This may lead to an equivalent capital outflow. Thus we consider an oil price of USD 102/bbl a serious trigger for negative market dynamics.

Recommended Positioning

Given negative market trends combined with heightened risk, we would stay away from bonds with long maturities, and where possible convert shorter duration positions into cash. If the latter option is unavailable, stick only with good, proven credit quality with short duration and sufficient liquidity. Sector-wise, we favour utilities, solid banks and sub-federal debt. For investors with larger portfolios for whom the above strategies are inapplicable, we suggest shortening portfolio duration by selling longer bonds and buying shorter issues with comparable credit quality. In this case, the yield loss should not be that substantial while risk would be decreased. It is also possible to form a shorter portfolio with comparable credit quality but with a wider spread to benchmark.