But a spectacular market recovery last year and promising signs for its economy suggest that Russia should not be frozen out just yet.

DOWN, BUT NOT OUT

The financial crisis hit Russia particularly hard. The Russian economy’s reliance on the export of energy and other commodities means it rode the wave of rising prices to mid-2008, but spectacularly wiped-out when commodity prices cracked.

In 2008, Russian shares lost 72%1 and at the climax of the crisis in September and October, when stocks around the world were tumbling in the wake of Lehman Brothers’ collapse, circuit breakers on Russian markets put trading to a halt for several days.

What followed in 2009 was a deep recession that wiped 9%2 of the value of Russia’s GDP.

The economy has now stabilised and Russia’s shares are among the best performing in the world since the nadir of the crisis having returned 206%1 from January 2009 to 22 March 2010.

Could Russia silence the bears in 2010?

OVERWHELMING OIL?

There is no escaping Russia’s reliance on energy exports. For all the efforts the government makes to rebalance the economy, an investment in Russia will be dominated by the ebb and flow of oil and gas.

In 2009, Russia became the world’s number one producer of oil and gas. Its giant energy producer, Gazprom, represents more than a quarter of the Russian equity market.

History suggests the tight correlation between oil prices and the Russian market – particularly at times of stress. Although the market turned at the top and bottom before oil, the magnitude and timing of the slide is comparable.

It is therefore safe to assume that a broad investment in the Russian market requires a bullish stance on energy prices and, by implication, world growth.

THE BEAR IS NOT TRAPPED

Goldman Sachs coined the BRIC acronym in arguing that the four countries would dominate the global economy by 2050. This argument remains intact, in spite of Russia’s economic setback in 2008.

By 2050, Goldman Sachs predicts that Russia will become the largest economy in Europe and the fifth-largest in the world, behind its fellow BRICs and the US.

But this prediction is not based on wildly optimistic rates of growth over the next few decades. In fact, the highest annual growth rate used in Goldman’s projections is 4.5%. That is considerably lower than the annual rate of expansion achieved since the financial crisis of 1998. To take its place among the world’s economic elite, Russia does not need to shoot the lights out, just avoid blowing up.

CURRENT MARKET CONDITIONS

That’s all very well, but 2050 is a long time to wait for an investment to come to fruition and Russia is still licking its wounds from a bruising couple of years.

What are the shorter-term prospects for the country?

The Russian authorities are wrestling with a growing dilemma. Oil has risen 80%* in value since December 2008, carrying with it the value of the rouble.

But high interest rates (currently 8.5%*), a hangover from a long-term battle against double-digit inflation, feed a growing rouble carry trade. While a strong currency is good for importers and consumers craving foreign goods, it damages the country’s wish to diversify the economy through strengthening export manufacturing.

IF IT AIN’T GOT THAT BLING

If Russia’s economy is to stand any chance of breaking its reliance on energy exports and enjoying a more robust economic recovery, its consumers need to rediscover their (sometimes extravagant) spending habits. In the decade since the Russian financial crisis, consumer spending had increased steadily especially in luxury goods and an appreciating rouble helped boost consumer’s spending power.

At the peak of the consumer spending boom in 2008, Russia’s taste for luxury mean that Porsche sold more cars in Russia than they did in the US.

But that growth collapsed in 2009 as consumers’ growing confidence was shattered by the crisis and the rouble shed 36%1 against the dollar. Relatively few Russians own shares so, in the general population, changing trends in spending are largely connected to insecurity about jobs and wages rather than the markets.

In a survey, a third of Russians said they planned to trade down in one or more categories of goods though some people suggest certain status-symbol luxury items such as fur coats are immune in a downturn.

RUSSIAN BANKING

• Russia has one of the most profitable and underpenetrated banking sectors in the world – Sberbank is Russia’s largest bank with a 51% market share of deposits3.

• Banks are typically more conservatively run than in other countries.

• Sberbank is well capitalised (at 17.2%) and its high deposit base means a high net interest margin on lending of +7%3.

• Among other things, its strong deposit and loan business are a play on the Russian consumer.

CONCLUSION

Russia might have lost some of its shine in the past two years, but fully justifies its position among the BRICs.

In spite of the damage to the economy suffered last year, it is still on course to become Europe’s largest economy. To be bullish on Russia in the short term requires a bullish view on oil, gas and, by implication, world growth (what emerging market does not?).

The paradox is that Russia’s Achilles heel is also its trump card and, among the BRICs, its vast oil and gas industries have the power to lift the entire economy and carry its consumers and other industrial and service sectors with it.

Russia faces some tough challenges in the short term, but should reward careful, well-prepared investors over the long term.

Even though the Russian market doubled in value last year, Russian equities are still relatively well priced. Goldman Sachs analysis indicates Russian equities, priced on a 12-month forward PE basis, are cheaper than the US, Europe, Japan and all its BRIC counterparts.

This is a guest post from Tom Stevenson, Investment Director at Fidelity International. It is the second in a series of articles in a BRIC by BRIC mini-series, produced exclusively for BrilliantWithMoney and Informed Choice. You can read the first article, about China, here.

Past performance is not a guide to what might happen in the future. Please note the value of investments can go down as well as up so you may get less than you invested. Investments in small and emerging markets can be more volatile than other developed markets and changes in currency exchange rates may affect the value of an investment. The ideas and conclusions in Tom Stevenson’s article are his own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

Sources:
1. Datastream
2. Goldman Sachs
3. Fidelity

Since the introduction of economic reforms more than 30 years ago, China’s importance to the global economy has grown dramatically.

It has experienced rapid growth in GDP but, in per capita terms, remains a poor country. Despite the expectation that it will overtake Japan in 2010 to become the world’s second largest economy, China is yet to experience the rapid acceleration in consumption that has typically been enjoyed by developing nations with similar income per head as China has today.

We should therefore expect domestic consumption to become the primary driver of economic growth, taking over from exports and infrastructure investment.

As this happens, investors should be able to find similar stock-picking opportunities to those in the UK and Europe a generation ago; despite its growing economic influence, China’s stock markets are still relatively immature.

THE MIDDLE KINGDOM ONCE MORE

The recent rapid growth in China’s economy marks a dramatic shift from the relative introspection and international isolation of the past two hundred years. On a longer view, however, it can be seen as a return to the status quo ante.

For hundreds of years prior to the industrial revolution, China was a leading player in the global economy. In recent years, China has decoupled from the developed world, with higher overall growth and a greater resilience to the financial crisis than its counterparts in the West.

China’s GDP has grown by an average of 9.9% over the past two decades. Having contributed 3.7% to the global economy in 2000, China is forecast by the IMF to account for 11.1% of worldwide output in 2014.

Goldman Sachs has forecast that China’s will be the world’s largest economy by 2027 and other estimates see the culmination of this power shift occurring even sooner.

China’s GDP nearly quadrupled between 2000 and 2009, from US$1.2trn to US$4.7trn, while that of the US rose over the same period from US$10.0trn to US$14.3trn. As a consequence, China’s contribution to global growth was 80% of that of the US, despite starting the period with an economy one-eighth the size of America’s.

China overtook Germany to become the world’s largest exporter in 2009, accounting for an estimated 9.9% of global exports in 2009, helped by a currency which China has been accused of keeping artificially low to stimulate overseas sales.

China’s economy has moved significantly up the value chain during the past 30 years. Since 1978, the number of Chinese working in the service sector has grown from around 50 million to 300 million, while the number working on the land has remained broadly unchanged at 300 million.

The increasing sophistication of the Chinese economy is reflected in the growing importance attached to science and technology, where research spending has grown rapidly, and by a rapid increase in the numbers of postgraduate students. China is no longer just the workshop of the world but increasingly a force to be reckoned with in the industries of the future.

CHINA AND THE S-CURVE

Despite the overall size of China’s economy, in per capita terms, the country’s GDP remains well below those of many developed nations such as the UK, Germany, Japan, France and the US.

Comparisons with other developing nations suggest, however, that China’s income per head is at a level where a rapid increase in domestic consumption can be expected. History shows that countries such as Korea, Taiwan and Japan experienced rapid increases in spending on household goods and services as their GDP per capita increased from about US$5,000 to US$10,000.

Low levels of personal indebtedness compared to the developed (and especially the Anglo-Saxon world) and a high household savings rate provide a solid foundation for domestic spending to continue growing at a relatively rapid rate.

The potential for further growth is illustrated clearly by car sales data which shows that, despite recently overtaking the US as the world’s largest market for auto sales, China still has an extremely low passenger car fleet when measured per head of population.

The expectation that domestic consumption can drive economic growth in future years is further underpinned by the relatively low contribution of private consumption to overall economic output. While the US consumer accounts for around 70% of American GDP, private consumption in China is less than half of total output.

CONCLUSION: THE STOCK-PICKING OPPORTUNITY IN CHINA

The Chinese stock market is relatively immature when measured against China’s economic influence and the markets of developed countries.

Despite its high ranking in global GDP terms, China’s stock market is smaller in market capitalisation terms than those of Germany, Switzerland and even Australia.

The relative insignificance of China in stock market terms has contributed to its quoted companies being less intensively researched than those in more developed markets. This lack of research is reminiscent of the markets in the UK and Europe 20 or 30 years ago and is likely to make the Chinese stock market a more fruitful hunting ground for fundamentally-driven stock-pickers.

Research has shown, moreover, that valuation differentials have a greater influence on stock market performance in emerging markets such as China than in more intensively-researched markets such as the US. The benefit of investing in the most attractively-valued stocks and avoiding the least attractive is far greater in emerging markets where the “information advantage” is most pronounced.

This is a guest post from Tom Stevenson, Investment Director at Fidelity International. It is the first in a series of articles in a BRIC by BRIC mini-series, produced exclusively for BrilliantWithMoney and Informed Choice.

Past performance is not a guide to what might happen in the future. Please note the value of investments can go down as well as up so you may get less than you invested. Investments in small and emerging markets can be more volatile than other developed markets and changes in currency exchange rates may affect the value of an investment. The ideas and conclusions in Tom Stevenson’s article are his own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

What should investors make of Japan?

Its stock market has promised much but delivered little in recent years. However, there are a number of reasons why it might be wrong for investors to simply write off Japan.

When global economies recover, Japan tends to benefit from the pick-up in international trade, while a new, domestically-focused government offers the potential for much-needed reforms.

Japanese companies are used to dealing with the unusual challenges now facing western economies in the shape of a broken financial sector, high debt levels and near zero interest rates. In short, they have been through these problems before. Indeed, Japan seems to offer greater potential for positive surprises at a time when emerging markets look like a relatively expensive place to invest.

A divided economy

Japan officially emerged from a deep recession in the second quarter of 2009. The country was one of the biggest losers of the credit crunch when consumer demand contracted sharply around the world after the collapse of Lehman Brothers. Japan’s strength in exports proved to be its undoing as the global economies all turned down together.

The impact of the credit crunch on Japan underlined the lack of balance in the economy. Over the 2000-2007 period, virtually all of the growth in the economy was driven by exports1. This reliance on overseas markets exposed Japan fully to the savage reduction in global demand. The fact that the weak domestic sector offered such little protection has become a prime concern.

Exploding the myths of Japan’s bubble

Some investors will remember Japan’s ‘lost decade’ of stock market underperformance that followed Japan’s 1980s asset bubble (a period when equity and real estate prices surged to unjustifiably high peaks before crashing back to earth).

This was followed by another largely forgettable decade and the Nikkei currently sits around 10,300 having peaked just below 39,000 at the height of the bubble at the end of 19892.

Many experts use Japan’s damaging asset bubble experience to explain the lacklustre performance of its stock market. Popular opinion holds that the west has acted more swiftly and with greater conviction than Japan did. While this argument holds water, it is overly simplistic.

In truth, the Japanese authorities made use of fiscal programmes as well as introducing highly experimental monetary policy. In 1999, Japan became the first major economy to move interest rates to zero.

New Government offers promise on needed reforms

The landslide election victory of the Democratic Party of Japan (DPJ) at the end of August ended more than fifty years of almost unbroken rule by the Liberal Democratic Party (LDP). This was essentially a vote against the status quo, reflecting the people’s desire for change and more effective government.

We should not expect revolutionary change, as that is not the way Japan works. But, we can expect the DPJ to be more focused on the domestic economy and there are already plans to encourage consumer spending.

The lacklustre domestic economy is at least partly due to Japan’s unfavourable demographics where a small labour force supports an ageing population. The DPJ’s proposal to introduce generous child benefits is the first attempt we have seen in Japan to make a significant change to consumer incentives that could have a lasting, positive effect on the domestic economy.

The immediate reaction of the stock market to the new government has been muted. This is no bad thing.

When the popular Junichiro Koizumi was elected, the stock market rose sharply for six months in anticipation of reforms. However, it then underperformed for several years, as investors realised that his policies failed to address Japan’s underlying problem of low domestic consumption.

This time round, the market is more cautious, but that leaves room for growth if the new, domestically-focused policies can have an impact.

Look for domestic recovery in the small cap sector

The major Japanese stock market indices, like the Nikkei 225, do not really represent the domestic economy, since they are dominated by large, global exporters like Sony and Honda. Small companies are much more dependent on the Japanese consumer. Despite flat domestic consumption, smaller company brands, such as Uniqlo and Muji, have built up healthy market share.

Fortunately, the DPJ seems to understand that Japan can no longer sustain a large imbalance between its domestic and external sectors. Shrewd investors should look for signs of policy success in this area, not in the Nikkei 225 Index, but in the small company JASDAQ index.

An improved outlook for company profits

We are moving into a phase of recovering global growth; this is historically the time when Japanese stocks benefit from a pick-up in global trade. At the company level, the interesting aspect of the recent recession is that Japanese companies cut their fixed costs earlier, which may mean there could be positive surprises on earnings growth.

In fact, a range of companies, spanning the metals, auto and foods sectors among others, have shown a sharp recovery due to the success of their aggressive cost-cutting measures and a tentative pick-up in demand. This suggests that corporate Japan is on the road to recovery.

Conclusion

The outlook for Japan is interesting. Reinvigorating the domestic economy will not be easy. There is also the scope for political disappointment if the new government does not deliver. However, Japanese policy-makers and companies are experienced in dealing with many of the tough issues that their western counterparts now face.
On balance, there are reasons to be optimistic:

-Japan should benefit from the recovery in the global economy

-Japanese companies have the potential to deliver healthy profits

-The increased domestic focus from the government is encouraging – the policy on child benefit raises the prospect of real progress on the domestic economy

-Japanese shares look cheap when compared to certain emerging markets, which are beginning to look expensive on some measures.

Throw in the fact that most investors appear to have given up on the Japanese stock market after a series of disappointments, and this makes Japan a very interesting contrarian trade. Sometimes, the forgotten areas can be a profitable place to invest, before the crowd gets involved. Certainly, Japan is a market which investors should think twice about leaving out of their portfolios.

Tom Stevenson joined Fidelity in 2008 as Head of Corporate and Investment Communications. Tom has been a financial journalist for nearly 20 years, writing for the Investors Chronicle, The Independent and more recently the Daily Telegraph.

1. Source: Societe Generale Global Strategy, 15.09.09
2. Source: Thomson DataStream

Reference to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The ideas and conclusions expressed in this article are the author’s own and do not necessarily reflect the views of Fidelity.