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Russia 2H10Half-Time Report

Expect More Action In The Second Half

July 2010

James Beadle

Investment Summary

Russia's economic situation has improved steadily in 2H10, while it's equity market

has held its ground, and debt has performed well given the increase in sovereignworries globally. Yet, growth and financial market performance have fallen short ofexpectations, despite sharp disinflation. Looking forward, weaker than expectedgrowth may be exposed to the risk of a global economic or financial shock. Investorspreparing for a sharp double dip, continued deflationary pressure or an uncontrolledsovereign default will want to avoid Russia as they avoid other risk assets. But for thoseexpecting a less catastrophic second half, Russia looks increasingly attractive.Accelerating growth and reform momentum are likely to bring strong, if volatilereturns over the remainder of the year.

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Russia 2H10 Half Time Report

About the Author

James Beadle is an investment professional with more than

eight years of experience working in and around the formerSoviet Union.

A British national, he holds and MBA from Barcelonas EADA,and an MSc in Financial Engineering from the InternationalUniversity of Monaco.

Since first visiting Russia in 1999 he has worked in sell-sideequity research, as a consultant for the OECD, as a journalistand as a hedge fund manager.

From 2006-09 he served as chief investment strategist for Pilgrim AssetManagement, where he co-managed $250 mln in funds and individual accounts.

As the manager of the Pilgrim Russia Investment Fund and the Pilgrim Pacific Fundhe successfully outperformed equity benchmarks and most of his peer group. Hestepped down from direct fund control in July 2008 (before the market collapsedduring the war with Georgia) when fund principals rejected his call to liquidate marketpositions. The Russian market went on to fallanother 75%, bottoming in March 2009.

James is currently based in Vilnius, Lithuania,from where he serves Russian and internationalclients with emerging and global marketstrategy.

- [email protected]

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Russia Focussed Track-RecordPRIF* Vs RTS Index

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* PRIF continued to trade after July 2008, when James stepped-downas manager after making a market-wide sell recommendation.

Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy securities. Prospective investorsshould review the appropriate offering memorandum and subscription documents, and consult with their own counsel andadvisors as to all matters concerning investment in Russia.

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Contents

Introduction...............................................................................................4

Economic Situation...................................................................................5

To The Present......................................................................................6

Economic Policy........................................................................................6

2010-2011 Policy & Planning.................................................................7

Market Performance..................................................................................8

Global Play.............................................................................................9

Domestic Opportunities........................................................................11

Political Progress....................................................................................11

Khodorkovsky & Reform.......................................................................12

Old Guard Challenge...........................................................................13

International Relations, The WTO........................................................13

Conclusion..............................................................................................14

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Introduction

Year-to-date, Russia's economic growth and financial market performances havebeen rather lacklustre. My strategic call for the year that Russia is a tactical buy for

2010 is on track, but moving slower than some might have hoped.

Ideally, this stacks impressive gains for the second half of the year, and indeed, onmost fronts Russia looks more exciting for the next six months than it has provenyear-to-date.

Chart 1: RTS Index & RTS Sector Index Performance (%, YTD*)

* As of 22 June 2010. Bloomberg data

The caveat will be global risk, which has arguably been the key burden on equityperformance in 1H10. As long as developed economies are tottering on the abyss,torn between fiscal strains and fears about withdrawing government support, we aredestined to live in a binary world of extreme risk concerns.

A discussion of the global outlook is beyond the scope of this report (but can befound in my weekly Outlook & Review), so suffice it to say that investing in anyhealthy growing market these days requires several assumptions:

That global deflation and depression are averted;

That no major sovereign default in an uncontrolled fashion; and/or

That healthy well-positioned emerging markets will avoid contagion.

The probability of these outcomes (particularly the latter) is, to the mind of thisinvestor, far from certain. But, assuming that the global macro environment doesn'tcollapse (it is certain to prove shaky, but Russia investors are used to volatility) thenthe case for going into, or staying in, Russia remains strong.

In fact, as this report will highlight, Russia's disappointing performance in 1H10makes it a more attractive play for 2H10 provided that global risk sentiment holdssteady. Russia's 2010 full-year growth outlook remains positive, and most of thegrowth is yet to come.

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Economic Situation

The key story for 1H10 has been disappointing GDP in Russia. After a horrendous2009 (-7.9% GDP YoY), Russia came into 1H10 with a very attractive base effect,

national and international momentum and stronger than expected oil prices. Withsuch a positive backdrop, many expected Russia to experience a healthy bounce.Not so, as the chart below shows, GDP has struggled to maintain positivemomentum, despite sharply declining inflation.

Chart 2: Russian GDP* Vs CPI, Percent Change, YoY

As Measured by the VTB/Markit GDP Indicator

CPI Bloomberg data

So, what has caused the economic disappointment? As the following charts show,many key variables including industrial production, wages, spending (andemployment) were indeed healthy throughout the period.

Chart 3 & 4: Wages Vs Retail Sales, Industrial Production, Percent Change YoY

Additionally, the government has been pursuing expansive policies. Falling inflationand sustained oil prices have allowed the central bank to lower interest rates, while

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the cabinet has pursued loose fiscal policies, not least of which was a 45% hike inpensions.

Although conclusive quantification is still difficult, we can point to a number of factorsthat have contributed to disappointing economic performance:

GDP Time-Lags. Many of the positive parameters observed such as industrial

production, do not automatically lead to real-time GDP growth;

Investor & Consumer Confidence. The severity of the economic crisis hit theRussian population very hard, not least since it was blind-sided by the government,which invested so much energy communicating that Russia was not exposed to theglobal recession and would not suffer.

As a result, and perhaps in line with global stresses, both businesses and individualshave been reluctant to resume their pre-crisis levels of activity.

Loan Growth. Perhaps most important, the government's efforts to force lendingthrough state-owned banks has struggled. The drivers of poor loan growth are ofcourse very controversial and go to the heart of any recession are banks beingover-cautious or is there are dearth of good lending opportunities?

In the case of Russia, it is most certainly blend of both, but the lending outlook is farbrighter than recent history. Not only has Russia averted the much-feared secondwave of bankruptcies that so many expected, but interest rates are now getting lowenough to attract a broad range of borrowers.

For many years, Russia has struggled with high costs of capital: growth was break-neck, but with such high inflation it had to be. Admittedly, inflation and interest ratesare unlikely to fall far from here, and the economy remains very inefficient, but thecurrent interest rate dynamic should bring a new generation of borrowers to themarket large corporate (invariably natural resource-based) crowding of the creditmarket is easing.

To The PresentMacro performance may have disappointed in 1H10, but the period ends with asunny outlook. Finally, as the spring has turned to summer, and the macro dynamichas picked up. Not before time. In fact, very few economists have revised down their2010 outlooks, and while the annualised growth estimate for GDP was only 2% forMay, the outlook for the full year remains considerably better in the 4-5% band.

Throughout 2H10, Russia should experience rapid economic acceleration, as therecovery kicks into gear, spurred by lending growth, seasonally lower inflation andresurgent confidence. This Fall, unlike in 2009, Russia's economy is unlikely to besignificantly affected by economic weakness in the developed world (catastrophicevents notwithstanding).

In short, current dynamics are the best of the year, and the outlook is for continued

improvement.

Economic Policy

Russia's disappointing economic growth in 1H10 has not come through lack ofgovernment effort. Ever the 'democratic' populists, the incumbent administration hasthrown the kitchen sink at turning around its economy. Efforts have proceeded on twofronts, with separate battles waging on short-term and long-term issues.

The prime minister, in his executive capacity, has been more closely involved with

tackling short-term questions. Be it hiking pensions or checking retail store prices inspontaneous visits, the ever-active prime minister has sought to portray himself asbeing out on the street, sharing the crisis with Joe Public and fighting on his behalf.

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In many nations, and with many leaders, the disappointing results might have led todeclining popularity, but there is little sign that Putin's support has weakened. Thereare good reasons for this:

Foremost, the majority of Russians know which politician they are supposed to

favour, and when asked they invariably remember who to name. Putin's popularityhas always been part-myth;

Russians also have an impressive living memory of crises, and they certainlyrecognise that the current down-turn is going better than many before it. With goodreason they credit this to the incumbents. We may contest the suitability of manypolicies, but the fiscal prudence of the last ten years has paid off amiably. Bluntly put,Russians are (still) used to far worse.

President Medvedev is driving the long-term growth perspective, with a focus onRussia's imbalanced economy, and the need to diversify away from naturalresources. His efforts are best exemplified by his recent visit to Silicon Valley to drum

up interest in Russia's technology park projects.Many argue that the state cannot force innovation and creativity. True, but if theproject were pursued professionally enough, it would grant sufficient freedom.

Unfortunately, freedom is unlikely to become a common-place word in Russia in thenear-term, particularly while Vladimir Putin holds active office. The dual leadershipstrategy neatly ignores the incongruity between the two men's policies. And thisstrategist, at least, believes that Russia is unlikely to lure the level of investment orinternational support it deserves as long as Putin and his ensemble remain publiclyengaged.

But the president's efforts look increasingly sincere, and determined. Russia reform isgaining subtle momentum, and will not be easily derailed. Ironically, Putin's presenceis a pre-requisite to protecting Medvedev and his goals. But, in stark contrast to 2008

sentiment, if Putin were to return as president under the current dynamic, the marketwould probably react negatively.

2010-11 Policy & Planning

Best efforts aside, Russia is presently pursuing policies that are as aggressivelyoptimistic as ever. Perhaps because policy makers are ill-equipped to cope with thesharp binary risk environment that we find ourselves in. As a result, after years ofconservative oil price expectations, budget forecasts of oil prices now price-in healthyglobal growth for the foreseeable future. For the first time in many years, budget oilprice expectations exceed the futures curve.

The concern is that Russia growth can no longer rely on a rising tide. While the

president's long-term diversification goals capture this essence, the government'sbudget planning does not.

A recent review by the IMF identified several concerning dynamics in Russia's post-crisis policies. The non-oil deficit is still on an upward trajectory, and much of theincrease is of a permanent nature.

The flip-side of this is that it adds emphasis to the need for structural (bureaucratic,pension age, taxation) fiscal reform. Unfortunately, there has been little effort on thisfront to date, nor is there likely to be until the administration feels that it has reallysowed the seeds for economic diversification a multi-year project at best.

It would be unfair to paint a bleak picture though. While Russia's government shouldpay closer attention to it's non-oil deficit, the reality is that it continues to draw in

massive revenues from natural resources.I would be among the first to suggest that populist policies to democraticallyunderwrite autocratic control are rapidly squandering Russia's great natural wealth.

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That said, it is hard to argue that Russia has not managed its cash-flows astutely (ifnot economically optimally).

It is true that this has largely been through luck populist measures were oftenintroduced well ahead of commodity price improvements. But the reality is plain Russia faces nothing like the kind of fiscal or debt strains that are pressuringindustrialised nations, and fiscal management could have been far worse. This is wellreflected in its bond price dynamics, which have impressively avoided contagion andpanic thus far in 2010.

Market Performance

The two charts below demonstrate the conundrum that is Russia investing. Chart 5,showing weekly returns, demonstrates that the broader Russian equity marketremains tightly correlated to oil prices. Yet, Chart 6 demonstrates that performanceshave become more divergent between sectors.

In theory this is very good news, as it demonstrates that there are increasingly strongopportunities for performance in Russia that are not directly oil correlated. While thisis welcome news, several caveats should be appreciated:

The non-commodity market is relatively small, both in terms of total marketcapitalisation and free-floating capitalisation, many stocks are illiquid;

In part due to their scarcity, such companies also tend to be more richly priced;

Also due to their relative supply/demand characteristics, non-commoditycompanies are often exposed to greater corporate governance and transparencyrisks.

Chart 5: Front Month Oil Vs RTS, Weekly Chart

Bloomberg data

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Chart 6: (As Chart 1) Sector Index Performance

As of 22 June 2010, Bloomberg data

For several years now, the Russian government has sterilised oil income throughtaxation, theoretically reducing the economy's direct correlation to oil prices. It mightseem odd then that the benchmark equity indexes are so closely correlated to oilprices. There are two reasons for this:

1. The indexes remain dominated by commodities stocks, with oil & gas, andmetals and mining making up nearly 70% of the RTS Index. Despite high taxation,these companies do not suffer when commodity prices (which are all closelycorrelated in the current bipolar risk environment) rise.

2. Taxation diverts revenues, but does not remove them entirely from the system Russia's money supply is closely related to oil prices. Hence, the gains of highcommodity prices continue to feed economic growth.

Of course, we could add the third reason, that financial assets now fall sharply intotwo groups risky and riskless. By such an analysis, commodities are nowpositively correlated with equities on a global basis.

Global Play

Revisiting Russia's valuation vis-a-vis its BRIC peers (Chart 7 below) it quickly

becomes clear that Russia continues to lag. In part, this represents the market'sdisappointment with 1H10 economic performance and in part it represents theglobal risk-off trade that has been under-way for most of the second quarter.

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Chart 7: BRIC Forward P/E Estimates

Bloomberg data

By contrast (moderate 2Q dynamics notwithstanding) Russian debt pricing has mademore progress in large part due to the April debt issuance. Not only were the 5sand 10s tightly priced (representing lower political and inflation risks), but theirissuance served to support liquidity and renew interest among internationalinstitutions (equally, increased institutional interest helps to reduce political risk asRussia won't want its bonds to be dumped in response to unwelcome geopoliticalissues).

Chart 8: CDS Spread Comparison Closing the Gap

Bloomberg data

At the macro level, then, Russia's bonds are leading its equities in closing the gap toBRIC peers. Assuming a stable global environment, Russia ought to see its equitymarket outperform over 2H10.

The key risk to such an outlook is that it has for most of the current year been atop pick GEM for many international investors, increasing the risk of a capital moving

out rather than into the market. Yet the sense remains clear, investors are longRussia with good reason. Provided the environment holds together, few markets lookso well geared for economic and financial market improvement.

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Domestic Opportunities

Given the divergence in sector performance already observed in 2010, it is alsoworth taking a moment to look at opportunities from a domestic perspective.

Commodity Companies. Russia's commodities companies continue to enjoybuoyant pricing and recovering exports, as well as increasing domestic demand. Oil& Gas companies again face rising taxation as the government has confirmed plansto remove tax breaks introduced to stimulate activity in the face of the global financialcrisis.

Although we may be at something of a cyclical peak in metals companies, minersand fertilizers continue to look attractive. Long-term, thanks to ambitious domesticdevelopment plans, the whole commodities complex should prove resilient andstructurally attractive, conditional on the global economy not collapsing.

Consumer Story. The real interest in Russia remains access to the consumer, whois such a major beneficiary of wealth distribution from oil taxation. There are severalways to play this theme directly through retail companies, which are highly valuedand highly volatile, through telecommunications companies, or through banks.

While highly valued, selective consumer companies continue to provide opportunityfor those bold enough to play them. Telecoms (especially the now integratedmobiles) and banks offer less volatile potential for gains, as both sectors continue torepair themselves post crash.

Utilities. Russia's electricity reform is a tale as long and as complex as its post-communist economic development. With the crucial privatisation phase finally over,focus has been able to move onto economic pricing transition and investment.Russia urgently needs to replace and augment most of its electricity complex, fewareas offer better investment potential.

Industrials. Russia's industrial companies remain very poorly appreciated, in largepart due to their lack of innovation, poor processes and outdated products. As Russia

moves closer to WTO accession, and the president's reform agenda picks upmomentum, it is reasonable to expect improved opportunities in the industrial sector.Of course, they should come with increased transparency and better corporategovernance.

Organic development potential is very limited, but the sector is worth watching forinternational deals, event trades and genuine turnaround stories.

Political Progress

The cornerstone of my 2010 investment analysis was how Russia's political

environment would evolve over the year. Russia entered 2010 with a very weakinternational reputation and, arguably, the largest risk premium among majoremerging markets. President Medvedev had made it his goal to reduce this premiumby reforming the country, tackling corruption and bureaucracy.

Some progress has been made, but unfortunately my prediction that reform would fallshort of the scope needed to put Russia on a healthy and sustainable investmentpath looks accurate.

Dual Leadership Successful Tandem, Shifting Roles

Gossip about rifts between Putin and Medvedev over how to manage nation havesubsided for now, largely as the prime minister has adopted a new pragmatism in his

communications, demonstrating active support for Medvedev's campaign to attractinternational investors and build a friendlier image.

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Putin has remained the hard man of Russia, and is unquestionably still the key policysetter. Yet, it is positive to see that he has clearly adapted to his executive role some asides, such as Ukraine, notwithstanding and has not openly conflicted withMedvedev over the presidential responsibility. Overall, the tandem is working well.

Yet, there also appears to be a gap opening between the two. Dmitry Medvedev fullyowns the campaign to clean up Russia (and its image). Little material progress hasyet been made on attracting investment, but it is clear that the president is beginningto entrench himself. If Putin were to return to the top job in 2012, the market reactionwould likely be negative (in stark contrast to the way it responded to his becomingprime minister).

Investors increasingly see Medvedev as having the progressive vision required tomove Russia forward, while Putin appears to favour maintaining a reputation forbeing the tough guy that got Russia out of a rut. At this early stage, the probability ofPutin returning to the presidency is waning.

Khodorkovsky & Reform

This reputation divergence is perhaps best typified by the ongoing Khodorkovskytrial, which has become a litmus test of reform progress. The second trial of Russia'sformer richest man, on charges of stealing oil, is no less of a legal farce than theoriginal trial of tax evasion. Old Russia hands will remember nostalgically how thejudges repeatedly fell asleep throughout the first trial. The current show, includesevents such as the prosecuting lawyer declaring that it is impossible for theprosecution to lie.

Entertaining as this farce may be, it should be remembered that it comes at cost toRussia's reputation. So long as foreign investors are curious about the fate of theman who stood up to the Kremlin, so the fairness of his trial will be seen as a test ofRussia's political evolution. Here there are some guarded grounds for optimism, thedefendants have been allowed to cross examine a stream of former officials, not onlythose (Mikhail Kasyanov) who have fallen out with the government, but also some(Victor Khristenko) that remain within it.

The outcome? Unsurprisingly, all claimed to be unaware of any theft of oil. (Howcould they not? But such an outcome serves the defendants well.) Several went on tosay that they would have known about such thefts and/or that transfer pricing wasentirely legal and standard business practise.

This amounts to an amazing demonstration of freedom of speech, such as wouldhave been unthinkable under Putin's presidency. It equally demonstrates that publicdifference of opinion is acceptable once more. The greatest change that Medvedev'spresidency has overseen (courtesy of the financial crisis) is a resurgence indiscussion, after a long era of passive acceptance.

And yet, as I noted in Worth a Tactical Look, reform progress is slow and painful, andunlikely to reach the scale necessary to ensure sustainable long-term economicdevelopment. A cynic might argue that Medvedev's liberalism is only permissible as itis backed by Putin's firm hand discussion is one thing, but the executive decisionsare unquestionable.

More pertinently, the Khodorkovsky trial serves to demonstrate the limits ofMedvedev's progress. While we can celebrate free speech, it remains highlyimprobable that Khodorkovsky can expect a fair, independent and honest hearing.Anything is possible, but he is likely to remain in prison for a considerable time.Freedom of speech is one thing, but impartial judiciary is a far bigger challenge.

The Khodorkovsky case marked a shift toward autocracy and nationalism in Russia,it remains a curious measure of where the nation is; as a result, this second trial will

have a direct impact on Russia's risk premium.

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Old Guard Challenge

Closely tied to the Khodorkovsky case, the campaign to reform Russia remainsgravely inhibited by presence within the ruling elite of the same old guard that ruledthe roost during the politically aggressive years of the Putin administration.

It is reassuring, but telling, to note that individuals such as Igor Sechin are moving toimprove their public image. Yet, as the recent departure of Dmitry Rybolovlev fromUralkali shows, elements of kleptocracy and vertical control persist, to the detrimentof a value accretive business environment.

Medvedev is believed to favour his new, more liberal team, and it is widely felt thatthe siloviki are struggling to retain their former influence. But, they certainly won'tfade out overnight, and of course they retain considerable influence over their leaderand benefactor Vladimir Putin.

International Relations, the WTO

Progress is also being made on the international stage. Russia is succeeding toimprove relations with a broad range of international partners, even whilst retainingits sense of individualism. The agreement to impose sanctions on Iran represents notonly the success of the Obama administration in pursuing a constructive internationalapproach, but also a shift in engagement policy on the part of the Russians.

Russia can be expected to continue its constructive bridge building, while maintainingits own policy identity. In part, this is because relations had fallen to such low levels.

Political progress will produce positive headlines, but little practical benefit to Russia.This is largely because economic relations remain ahead of political links, thepoliticians are playing catch-up, and it will take an extended period for their efforts tobring material economic improvement.

One of the biggest calls of my 2010 strategy was that Russia was more likely than

ever to accede to the WTO. Progress on this front is clear, but not without its ownabsurdity. With much of the negotiation effort completed, Putin who has alwaysbeen more guarded in his rhetorical eagerness to join shocked all involved byannouncing that Russia would only accede along with its new customs unionpartners, Kazakhstan and Belarus. The complications were obvious, leading tospeculation that either this was just one more stalling tactic, or that the logistics offitting the customs union and WTO together had simply been misunderstood.

Russia investors everywhere must have breathed a sigh of relief when thisimpractical condition was dropped, and now it appears that the customs union ismore likely to fade away than the WTO accession. (Not least in the face of anotherbout of gas supply conflict with Belarus.)

Going forward, the WTO deal remains a huge challenge. The Obama administration

will certainly take a pragmatic approach (despite his earlier anti-free trade rhetoric).Yet, the political balance is tough Russia needs to show enough commitment tooverturn the Jackson-Vanik amendment, without surrendering too much of its owninterest. Medvedev has also shown pragmatism on the political stage though, so thechances of success remain very good.

Russia will not formalise its accession to the WTO overnight not least it will take theUS politicians time to deal with the question. But it remains probable that aframework agreement will be announced in the near future. As previously noted,such a deal would not bring the level of benefits enjoyed by, say, China, on itsaccession; but it would contribute considerably to a reducing legislative risks, andopen the door for increased foreign investment.

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Conclusion

Steady as she goes. Russia's economy and financial markets have underperformedhigh expectations in 1H10. There is now a risk that global crises will knock this weak

recovery off track, but the overall perspective is more optimistic. Russia issuccessfully pursuing the reform path that I highlighted in my outlook for the year.And at least this is well on track, if not moving ahead of optimistic expectations.

Economic growth will strengthen in 2H10 and, absent acute global risk waves,financial market returns should be impressive. Russia is well-positioned, bothcompared to its peers and the developed world. Going forward, risk premiums arelikely to continue declining, and company fundamentals are likely to rise.

More detailed advise on security valuation, selection and timing is available on anindividualistic basis.

- James

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James Beadle

[email protected]

+370 643 33238

+44 754 5281 587

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