Riding a Russian equities position this year has had much the same effect on one’s nerves as a flight on the Soviet-era Aeroflot. In those days, Aeroflot didn’t see the point in wasting money on retraining military pilots for the more delicate civilian trade. If you couldn’t stand the G-forces of their takeoffs, landings and mid-air manoeuvres, well, you could walk to Yakutsk for all they cared.

I took a long-term, philosophically based bullish view on Russian equities in May – not the best time to do so. My reasoning was that with the huge cash flows from oil and gas revenues, and the increased participation of the Russian public in the country’s capital markets, the equities would be somewhat insulated from the vicissitudes of developed-world portfolio management.

Well, not entirely. From the middle of May to the middle of June, the RTS index of Russian stocks dropped by about 30 per cent. Three Oh. In a month. Yes, what is the problem, comrade passenger? A new airsickness bag? There aren’t any.

If, however, you were made of strong stuff, of the sort that can survive winter in Norilsk, you will have been making your way back. Up through last week, the RTS rose more than 33 per cent from its June lows, which, mind you, still left it about 7 per cent down from the peak. The index and the big stocks now look as though they’re on the way through their previous highs.

So was my original thesis correct? After all, violent corrections in the middle of rallies aren’t new to Russia. Early last year there was a 12 per cent correction in the RTS before it rose 78 per cent to a new high. But in the next bear market for developed markets, will Russia continue to bob along its upward path?

Harvey Sawikin still thinks so. He is the manager of the Firebird Republics fund, which specialises in Russia and the other countries that were part of the old Soviet Union. The fund is up more than 30 per cent for the year, even with the fireworks in some of his stocks. “We will see Russia continue to outperform most equity markets over several month periods,” he says, “as long as oil prices stay at this level.

“Part of the problem was that the Hermitage Fund [whose shareholder rights-minded manager has been unable to re-enter Russia] had withdrawals in May due to their political problems and had to liquidate large positions.” Also, newbie emerging markets hedge fund managers had margin calls in other parts of their portfolio and found the relatively liquid Russian markets would accommodate their sell orders.

But now most Russian market liquidity is coming from local investors who have had some of the state’s energy billions gush down to their personal accounts. Foreigners are a smaller and smaller part of the buy side for Russian securities, so their margin calls and communicated distress will have less effect.

And while Russia’s aggressively politicised energy policy isn’t aligned with western interests, for the moment it’s working both for the state and for state-related companies such as Gazprom. “I love Gazprom,” Mr Sawikin says. “When a Russian opens a brokerage account, the first thing he buys is Gazprom.”

The day after the Federal Reserve paused, and investors sold off on the implicit forecast of a slowdown, Russian stocks rallied – with Gazprom in the lead. So perhaps Russia will be “decoupled” from western troubles after all. But remember those energy prices. While Russia’s external accounts will still be healthy with an oil price down to, say, $40, its energy stocks will take a hit.

If you don’t like the Russia story, you’d better look for some other lifeboat securities because the action in the credit markets tells me you’ll need them. The market for corporate debt has been expecting the Fed pause with the institutional buyers jumping into a late-cycle sucker’s rally.

“The institutions are acting like traders, not investors,” says Greg Peters, the credit strategist for Morgan Stanley. It’s all right for traders to go for a few basis points of extra yield, since they won’t be in their positions very long but when institutions play that game, though, they’ll lose out to the real traders.

At the moment, when more caution is called for, credit instrument buyers are pushing the envelope. They’re accepting much higher levels of debt on leveraged buy-out deals, for example, as deal sponsors from private equity funds pay to put money to work. As Mr Peters says: “There are a lot of situations in the market where secured loans trade cheaper (ie have a higher yield) than unsecured bonds. One name we’re focused on is Georgia Pacific, which has a very top-heavy capital structure in which the (unsecured bonds) trade at the same yield as GP first lien paper. You give up security for no gain in yield.”

Credit default swaps for corporate risks in many cases have yields lower than the bonds of the same companies. The CDS yields have been driven down because the derivatives are such a low-cost, liquid (for the moment) way to create “product” in the form of structured credit.

There are sane ways to deal with credit markets in the late stage of an economic cycle. First, stay in shorter-term paper, even for potential leveraged buy-out candidates. The banks that finance LBOs won’t want bonds on the target company that mature before their loans. So before the company is leveraged, you’ll be cashed out.

Second, go for better-secured debt. Professional investors are grabbing all the security they can, putting more junior bonds at risk. Follow their lead.


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