By Frank Holmes, John Derrick and Tim Steinle
Co-managers of the U.S. Global Investors Eastern European
The Russian MICEX Index, which increased 22.5 percent in 2010,
has jumped 15 percent so far in 2011, significantly outperforming
many other markets.
China is the second-best performer of the BRICs, rising more
than 5 percent, while India (down over 10 percent) and Brazil
(down over 2 percent) have lagged. Overall, the MSCI Emerging
Markets Index has dropped just over 1 percent.
This has effectively recoupled Russia with the other BRIC
countries. The Russian economy lagged out-of-the-gate once the
global recovery began, leading some to question whether it
belonged in the same category as Brazil, China and India. Those
sentiments seemed premature and symptomatic of an anti-Russia
Russian's outperformance has been driven by several factors.
First, the Russian ruble has appreciated 7 percent against the
U.S. dollar, boosting stock market performance for U.S.
investors. This development also has a long-term benefit as a
strong ruble benefits the country's domestic sectors, something
we'll discuss later.
A second factor driving Russia has been the geopolitical and
natural disaster events that have transpired during the past few
weeks. Russia is relatively safe from the type of political
uprisings seen in the Middle East and North Africa. Its
government is decidedly popular with the public and the one-two
punch of President Medvedev and Prime Minister Putin give the
government clout on both international and domestic fronts.
The price of oil has risen roughly 25 percent since the unrest
and turmoil began in the Middle East and North Africa. As an
energy exporter of crude oil and natural gas, Russia is one of
the few large economies in the world that directly benefits from
higher energy prices.
Russia is the world's largest oil producer and it's estimated
that for every $10 increase in the average annual price of oil,
Russia's revenues rise by $20 billion, according to the
. Since Russia is not a member of OPEC, it is not bound by
production caps and can increase production as it sees fit while
prices are at elevated levels.
Russia is also the world's top exporter of natural gas and
Stratfor Intelligence points out the situation in Libya has shut
down 11 billion cubic-meters of natural gas flow to Italy. As
Europe's third-largest consumer of natural gas, Italy has turned
to Russia for gas supplies. In addition, a shutdown of several
Japanese nuclear facilities could mean as much as a 14 percent
increase in natural gas consumption to meet the Japan's energy
In the energy sector, the
Eastern European Fund (EUROX)
portfolio emphasizes companies that show strong growth in
production, reserves and cash flow, relative to their peers.
Specifically, Novatek, Rosneft and TNK-BP fit this profile.
Russian energy equities, which carry the largest weighting in
the MICEX, have gained 25 percent this year. This is higher than
non-oil Russian equities, which have risen only 7.7 percent.
However, as oil and gas taxes swell the government's revenue,
these funds are increasingly allocated to social and public works
programs which are likely to create an opportunity for non-energy
related equities. These sectors appear poised to benefit from the
current macroeconomic environment.
This table from Merrill Lynch shows the performance of the
different sectors of the Russian market following a sustained
rise in oil prices. Merrill Lynch compiled research on the seven
instances where oil prices rose 20 percent in a two-month span
and maintained at least half those gains over the following six
Historically, the average gain for Russian equities is more
than 34 percent. While energy generally jumps out ahead when oil
prices move higher, you can see that it lags other sectors as the
rally progresses. We have long been positive on both Russian
financials and the consumer sector and these sectors appear well
positioned going forward.
Consumer-oriented equities such as retailers have historically
been the best performers, netting an 85 percent gain on average
and triple the gain of energy equities. Retailers X5 and Magnit
should be able to capitalize on these trends. Russian financials
are next with an average 83 percent gain. Sberbank, Russia's
largest bank, is the largest holding in
Another area that could directly benefit from the Kremlin's
cash-filled pockets is infrastructure. Russia is in dire need of
a significant revamping of its infrastructure. Similar to the
American Society of Civil Engineers report that rates America's
infrastructure a "D," the World Economic Forum says the quality
of Russia's infrastructure lags that of other emerging countries
such as South Africa, Turkey, China and Mexico.
The areas most in need of upgrading are Russia's
transportation and electrical power grid. The quality of Russia's
roads ranks in the bottom-third in the world, according to
Merrill Lynch, and it's estimated that Russia loses 6 percent of
GDP each year due to underdeveloped roads. In fact, the combined
length of Russia's roadways declined 6 percent between 2002 and
2010 despite a 60 percent increase in car penetration,
It's a similar story for Russia's airports and rail network.
Russia currently has roughly 300 operational airports but just 40
percent of them have paved runways and 30 percent do not have an
airfield lighting system, Merrill Lynch says. The rail network,
almost entirely constructed during the Soviet era, is highly
concentrated in the Western region of the country and is
estimated to require more than $70 billion in investment for
upgrades and repairs by 2020, according to Merrill Lynch.
Russia's aging power grid is unreliable and accident prone.
Merrill Lynch projects that significant investment by 2020 is
required to update and modernize the grid. With industrial
consumers accounting for 85 percent of electrical consumption,
keeping the power up and running is essential to maintaining
Russia's industrial production levels.
To finance the much needed infrastructure improvements, the
Russian government created the $420 billion Federal Target
Program (FTP). The FTP focuses on key transportation areas such
as rails, autos, marine and civil aviation.
The FTP has specific goals to meet by 2015 such as increasing
the percentage of roads that meet federal standards by 23
percent. The plan also calls for a 47 percent increase in the
shipment of goods and a 40 percent increase in airline
penetration through improvements of aviation infrastructure.
In addition to the FTP, three special events will help drive
Russia's infrastructure spending: The 2012 Asia-Pacific Economic
Cooperation (APEC) Summit, 2014 Winter Olympics in Sochi and the
2018 World Cup. Merrill Lynch estimates that total spending for
the World Cup will reach $50 billion. Construction for the Games
in Sochi includes 161 miles of roads and 65 miles of rails, and
the APEC calls for 48 new objects to be constructed for a total
of $83 million.
While higher energy prices are in danger of slowing down
consumers in the U.S., Western Europe and certain emerging market
countries, it has the opposite effect for the Russian economy.
With increased cash flow from its natural gas and crude oil
exports, the Russian government has the much needed capital to
invest in the country's aging infrastructure and to support
This should drive outperformance of Russian markets throughout
2011 and stimulate demand for infrastructure-related commodities
such as crude oil, copper, cement and iron ore.
Frank Holmes, John Derrick and Tim Steinle are co-managers
of the U.S. Global Investors Eastern European Fund (EUROX). For
more updates on global investing from Frank and the rest of the
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Please consider carefully a fund's investment objectives,
risks, charges and expenses. For this and other important
information, obtain a fund prospectus
by visiting www.usfunds.com or by calling 1-800-US-FUNDS
(1-800-873-8637). Read it carefully before investing.
Distributed by U.S. Global Brokerage, Inc.
Foreign and emerging market investing involves special risks
such as currency fluctuation and less public disclosure, as well
as economic and political risk. By investing in a specific
geographic region, a regional fund's returns and share price may
be more volatile than those of a less concentrated portfolio. The
Eastern European Fund invests more than 25% of its investments in
companies principally engaged in the oil & gas or banking
industries. The risk of concentrating investments in this group
of industries will make the fund more susceptible to risk in
these industries than funds which do not concentrate their
investments in an industry and may make the fund's performance
All opinions expressed and data provided are subject to change
without notice. Some of these opinions may not be appropriate to
every investor. The S&P 500 Stock Index is a widely
recognized capitalization-weighted index of 500 common stock
prices in U.S. companies. The Bovespa Index (IBOV) is a total
return index weighted by traded volume and is comprised of the
most liquid stocks traded on the Sao Paulo Stock Exchange. The
Shanghai Composite Index (
) is an index of all stocks that trade on the Shanghai Stock
Exchange. The MICEX Index is the real-time cap-weighted Russian
composite index. It comprises 30 most liquid stocks of Russian
largest and most developed companies from 10 main economy
sectors. The MICEX Index was launched on September 22, 1997, base
value 100. The MICEX Index is calculated and disseminated by the
MICEX Stock Exchange, the main Russian stock exchange. The Bombay
Stock Exchange Sensitive Index (Sensex) is a cap-weighted index.
The selection of the index members has been made on the basis of
liquidity, depth, and floating-stock-adjustment depth and
industry representation. Sensex has a base date and value of 100
on 1978-1979. The index uses free float. The MSCI Emerging
Markets Index is a free float-adjusted market capitalization
index that is designed to measure equity market performance in
the global emerging markets. Holdings in the Eastern European
Fund as a percentage of net assets as of 12/31/10: Novatek 5.39%,
Rosneft 4.39%, TNK-BP 2.70%, X5 3.42%, Magnit 1.73%, Sberbank