Expectations are Unexpectedly Better Than Expected

Markets supposedly represent the contemporaneous collective interpretation of multiple players. That seems to make some intuitive sense in small numbers. But imputing that behavior when the market is large and diverse is a bit more of a philosophical leap. Sometimes it even makes it hard to explain something that’s already happened.

2005 was another banner year in the Russian equity market; The RTS and MICEX indices both finished out the year with an 83% gain. December was a great month (+8.5%) despite our belief that a US Christmas rally would be a necessary pre-condition. And yesterday’s open to the trading year saw the RTS Index leap another 5.8% from that healthy end of year print.

But why? We’ve been struggling to understand the source of that strength and why it has spilled over into the beginning of this year. All sorts of data points and impressions are aired during our investment meetings. Our head of fixed income came up with the best characterization so far, and I’ve used it as the title for this post.

I guess in a way, he’s got the right sentiment in the funniest possible words; in the short-term, sharply positive revisions (and lack of negative revisions) to the outlook for 2006 have improved the investment case in the capital markets. Oil seems stubbornly stuck above most long-term average price per barrel estimates, and the nuclear dilemma in Iran may not make it any worse but it certainly won’t make it any better. The Ukrainian natural gas standoff was resolved and will result in even better profits at bellwether Gazprom. Overall, I suppose its safe to say that the macro situation in Russia is benign to positive.

The really big deal from the perspective of the local markets, though, is that more foreign investors are beginning to notice what’s going on. In the first week of January alone, best estimates are that more than $1 billion have been committed to emerging market funds. And Russia, with its barn-burning 2005 performance, is a major part of the allocation.

As a result of this new found attention, fixed-income spreads (versus the US treasury) have tightened, Russian equities are now at a slight premium to emerging market peers, and overnight rates (a widely watched measure of liquidity) have fallen to between 1% and 2%.

So what does this mean for 2006? I suppose it means most of the “convergence” theme has played out and that the really easy money has already been made. Now, local companies will have to start posting some decent profit numbers to justify the new valuations. In a way, the New Year has brought with it a whole new market with a whole new set of challenges.