Mordy: Bearish On Russia? Buy Palladium

May 22, 2014

Being bearish on Russia doesn’t mean there’s no Russia-related play.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investment Stewards.

There’s an old Russian proverb: “The church is near, but the road is icy. The bar is far, but we will walk carefully."

Global investors should also tread cautiously with Russian assets. The country’s economic outlook has been passionately debated this year (even within our firm’s investment committee), and the recent crisis in Ukraine has uncorked a flood of volatility in Russia’s capital markets.

To be sure, President Putin’s political agenda has created a veritable wasteland of investment land mines. The annexation of Ukraine’s appendage called Crimea will almost certainly be a Pyrrhic victory. The West continues to denounce it as a violation of international law, and collateral damage to Russia’s reputation as a place to do business has been widespread.

Yet many argue that Russia’s dirt-cheap stock market—now the cheapest country stock market in the world—already prices in these policy risks. Better to observe Sir John Templeton’s advice and “buy when there’s blood in the streets.”

We get it. Russia is in the bargain bin. I’m not particularly comfortable with Russia’s prospects, but as the title of this piece suggests, we see palladium and an ETF like the ETFS Physical Palladium Shares (PALL | A-100) as worth looking at in connection with Russia’s outlook.

But let’s return first to Russia’s macroeconomic picture before discussing to PALL.

We see Russia as classic “value trap”—a cheap market that could stay inexpensive for some time.

Why? Consider the primary reason for Russia’s recent multiyear boom: China. In the years spanning 2002 through 2011, China’s average annual real gross domestic product growth rate was 10 percent. The labor force grew by an astonishing 200 million people (for perspective, the entire U.S. labor force is just 159 million).

Consequently, commodity prices reached stratospheric levels and boosted asset markets of all EM resource exporters, not least of which was Russia’s commodity-stuffed stock market.

Russia’s Hangover After The Commodity Party

China’s rapid industrialization era is now over. Policymakers are now rebalancing away from investment-intensive growth and the labor force will start shrinking in 2016. Unsurprisingly, broad commodity indexes have been lackluster.

What does all of this mean?

First, yesteryear’s winners are unlikely to provide tomorrow’s market leadership. In general, commodity-exporting EM countries face deteriorating terms of trade, capital outflows and contracting liquidity. For global ETF tactical asset allocators, these countries should remain secular “underweights” relative to global benchmarks.

The second lesson is that in a “G zero” world, where there is a lack of cooperative international political power, economics trumps politics (regardless of how belligerent or bullying leaders may become). While Putin’s style is a growing anachronism in modern politics, and certainly hasn’t won Russian any new friends, macroeconomics will dictate future shifts in country alliances.

As an example, both Russia and China have ambitions to increase their influence in Central Asia. The Kremlin plans to establish a Eurasian Economic Union—critics call it a “Soviet Union-lite”—while Beijing is building a new “Silk Road” to Europe.

Clearly, both have big ambitions. However, China is far more likely to displace Russian’s traditional influence in the region simply because it has the financial and economic power to do so.

Since the global financial crisis, China has aggressively purchased energy assets and financed infrastructure investments in Central Asia. By contrast, Russia is steadily losing both its energy monopoly and its political clout in the region—regardless of Putin’s geopolitical maneuvering.

Finally, as the EM boom moderates and corporate earnings growth rates converge with developed markets, investors should scrap the broad EM versus developed market divide. Individual country or sector dynamics are now more important. Similarly, commodity exposures should be targeted instead of broad-based.


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