Mechel intends to increase the share of high-margin products manufactured under its Steel division. The company will process the cold-deformed reinforcement wire at its production unit in Moscow into quality wire rod highly demanded in construction. Mechel foresees an increase in demand for this new class of steel products. The company has already received an order for reinforcing wire of BMP production. 

Due to low carbon content and mechanical strengthening, the cold-deformed reinforcement wire has several advantages compared to hot-rolled reinforcement wire such as improved welding characteristics, increased toughness and durability, and lack of scale. Additionally, cold-deformed reinforcement wire has higher design resistance to expansion and compression allowing reduction of its expenditure at 10% to 15%.

Demand for steel in Russia is expected to be high in the coming years. Mechel and its subsidiaries have implemented a $5.2 billion investment program for 2008–2012, focusing on the development of its Mining and Steel businesses. About $3 billion would go to the Mining business, $2.2 billion to the Steel business, and $42 million to energy projects. Of this, $1.3 billion will be invested in the development of the Chelyabinsk metallurgical plant (Mechel’s primary steel production facility) until 2011.

The investments should increase total steel capacity by 35% to 6.5 million tons, besides cutting costs through a complete changeover to concasting. Chelyabinsk will increase its flat stainless sheet production by seven times to 300,000 tons and expand its range of construction and engineering steel. As a result, steel production should rise 12% and rolled products output should grow 26%.

Mechel is looking to invest $1.2 billion in the Mining segment. Part of the spending will be used to increase coal production at Southern Kuzbass by 47% to 21 million tons by 2011. Mechel recently obtained controlling stakes in the coal companies Elgaugol and Yakutugol (68.86% and 100%, respectively), paying $2.34 billion. The companies produce coal in the East Siberian region of Yakutia and had been the largest remaining standalone coal producers in Russia prior to their acquisition by Mechel. Their output is mainly high quality coking coal. Yakutugol produces 10 million tons of coal per year, most of which it has been selling to customers in Japan and Korea. The company plans to increase this output to 15 million tons and redirect it to the domestic market.

We maintain our Neutral recommendation on the stock.

Bank Rossii began managing the ruble's exchange rate in February 2005 against a
currency basket comprised of about 55 percent dollars and 45 percent euros.
Policy makers let it trade within a fixed range in mid-May. Since then, it has
dropped 2.1 percent against the basket to 30.4020. Though the central bank
doesn't reveal the limits of the band, BNP Paribas considers 30.40 to be its
weaker end.

Russia's National Wealth Fund will invest $6.9 billion, or nearly a seventh of its total reserves, in buying domestic stocks, Pyotr Kazakevich, the head of the Finance Ministry's debt department, said Monday. From Tuesday onwards the fund will be able to deposit up to 625 billion rubles ($24.0 billion) in state-owned Vneshekonombank, better known as VEB, which would be the government's agent. The fund has previously invested in currency deposits and top-rated sovereign bonds outside Russia, such as U.S. government Treasuries. "The first part of this money has been transferred to VEB. From this day, they have the right to invest," a spokesman for the Finance Ministry told Forbes.com. "I think that this investment will be made in five years or more."

``We expect Russian corporate and financial sector default rates to increase as
debtors' access to official funds will vary,'' S&P said in the statement.
``Other uncertainties remain regarding what the economic policy response will be
to weakening growth, and whether the ongoing concentration of the financial
system in state hands is permanent or temporary.''

``There are two main consequences for Russia, a lack of confidence and a lack of liquidity,'' Sharonov, a deputy economy minister until resigning in July last year, said in a Bloomberg Television interview in Moscow. ``This problem is not only for financial institutions, but for the whole of industry, for the whole economy. Many companies feel these problems with debt financing.''

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

I think it is important to bear in mind here that Russia's economy actually grew at an annual 7.5% in the second quarter, while manufacturing growth was nearer 5%. Which means that in a "newly industrialising country" the weight of industry in the economy is declining. This is obviously unsustainable, since however resource rich Russia maybe, you cannot live from oil alone, especially when your oil output has a ceiling. Basically the more living standards in Russia rise, the less important oil will become as a percentage of GDP, and the more dependent the Russian economy will become on other sectors. This is why the current consumer price and wage inflation levels are no mere trifle.

Obviously the Russian authorities have deperately needed to get a grip on the inflation problem, and this is just what the central bank has clearly failed to do, with the annual rate rising again to 15 percent in August, up from 14.7 percent in July. So one part of the present financial crisis is clearly an institutional crisis of confidence. With the benchmark interest rate at the central bank currently at 11%, Russia has negative interest rates of 4% which obviously make it very easy to fuel a lending driven consumer and construction boom, but very much more difficult to communicate to observers that you actually know what you are doing. So while the fx muscle that the central bank can put to work in the short term to stamp out the present will in all probability work, they are clearly not able to prevent such forest fires breaking out in the first place, and we should, of course, expect more. Brazil's central bank which currently has interest rates at 13.75% while inflation is just over 6% (ie 7.5% positive interest rates) is currently justifiably earning for itself a reputation as Latin America's new Bundesbank, a way in which it would never ocur to anyone to refer to the Russian equivalent. And the comparison I would make with Brazil is not meant idly, since Brazil is, of course, also an oil and resource rich emerging economy.



So it is clear that Russia has special problems, which set what is happening in Russia rather apart from what is currently happening in a lot of emerging market economies.

Rout On The Bourses

Both Russia's MICEX and RTS exchanges remained effectively closed first thing this morning following trading being suspended again yesterday (Wednesday) - they were in fact open for less than two hours - in order to prevent a further sell-off on top Monday's record-breaking falls. The ruble-denominated Micex Stock Exchange did resume some very limited trading at 11:00 this morning, but only limited operations were authorsied - the decision was effectively simply to allow participants to close repurchase deals still outstanding from Sept. 16 and Sept. 17.

Russian stocks have now plunged around 60 percent since their May peak, and while the Micex did initially gain 7.6 percent in initial trading yesterday, this gains were very rapidly erased and then turned negative, as the index plunged as much as 10 percent before a halt was called. Russia's dollar-denominated RTS index stood at 1,058 points when trading was halted, nearly 58 percent down from its peak of 2,498 points reached in May.

Emerging Market Woes

In part Russia's problems only reflect more general "risk aversion" issues which are facing all emerging market economies. Emerging-market stocks have fallen the most in 11 years this week, their currencies have been falling, and the cost of insuring emerging market bonds has rocketed as rising lending rates and tumbling commodities have prompted investors to sell riskier assets.

Every emerging stock market in MSCI indexes has been retreating this month, and the MSCI Emerging Markets Index fell 2 percent yesterday to 768.92 a time, its lowest level since October 2006. The index is now down 19.59% since the start of the month, and 29.27% over the past 3 months.



The Russian MSCI index, in comparison, is down 36.1% on the month, and 54.2% over the past three months.



Of course, to put the recent fall in perspective, this recent fall follows several years of rising stock values, and thus is to some extent cyclical, as can be seen from the 4 year MSCI index chart (below).




Falling Oil Prices


In the forefront of the fall in Russia share prices have been energy stocks, including Russian oil producers like OAO Gazprom and OAO Rosneft, who have declined substantially following the sharp drop in crude prices. Gazprom, the world's biggest natural-gas producer, lost 18 percent to 158.41 rubles in the latest turmoil, while Rosneft, Russia's largest oil company, sank 22 percent to 132.20 rubbles.

Oil prices were down again this morning, after bouncing back somewhat yesterday. Light, sweet crude for October delivery fell 97 cents to $96.19 a barrel in electronic trading on the New York Mercantile Exchange midafternoon in Singapore. Overnight, the contract rose $6.01 to settle at $97.16, after having dropped $10.03 the previous two trading sessions. But the trend is decidedly down, and crude has now fallen more than $50 — or over 35 percent — from its all-time trading record of $147.27 reached July 11.




Urals crude peaked at $140.80 a barrel on July 3, and has fallen about 36 percent to $90.01 since then. Still, the oil price averaged $108.65 a barrel so far this year, compared with $63.54 a barrel January 02 through Sept. 18 last year.


Foreign Exchange Reserves


Evidently the Russian economy is in no evident danger of short term default, and foreign exchange reserves, which stood at $560.3 billion on September 12 (according to data from the Russian central bank) - the third largest globally, after China and Japan - are evidently ample. In addition Russia has a $163 billion SWF (the National Welfare Fund), which is split into two parts, $130 billion in a reserve fund, and $33 billion in the National Wealth Fund (the SWF proper).




Nonetheless, the reserves have dropped quite sharply since early August, and are now down some $37 billion since their August 8 peak, and reserves declined by $13.3 billion to $560.30 billion in the week ended Sept. 12, after falling $8.9 billion in the previous week. About 47 percent of Russia's reserves are held in U.S. dollars, 42 percent in euros, 10 percent in pounds and 1 percent in yen, according to the most recent figures released by the central bank (June 30, 2007.

Part of this reduction in reserves is a result of central bank intervention in support of the ruble, since Russia operates a policy of trying to maintain the currency steady within a trading band set against a basket of euros and dollars. Evgeniy Nadorhsin, a senior economist at Trust Investment Bank in Moscow, estimates that the central bank sold approximately $3 billion in fx reserves last week.


So Where Do We Go Now?

This is very hard to say. Clearly we should expect the economy to slow substantially in the last quarter of 2008 and the first quarter of 2009, as credit conditions tighten for households, and the decline in oil prices restricts revenue flows. As just one indication of the worsening credit conditions we could note that Russian 5-year credit default swaps are trading with a spread of around 253-255 basis points, little changed this week but more than double the level seen before the start of the conflict with Georgia.


On the other hand Russia is hardly the Baltics, so we should not expect the economy to go into a nosedive. A lot depends on the view you take about the future of energy prices. Since my own view is that the global economy will slow down considerably - in addition to the reduction in growth rates we have seen so far this year -following the most recent bout of financial turmoil, and this will serve top bring oil prices down even further, but we should see a floor, at around $80 perhaps.

More importantly I am not expecting a long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009.

As we can see in the JP Morgan EMBI+ index (see below), bonds from these economies have taken one hell of a battering in September. Looked at the other way round, the extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries has been going up, and today rose 2 basis points to 4.24 percentage points, the widest spread since September 2004, according to the EMBI+ index. So EM bonds have been taking a battering but they have taken a battering because of nervousness about the implications of a financial crisis in the developed economies, rather that as the result of any inherent problems in their own ones. That is what sets this crisis apart from the 1998 one, and that is what means that the financial markets in these economies will in all probablilty bounce back again quite substantially once all the nervousness dies down. Basically most of these markets are neither "oversold" nor are they "maxed out".

What is interesting about the above chart is the way in which things seem to have really taken a decisive turn for the worst in late August, and it is curious to note on the chart below that the Russian MSCI index also started to deteriorate further starting on or around 2 September (see chart below which is from May 2008 to date). So while the Georgia factor may have made people nervous, other, deeper, structural factors are obviously at work.

And while I am on deep structural factors, and the MSCI Emerging Markets index, I would like to conclude by pointing out that the decline since mid May has been pretty generalised, and in some sense is obviously cyclical. The point is that this fall will at some point hit bottom, after which time we should be ready to see a rebound, as investors move in and snap up what will obviously be seen as very attractive buying opportunities.

read more

``We could be in for a volatile period until there is a resolution to what's going on in Georgia,'' said Vlad Milev, an analyst at Metzler Payden, which oversees $1 billion in East European stocks. ``We are not trading on economic fundamentals or company earnings. We are trading on headline news, and the headlines have been largely negative since the events in Georgia started.''

Russia's ambassador to Moldova, meanwhile, said the country's leaders should be wary of what happened in Georgia and avoid a "bloody and catastrophic trend of events" in the separatist, pro-Russia region of Trans-Dniester. The ambassador, Valeri Kuzmin, said Russia recognized the independence of South Ossetia and Abkhazia because of "Georgia's aggression against South Ossetia." Trans-Dniester broke away from the former Soviet republic of Moldova in 1990. A war broke out between Moldovan forces and separatists in 1992 leaving 1,500 dead. Trans-Dniester is supported by Russia but is not recognized internationally. Russia has 1,500 troops stationed there to guard weapons facilities.

``We're shocked by the magnitude of the numbers, especially given that the company revised its investment plans only a month ago,'' Troika Dialog analysts Oleg Maximov, Valery Nesterov and Alex Fak wrote in a note to investors today. ``This raises questions about whether the management actually intends to generate any meaningful free cash flow.''

"In terms of the cost of the conflict, the impact on the economy is negligible," Parker told Reuters in a telephone interview. "We're not expecting to take a negative action with regards to Russia's rating. The main potential impact on Russia is through an impact

"We don't see any immediate impact -- it's more a potential impact if Russia decides to take more aggressive action in due course," Parker said. "But it is affecting investor sentiment."

Key News
• The U.K. economy stagnated unexpectedly in the second quarter, ending the nation's longest stretch of economic growth in more than a century. (Bloomberg)

British pound futures 60-min: News of stagnation not taken well. Ouch!
 

• The Nikkei average sank 0.7 percent to its lowest close in almost five months. (Reuters)
• Investors pulled their money out of Russia in the wake of the Georgia conflict at the fastest rate since the 1998 rouble crisis, new figures showed on Thursday. (FT)

Key Reports Due (WSJ):
There are no economic indicators scheduled for today.

Quotable
“Hatred of the producers of wealth still flourishes and has become, in fact, the racism of the intelligentsia.” 
     George Gilder

FX Trading – That giant sucking sound and the daisy chain of dollar bullishness
I used to work for a man named Ross Perot back in the early 80’s, during my corporate finance life.  You may remember Mr. Perot; he was a colorful character to say the least.  But as odd as he was at times, I do admire the man as he built himself from nothing, worked hard, and cared deeply about his country.   He went on to national fame by creating his own political party and running for President.  He also gained fame for the phrase, “That giant sucking sound you hear is jobs leaving the US and heading to Mexico,” which is how he described the impact of the NAFTA Treaty.  Of course, he was right.  And the sound got even louder thanks to our jobs for corporate profits exchange with China.  In the financial markets today, we hear a different kind of sucking sound, but it’s growing louder by the day; it’s the sound of global capital draining from the global economy.

A friend forwarded the latest PIMCO piece penned by Paul McCulley and Saumil Parikh titled, The Narrowing Ecologies of Global Growth.  In the piece they presented a chart that I think tells the story:

 
                        Source: PIMCO

I have referred to this as the Big Four major economies heading south at the same time.  Others have termed it the global economic race to the bottom.  But needless to say, I think it has one important implication longer term, even if we can pull off a very difficult dollar correction near-term—this draining of global capital is US dollar bullish.

It is the center to the periphery back to the center money flow:

The developed world still provides the capital for the rest of the world.  Think of it as the center to the periphery i.e. credit created in the most efficient and deepest capital markets is used to fund investment (risky and otherwise) to markets outward on the periphery that don’t have their own domestic capital markets ready and available to do the job.  Therefore, when money starts to move out of the periphery (that which is still left possibly after systemic shock) and back to the center as it is now during this global delivering period, the dominant receiver of this flow back to the center is the US capital market.  Thus, receding global credit is dollar bullish.  The supply of the world’s money, the US dollar, is falling.  That is a big net positive for the buck.

Now of course the other implication is the impact of the Big Four’s declining demand as it impacts the demand for commodities.  Logically (a word that can always get us into trouble in a world that can be dominated by illogical players for long periods of time), one would think there is little chance of current prices for energy and industrial metals (and gold) to be sustained.  And if these commodities were hiding places for money fearing a dollar meltdown, that would be another net positive for the dollar.

And sticking to the commodities, oil in particular, we are gaining more confidence in our theory/guess that maybe the fall in crude means a rapid closing of the “Oil – Dollar Carry Trade.”  (We explained the “Oil – Dollar Carry Trade” in detail in a Currency Currents about a month or so ago, if you would like a copy of that please let us know.)  Closing of dollar borrowing by countries to buy high priced oil is yet another net positive for the dollar.

And of course, last but not least, interest rates. 

If global demand is tanking.  If global credit is receding.  If commodities prices fall.  Then we are confused how this great inflationary environment is going to overwhelm us. 

We believe there is far greater danger from global deflation in a world of continuous debt repudiation.   The central banks can pump all they want, but if the financial institutions are using the money to save themselves and consumers are shoring up their own balance sheets and business see fewer decent capital investment prospects, then this money is not stimulative. 

In this world, we expect central banks to aggressively cut interest rates—most all of the major economy banks that is.  They will be playing catch-up with the US Fed.  And of course, this means the seemingly very negative US dollar yield differential gap could close quite quickly.  And you guessed it; an improving dollar yield differential is a powerful net positive for the dollar.

And of course last but not least is the impact on credit from the world’s largest depository of collateral for loans—the stock market.  Falling stocks speed the process of credit draining from the economy, and it has broader psychological impact to boot.  Institutions and individuals lose a key source of wealth and major source of collateral value to support existing loans.  Financial institutions already in “save thy self mode” are calling loans more quickly; falling stocks will reinforce this trend.  

Looking at a chart of the Dow Jones World Stock Index Weekly we’d guess a major top is in place and we are clearly entering a major bear market.

In short, any cratering of stocks will speed this daisy chain of global macro interlinked events that in the minds of many will turn out to be perversely dollar positive. 

We are already hearing howls from those that say it isn’t fair.  It isn’t fair the US dollar could benefit by being the cause of much of the problems now in the global economy.  But the same crowd never thought of fair as the world’s money was funding risky asset investments and blowing bubbles of dubious wealth in its wake around the globe. 

 
The chart above is that of the famous US Current Account Deficit.  Though there is no, I repeat, no correlation between the dollar and the US Current Account Deficit, for reasons we have not the time to cover this morning, there has been an interesting correlation between stock market crashing and improvements in this series.

And of course, those dark grey vertical bars which represent official recessions also seem correlated to improvements in the US Current Account.  Why?  It’s because the dollar IS the world’s money.  And when the world’s money packs up and goes home, the world loses its major source of credit.  And when credit goes away in our global financial system, bad things happen.

So, if your 401-k melts down to worthless territory, just remember all those financial commentators who told you the US must get its current account under control—it’s causing all the problems. 

Well ladies and gentlemen we think we just may be in the midst of what the economists wanted—global rebalancing.  US exports grew faster than did China over the last 12 months.  The US Current Account is improving.  The US consumer is buying less and saving more.  Commodities prices are about to breakdown in a big way.  And inflation will be squeezed out of the developed world economies no matter what the central banks decide to do. 

Maybe rebalancing is what is needed to cleanse a global financial system chock full of malinvestment.  But we think it will be a very painful process. But we also think it will usher in a major long-term bull market in the US dollar.

Have a great weekend.

Jack & JR