Equity valuations are well supported by strong domestic economic and earnings growth, while the Russia story remains one of the best in the EM asset class. That said, the market is now more highly correlated with global markets than any other factor, and until 4Q07, when transition issues are expected to drive performance higher, the RTS is expected to remain vulnerable to the volatility in major global markets and in GEMs.

The RTS suffered a 6% decline last week, in line with the correction seen across global equities. Prices are rebounding today after the better US market yesterday, but all major equity markets remain vulnerable to the sort of volatility seen last week. That backdrop will likely last until the autumn, when investors will assess prospects for 2008.

Options traders have been betting heavily on a 5-10% global market correction, and those "bets" remain in place. The VIX (volatility) Index remains at the upper end of its historic range, indicating the expectation of continued high levels of volatility and market risk.

The key assumption is that US and global growth will continue at forecast levels (available data support that view). Historically, it is economic and earnings growth that supports strong equity markets, while rising interest rates have only a limited impact.

The main "event" for the markets this week will be Friday's nonfarm payrolls report in the US.

Russia's "fundamentals" remain very market supportive and are amongst the best in the world. When global markets settle, these factors should help the local market recover and rise to a new record.

Historically, the RTS tends to suffer corrections of 10-15% before then stretching to new record levels. Such corrections, like the current one, are therefore good buying opportunities.

The RTS moved in line with the GEM average during 1Q07, underperformed in 2Q07 due to the perception of increased political risk and oil sector issues, and is expected to move in line with the global trend in 3Q07. Our current view is that the 2Q07 underperformance will be reversed with strong outperformance in 4Q07.

The outlook for 2008 remains very favorable for Russian market outperformance. That view is based on an expected growth and valuation driver of increased state support for infrastructure spending and higher levels of spending by both the state and other investors in strategic industries.

Global investors have been returning to GEMs and Russia with high levels of inflows during July. They are attracted by high growth, modest valuations, fiscal strength, and reduced levels of risk perception.

What next for Russian markets?

Over the past year, i.e. roughly from the time that Russia hosted G8 and the Rosneft IPO, the RTS developed its closest correlation with the MS GEM asset class. Prior to that, the price of oil had the dominant influence. But, as can be seen in the graph below, the correlation broke down in mid-April as the perception of political risk increased with Cold War rhetoric and as investors came to appreciate the profit issues in the oil sector. Since the G8 meeting in early June and the softening of the dialog between the Kremlin and Washington, the RTS has closed the performance gap to some extent but year to date is still significantly lagging. Since January 1 the RTS is up 2.4%, the MS Russia Index is down 1.8% while the MS GEM is up 18.9%.

and GEM markets during this period of turbulence. But assuming that global markets avoid the worst-case scenario of a major or long lasting price crash, equities should settle by the fourth quarter.

That is our major assumption for 2007:

. Equities run through the first quarter with a close correlation to the GEM asset class - the portfolio bias being with domestic themed stocks and industry reform stories.

. The second quarter saw that relationship break down as the perception of political risk increased and Russian equities underperformed.

. The third quarter basically sees the correlation restored, but with only minor performance catch-up.

. The fourth quarter, assuming stable international markets - even at lower levels - should be when Russian equities outperform and close up a large part of the 2Q07 performance gap. The reason being the better understanding of the stable political transition and the expectations of a growth driver based on increased state spending and still rising consumption in 2008 and 2009.