Uralsib -

Russian equity gains have slowed markedly since the oil price hit $100 per barrel in February. The last day of sub-$100/b Brent was February 7, and since then oil has risen by 25% while the MSCI Russia has returned just 6%, underperforming all other markets in MSCI Emerging Europe (all of which are, incidentally, oil importers).

From the beginning of 2009 until February this year, as the oil price rose from $40/b to $100, Russian equities had been almost perfectly correlated (R2 of 0.92) with Brent. As oil moved above $100, this relationship has broken down. What has gone wrong?

Why have Russian equities missed out?

The market appears to be telling us that there is a limit to how high the oil price can rise in the short term without undermining the global recovery and causing demand destruction. Memories are fresh of the March 2008 oil price spike to about $145/b and the subsequent collapse, and though there has been a deflation of the credit boom since then, the fear is that a continued tracking higher of the oil price could start to sew the seeds of its own destruction. This view has been reinforced recently by the IEA's warning that "there are real risks that a sustained $100-a-barrel-plus price environment will prove incompatible with the currently expected pace of economic recovery" and the IMF's comment that "the key downside risk to growth relates to the potential for oil prices to surprise further on the upside because of supply disruptions".

There is another view that the current oil prices could incorporate a sizeable political risk component, with Brent having risen from $96/b before the Egyptian revolution kicked off on January 25 to $122/b currently. However, the dollar has weakened by about 5% since then, and Opec countries have increased social expenditures, which argue for a potentially higher price medium-term. To prevent market oversupply, in March Saudi Arabia reduced production by 840,000 b/d.

The final drag on the market is equity issuance. Although Russia-country funds have seen $4.2bn of inflows year-to-date, more than two-thirds of this has come to ETFs, which are not active participants in IPOs. We see potential for approximately $25bn of equity supply from Russia this year, with $6bn so far having been placed.

Thus the market has found itself hemmed in by short-term fears that a further significant rise in oil prices might ultimately lead to a much sharper fall; while an oil price decline on reduced MENA political risk cannot be ruled out. Add IPOs to the mix, and it is easy to understand why the Russian equity rally has slowed.

It is not all bad news, however. The lag of Russian equities versus oil means that the market would currently appear to be pricing in only around $104/b for Brent (according to the 2009-2010 correlation of the market to oil), meaning that the market ought to (in theory at least) be relatively cushioned against modest declines in oil prices.

Since January 2008, the Russian market has de-rated significantly versus its long-run average, and has also de-rated slightly since Russian President Dmitry Medvedev's end-March reform comments, suggesting that the market is not currently a buyer of the reform program. On a 12-month forward P/E basis, Russia is currently trading at 6.7x, almost a 20% discount to its 10-year average of 8.2x, and less than half the August 2006 peak of 13.8x. On a relative basis, Russia has also de-rated, currently trading at a 39% discount to GEMs, compared with a 10-year average of 25%, and a premium of 15% in June 2006.

The earnings outlook for 2011 is also good: consensus expects 22% earnings' growth for Russia this year, the highest in the region. Russia is currently the only country in emerging Europe seeing upwards revisions of FY2 EPS forecasts.

Going forward

So how could Russia perform from here? So long as oil stays in a trading range of $100-120/b (our house view for 2011E is $110/b), then we see the focus moving away from short-term tracking of the oil price up and down to more medium-term drivers. We see these as:

1. The reform programme - Medvedev has described the investment climate in Russia as "very, very bad". The market is for now not pricing in a substantial improvement in the investment climate, and the market has actually de-rated since Medvedev announced his ten-point investment climate reform plan. We believe that reforms to improve the investment climate may actually have wider support within the administration than is currently acknowledged by the market - and represents a logical entrée to the second act of post-Yeltsin Russia for both reformists and siloviki alike.

2. Economic acceleration and the turn in inflation - as the year progresses in Russia, we see economic growth accelerating (after a weak first quarter) as oil revenues feed through the economy and corporate capital expenditure picks up; we also see scope for additional pre-election spending, given the healthy state of budget revenues. Real wages should also start to pick up as unemployment continues to fall. We see year-on-year inflation in Russia starting to head down as we move into the summer harvest season (assuming a more normal harvest in 2011).

3. The "time value" of oil, meaning that in the absence of a very sharp decline in oil prices, the market should start to price in a higher baseline for oil as the global recovery continues. This is in particular if events in the Middle East continue to argue for an elevated political risk premium in oil prices and/or additional budget expenditures on social programs in producing countries are seen as conducive to OPEC trying to defend a higher oil price. We note that, to prevent market oversupply, in March Saudi Arabia reduced production by 840,000 b/d.

While the last two factors can help the market, the key for us is the potential turnaround in investors' current level of extreme scepticism when it comes to reform in Russia. Medvedev's recent, clearly announced reform package has explicit deliverables over the next six months. Interestingly, the market has not priced this in at all - the market has actually de-rated slightly since Medvedev announced the plan.

However, we have seen reform turn the market around in the past. Russia saw a similar underperformance versus oil in the summer of 2009. What turned it around was Medvedev's "Go Russia" article, published on 10 September 2009, in which he outlined his vision for a modernized, liberalized Russia. A month later, MSCI Russia was up by 22%, despite a flat oil price. In the right conditions, reform can be an important driver for the Russian equity story.

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