Recent months have been kind to investors in Russian equities. Year-to-date (ie. to May 13) the market was up 22% in dollar terms, leaving behind both the MSCI Emerging Market Index, which was flat over the same period, and developed markets, which were almost 2% down. Given that not all is well in Russia’s economy, and taking into account the notorious volatility of the country’s stock market, fears of a looming correction do not look implausible. However, the recent strength of oil prices and modest signs of an improving economic backdrop may help extend the rally.

Once again the price of oil turned out to be the key driver for Russian equities. Since hitting its nadir in mid-January at $26 per barrel, the spot price of Brent, the most important benchmark for crude oil, has gained 70%. In light of Russia’s exposure to hydrocarbons, the positive link between oil and equities is not a particularly surprising fact. However, a look at the performance in recent years (Figure 1) shows that from 2011 to mid-2014 the ties between the oil price and the RTS, Russia’s main dollar-based stock index, were quite loose. While crude mostly hovered above $100 per barrel, Russian stocks were drifting lower, partly reflecting the general weakness of emerging markets, but more importantly as a result of Russia-specific risks. The combination of slowing growth, stalling economic reforms and the war in Ukraine, plus the related tensions between Russia and the West, weighed on the performance of Russian stocks.

Only at the end of 2014 was the ‘normal’ relationship between oil and stocks re-established, driving stock prices lower in 2015 but supporting the market rebound in 2016. This temporary de-coupling of Russia’s equity market from oil between 2011 and 2014 can also be seen in Figure 2, which shows the correlation between weekly changes in the Russian stock index and the oil price. 

Less economic pain

While the rebound in oil prices has certainly been the key factor behind the stock rally, signals of an improving macroeconomic backdrop have also helped. The main activity indicators are still in negative territory year on year, but the economy’s descent is decelerating. Industrial production is almost back to its level of a year ago, and the decline of retail sales has halved relative to the second half of 2015. The GDP in the first quarter of 2016 was just 1.2% down y/y, much better than the expected -2.0%.

Of course, the data flow is not suggesting that the economy is in a good shape. The consensus growth forecast for this year is still -1.5%, and while the figure for 2017 is positive at 1.2%, it is far below what emerging markets investors typically expect in return for the risks related to investing in this investment class. However, after more than a year of recession, following an extended period of poor growth, any signs of a turnaround will likely support investor sentiment.

Still trading at a discount to EM peers

As a result of the recent rally, the valuation gap between Russia and its emerging market peers has narrowed. Based on estimated earnings the Russian market is now trading at a 40% discount – exactly in line with the longer-term average (see Figure 3).

The massive valuation discrepancy is mostly due to the high share of oil and gas stocks in Russia (around 60% of the market’s total capitalisation), which are trading on just 6.3x estimated forward earnings. Outside the oil and gas space, Russian stocks are also trading at a discount, but at 17% it is much smaller.

Bottom-line: The rally in Russian stocks both in absolute terms and relative to other markets has been driven by the rebound in oil and, to a lesser extent, by modestly improving macroeconomic data. Both developments are unlikely to reverse in the near term, so the chances that the rally will continue are high – as long as the risk appetite of investors is not hurt, for example, by the US Federal Reserve starting to tighten faster than expected, or by European political risks such as a Brexit.