COMMENT: Russian equities - the next leg up faces hurdles

By bne IntelliNews June 18, 2014

Peter Szopo of Erste Asset Management -


The latest Russian stock rally was strong but short. It started in the last week of April and may have ended already in mid-June, as the situation in Ukraine began deteriorating once more. The main RTS index rose by 23% in just 31 trading days. Whether the positive momentum will return in the case that political tensions again start receding is not certain. Undemanding valuations, a recovery of corporate earnings and most likely an improving domestic economy later this year should be supportive. Other factors, however, suggest caution: developed market (DM) equities look toppy, the VIX touched seven-year lows in June, and following the European Central Bank's (ECB) recent move toward monetary easing the dollar is likely to strengthen, which is usually not supportive for emerging market (EM) assets.

The recent upward move of Russian equities was in many ways not typical. In previous rallies – there were ten since 2009 not counting the latest one – the RTS rose by 28% on average (using the median), outperforming EM and DM peers, which showed strong gains as well. During this period, oil and industrial metals prices typically posted double-digit gains, while gold advanced moderately; the massive improvement of risk indicators such as Russian credit default swap (CDS) spreads and the VIX usually helped; and the euro as well as the ruble strengthened against the dollar. Rallies were typically also accompanied by earning upgrades.

This time, the rally in Russian stocks has had little support from international peers. EM and US indices were only moderately up, while European equities moved mostly sideways. Moreover, crude and industrial metals, which normally fuel Russian rallies, had a muted price performance during the latest rebound. The main driver, looking at CDS spreads and the ruble, was falling Russia-specific risk, suggesting that the market benefited from a relief rally with little backing from better economic fundamentals.

However, for a number of reasons we will likely see further gains, if the situation in Ukraine doesn't escalate and there is some progress in the gas dispute between Kyiv and Gazprom (although there is no guarantee that this will happen):

First, the market has not fully recovered the lost terrain against EM peers in the first months of the year as the crisis in Ukraine was unfolding. From a purely technical view, there is possibly another 10-15% upside.

Secondly, and more importantly, the recent upward pressure on the oil price may last longer than assumed in response to the turmoil in Iraq. Particularly if the conflict spreads to the country’s South (the "Iraq Nightmare scenario", as Joe Weisenthal sees it here) or spills over to other producers in the near and Middle East, Brent could easily jump to above $120 a barrel again for an extended period.

Third, earnings revisions, which were negative for six months starting last November, have only recently turned positive again. With a weak ruble and stronger-than-expected oil prices, earnings momentum will likely continue improving, specifically in the oil sector, which accounts for almost three-quarters of the listed corporate sector’s total earnings.

Fourth, the Russian economy seems to be more resilient than assumed at the height of the Ukraine crisis. In April, industrial production accelerated unexpectedly to 2.4% year on year, while the fall in business investments, which have been shrinking since the beginning of the year, slowed. Of course, one should not rely too heavily on previous month's figures, but the government has indicated that stimulation measures for the economy are being prepared and the central bank of Russia (CBR), despite its recent hawkishness, may cut interest rates later this year as inflation is expected to peak in the summer. With higher oil income and a weaker ruble, fiscal policy should gain some room for manoeuvre.

Finally, valuations still appear to be undemanding relative to EM and DM equities. Both trailing and forward price/earning (PE) ratios are around 5.2x, implying a 55-60% discount to EM peers. Of course, as everybody knows this discount partly reflects the high share of oil and gas in Russia. However, the picture does not change fundamentally if one looks beyond the hydrocarbon sector. Based on the author’s estimates, non-oil and gas sectors are on average trading at a forward PE of 9.1x, well below their EM peers (15.1x), indicating a hefty 40% discount.

The main hurdle against a prolongation of the rally is, of course, the situation in Ukraine. The mixture of a major geopolitical conflict with ethnic tensions in combination with a simmering energy dispute has a lot of disruptive potential.

In addition, the global financial market backdrop could quickly turn less benign. The main risks are a correction in DM equities and the strengthening of the US currency. Regardless whether one views US equities as fairly priced or overvalued, after five years of almost continuously rising stock prices, the risk of a significant correction in the world’s biggest stock market is clearly rising, and nobody can in advance identify the possible trigger. Less disruptive but still precarious for EM assets would be the effect of a rapidly strengthening dollar due to the simultaneous monetary easing in Europe and tightening in the US. Historically, a firming US currency has rarely been supportive for EM assets, including stocks.

So in conclusion: yes, there exists upside potential for Russian equities linked to both technical and, more importantly, fundamental drivers. However, Ukraine-related issues plus risks of a worsening global backdrop suggest that the next leg up could be a bumpy ride.


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