Ben Aris in Moscow -

The political rhetoric between the Kremlin and the West remains fraught since the start of the Russian bombing campaign in Syria, but investors have started to warm to Russia as an investment destination; Russian bonds are the best performing amongst major emerging markets year to date and Russian-dedicated funds saw their first big inflow for a year at the start of October

The most important factor driving this modest interest in Russian assets is the growing possibility of an end to hostilities in Ukraine and easing of the sanctions regime on Russia at the end of this year.

A tiny crack in the regime alreadt appeared in October when the EU actually lifted the sanction on Russian hydrazine – a rocket fuel used by Europe in satellite launches – to facilitate cooperation between Roskosmos and the European Space Agency. More could come if hopes for a long-lasting peace are borne out after a “Normandy Format” meeting of heads of state took place in Paris on October 2. The meeting thrashed out the details and commitments on both the Ukrainian and Russian sides to implement the Minsk II peace deal terms.

Some significant progress has already been made to meet the Minsk II terms signed at the start of this year to bring the conflict between Russia and Ukraine to an end; many of the 13 points in the plan have been fulfilled, but a few remain problematic. 

The pullback of heavy weapons was achieved on time, although there has been intermittent fighting since, where some heavy weapons were brought back up to the front line. However, the ceasefire has more or less held.

What has changed recently is that as the Kremlin got ready for its campaign in Syria, fighting in Ukraine not only fell off dramatically, but fighters are now being withdrawn from the front line too.

All the points 1-4 are now in place, but there is still work to do on the rest. The special status law forthe Donbas region was put in place within the 30 days after the signing of Minsk II, but the law grants this status only for three years and the point 11 change to the constitution has yet to be completed. That will be hard, as many in Kyiv see granting Donbas pseudo-autonomy would be caving into Kremlin aggression. To make the point, someone threw a grenade into a crowd protesting against the Ukrainian government’s first attempt to change the constitution in September, killing four policemen and injuring 100 others.

An amnesty law has yet to be passed and probably won’t be: Ukrainian President Petro Poroshenko admits this will be hard to get through a Rada vote and has suggested that amnesties will be granted on a case-by-case basis – an approach that will displease Moscow. Social payments are not being made in full either. But both of these points can be done. The return of control of the border only comes at the end of the process, so that means everything hangs on organising acceptable local elections in Donbas and making the required changes to the constitution on the status of the region.

For its part, Russia has not stopped supplying the rebels and presumably there are still Russian military personnel “holidaying” in Donbas as winter closes in. The Kremlin will clearly not halt is military meddling until Kyiv has ticked off the remaining points on the Minsk II list. Given the political problems of completing the last two points, it now appears almost certain that the Minsk II deadline will be extended beyond December 31.

Russia bonds bloom

Still, even the incomplete process in Ukraine looks a lot better than at anytime in the last year. Most importantly, the fear of expanding sanctions has turned to hope of fading sanctions.

On the flip side, the Kremlin has given up on the idea that Asia would emerge as an alternative source of financing for the Russian economy. At VTB Capital’s sixth annual "RUSSIA CALLING!" Investment Forum in Moscow in October, the audience was predominately US-based fund managers who posed most of the questions to Vladimir Putin during his session. The Kremlin has said throughout this crisis that all the problems are political and it remains open to Western investment.

The fear of the EU and US extending their sanctions list made all Russian assets toxic for most of the last year. While the number of banks and companies named on the financial sanctions list is relatively short, the possibility that a company or individual’s name could be added was enough for international compliance and risk management departments to nix any Russian deal. That has changed now after several companies started issuing the first Eurobonds in a year in October. And at the start of October, Deputy Finance Minister Sergei Storchak suggested the Russian government could also return to the international market for $3bn if the mood was right.

Moreover, investor appetite for these high-yielding Russian bonds is strong in a world where most governments have cut interest rates to next to zero; Russia’s bond market has been the best performing among the major emerging markets this year, returning 17% year to date, according to Bloomberg. Franklin Templeton excluded Russia from its portfolio in the summer and missed out on the rally, but money managers at Aberdeen Asset Management and Ashmore Group both say there is still more upside in Russia’s bonds, according to Bloomberg.

Russian equities see green shoots

Russian stocks have also joined the party, with the Market Vectors Russia ETF yielding 15% this year, the best performance among 776 US-domiciled tracker funds.

Equities remain deeply discounted, but that is the appeal for investors. If the political tensions cool, then the market should bounce from its current deeply discounted position and Russian equities have already risen 11% year to date as of October 14 and the dividend yielding stocks even more than that. The dollar-denominated RTS index is at about 875, but still way off its all-time high of over 2600 set in May 2008. However, both the RTS and the ruble-denominated Micex index remain largely range bound; the equity rally has not begun.

As the first green shoots appear, a few companies are talking about IPOs. The billionaire owner and chairman of Russian oil refining company Russneft, Mikhail Gutseriev, may merge his business with the Neftisa oil company and then carry out an IPO of 25% of the resulting company, he said on October 13. Earlier in October, Gutseriev said the merger would only be possible if the oil price exceeds $50/barrel (oil was $49 on October 14), while the IPO would also be conditional on high oil prices.

And Russia took in $100bn of inflows in the first week of October – a 23-week high, according to Gazprombank. "The worst is over for emerging markets," Gazprombank said in a note. "The staunching of EM equity outflows illustrates that weak US payroll/dollar-weakness was the best news for EM/commodities/resources complex."

Macro picture bad but not black

Sentiment on the political future is driving the Russian investment story, but Russia Inc.’s slowly improving economic context is helping the story along.

Widely regarded as a petro-economy, Russia suffered a heavy blow from the collapse of the oil price in December, which engendered a swathe of “Russia is doomed” commentaries. Most prominently Swedish professor Anders Aslund predicted that the Russian economy would contract by 10% in 2015 and its reserve funds would be exhausted: the economic contraction was actually 3.9% year to date by September, while reserves were beginning to rise again and were $370bn as of October 1.

The oil price recovery in the last few months has done a lot to underpin the growing optimism: after plunging to around $40, oil had staged a 26% recovery in the year to date to October. Likewise, Putin proudly cited the first capital inflow in well over a year during his speech at the VTB conference after a net $5.8bn arrived in September. On top of that, capital flight is expected to fall to some $45bn this year – much of it going to pay off corporate international debt – after several years of $100bn-plus a year capital outflows.

Much of the reason for this pink blush on the economy’s face is thanks to the beneficial effects of the ruble devaluation. Raw material producers still earn revenues in dollars, but have costs in devalued rubles. Likewise, retailers of domestic products like food have been largely unaffected by the devaluation. In general, corporate profits in ruble terms soared to their highest level since 2008, according to the Bank of Finland, as traditional foreign import competitors were effectively cleared from the market at a stoke.

The problem remains, though, that domestic investment continues to shrink and Russia will not return to health until domestic and foreign investors can be persuaded to start putting money back into the economy. And that is going to take awhile. Investment in the bond and equity markets is welcome, but currently this is almost exclusively “hot money” looking to make a fast buck on the rerating of Russian assets after the country's risk profile goes from “insanely dangerous” to merely “appalling”.

For any sort of sustained rally to occur, the government will have to tackle the deep structural reform issues head on and do a deal with the West that ends the financial sanctions. Putin made a lacklustre presentation to a room full of international investors at the VTB conference, but his impassioned defence of Russia’s actions in Ukraine and Syria made clear that the government will not be interested in economic reforms until it wins its geopolitical game of chicken with the US. How long will that take? Who knows? But most of the delegates at the conference are getting ready for several years of gloom.