Chris Weafer of Macro Advisory -

Russia’s equity indices (especially those denominated in US dollars), debt prices and the ruble have all surged strongly since the start of the year as investors became much more optimistic that the sell-off in 2014 was excessive and the risk premium depended too much on fears which are unlikely to be realized.

• The dollar-based equity indices – RDX and RTS – have performed best, with each rising by more than 40% on the back of investor optimism and the ruble recovery.
• Sovereign debt instruments, along with those of the best-positioned corporates, have also moved strongly ahead and ignored the ratings downgrade by both S&P and Moody’s. The yield on the Eurobond ’30, which is the benchmark instrument for Russia, has fallen from 6.4% at the start of the year, to 3.6%. The yield on the ruble denominated OFZ – 9yr, has fallen from 13.6% to 11.1 % since early January.
• The ruble has recovered by almost 16% against the US dollar and by 25% against the euro

After such a strong performance over such a short period of time the obvious questions for those with profits is whether to lock that in and walk away, while those whose performance against the MSCI EM and EMEA benchmarks will have suffered because they remained light in Russia exposure, are asking if the rally can drive even higher?  At the back of everybody’s minds is a possibly similar situation in the first half of 2009 when it was deemed reckless to buy Russia in January when the RTS traded just below 500. The index reached 1,000 in early June as the oil price, which also defied predictions of sustained weakness in early 2009, rallied and brought the ruble with it.

So what should investors now be focused on as they make that decision? The following will likely be the key determining factors for the market over the next quarter or two;

Ukraine. The situation in eastern Ukraine remains very fragile, according to reports from all sides. There is a fear that, unless an acceptable longer-term deal can be secured, then fighting may flare up again in the spring or summer. However, for now the political rhetoric from Moscow and Ukraine’s presidential office remains in support of looking for a deal rather than a return to a broader war. If that were to happen, and the separatists were to again use heavy weapons, then the finger of blame would point to Moscow and any hope of sanctions relief would greatly diminish.

Gas talks. The talks between Moscow and Kyiv, notionally between Gazprom and Ukrnafta, are always a good indicator of whether political relations between the two governments remain pragmatic or strained. President Vladimir Putin recently ordered an extension of the winter gas deal for a further three months to the end of June, which provides at least a less contentious backdrop to the political discussions.

Geopolitics and sanctions. Following on from, but very much part of the events in eastern Ukraine, investors will be very sensitive to any fresh news about sanctions. The current hope, and part of the reason for the year-to-date rally, is that, if the Minsk-II ceasefire agreement holds and can be built upon, then the EU may not renew the financial sector sanctions when the block of sanctions comes up for renewal on August 1. If that is the case, and a final deal between the UN and Iran over its nuclear programme is also agreed, then the hope is that the White House may follow the EU and drop, or ease, financial sector sanctions in the autumn. There is no great advantage to only the EU dropping sanctions, as EU banks will not go against a US sanction.

Oil price. The link between investor sentiment and the oil price is clear. The price of Urals has been much stronger than had been expected early in January. The reason is because traders expect either US shale production to start falling, ie. as some producing wells are now loss-making on a full cost basis, or Opec’s resolve may weaken and it might start to reduce supply. So far, even if the price of Urals stays above $60 per barrel, there is no evidence that either is happening. The key date for the oil price will be the June 5 meeting of Opec oil ministers. What comes out of that meeting may set the oil price on its course for the summer and early autumn.

Ruble. The Russian currency is expected to weaken this quarter as the Central Bank of Russia ends the forex repo support operations, or makes it much more expensive, and cuts its Key Rate by up to 200 basis points. The Finance Ministry has also said it believes that the ruble rally is too much and is in danger of eroding the competitive advantage for domestic producers, which has led to a big drop in imports and a boost to both manufacturing sector growth and the current account. A drift out to RUB55 per dollar would not greatly upset investors, but anything worse might.

Macro. The first-quarter numbers point to a very moderate recession, which is probably now largely built into earnings forecasts. In that case, equities are still very cheap relative to emerging market peers. The question that still needs to be answered is whether the trend will get a lot worse? The World Bank certainly believes that to be the case and recently cut its growth outlook for Russia to a 3.9% contraction in GDP for this year and a more modest, but still negative 0.3% contraction for 2016. If the second-quarter data does start to deteriorate, then concerns about earnings, and therefore the valuation gap, will re-emerge.

Dividends. Companies paying a dividend yield of 6% or higher should see good support from income-focused investors. There is a question mark over how much dividends will be cut this year. A small cut will provide another boost for the market.

New issuance. Already this year, retailers Lenta and Magnit have successfully raised new money via secondary share offerings. The former raised $225mn and the latter attracted $143mn. While these are small amounts, they represent a disproportionately positive event in the market, as the consensus was that nobody would be able to raise money this year. Railcar manufacturer, United Wagon Company, has since announced its plans to float at least 10% of its shares on the Moscow exchange. That would be the first IPO of Russian shares since Lenta listed stock in February last year. A successful listing would also greatly boost sentiment amongst investors.

Buy-Backs. Uralkali has recently announced plans to buy-back up to $1.5bn of its shares, as it considers the market price to be too low relative to its business growth prospects. That is a very positive action and shows confidence amongst owners. If any others follow suit, this will provide a lot of justification for investor confidence.

Government actions. For now, the government is very focused on a damage limitation strategy and is devoting all of its efforts, and resources, to ensure stability in the economy, reduce inflation and cut interest rates, and to support the ruble. That has been a good enough backdrop for the markets to stage the strong rally, but it will not be good enough to sustain that rally beyond the trading bounce. For that to happen, investors and business leaders need to be convinced that the government is more serious about creating the right conditions to attract a sustainably higher level of investment and for businesses to grow. That may start to become clearer at the St Petersburg Forum in June, or perhaps if/when sanctions start to ease.

US interest rates and the dollar. If the US Federal Reserve proceeds to raise its benchmark rate, as it has indicated it plans to do, then the boost to the dollar will both hurt the price of oil and also investor appetite for risk assets. A strengthening US dollar is usually bad for emerging market equities. However, Russian assets are not so exposed, because risk-adverse investors have long since departed and there is no vulnerable overhang.

Eurozone. If the European Central Bank’s QE program continues as the Fed raises rates, then the euro may easily reach parity against the dollar. Half of Russia’s imports are priced in euros, so weakness in that currency could undermine the government’s efforts to boost the competitiveness of the manufacturing sector and to advance its import-substitution strategy.

Russian asset valuations are still very cheap relative to emerging market peers and to their own history. But while cheap valuations provide the justification for investors to buy, the market catalysts are still rooted in sentiment. If investors believe that risk continues to ease, then the valuations easily justify a doubling of equity indices from here and another cut in the yield gap between Russian debt issues and emerging market peers.