Coming into the last weeks of 2016 Russian equities have been the star performer amongst the major global asset categories. Over the year to December 15 the ruble denominated MICEX Index rose 26.7%. That compared with a gain of 8.2% for the MSCI EM Index. The dollar denominated RDX (Russian DR) Index is up a much more impressive 51.1% in the same period.

Optimism is also very high that Russian equity indices will also be the best performers through 2017 as evidenced by the fact that EPFR-tracked Russia-focused equity funds attracted $451mn in the week to December 14 – the highest weekly inflow since the first quarter of 2011, while the largest Russia ETF saw its asset value rise 33% through a mixture of price appreciation and new subscriptions.

But what are investors actually betting on over the next six to 12 months? What are they assuming will happen to drive asset prices higher?

Politics always looms large in terms of investment risk. As a very unusual year ends, the international headlines continue to be very mixed concerning Russia. The leadership changes in the US and those now happening and expected across the EU should lead to a less confrontational relationship between the Kremlin and the West than has been the case since 2013. President-elect Donald Trump is a black-box when it comes to geopolitics, but at least he promises to start with a more pragmatic stance towards Moscow than has been the case with the Obama White House. It is of course well understood that President Trump will be restrained in what he can actually do, because he will have to deal with a Congress that remains very hostile to Russia. But a willingness to engage and to take into account Moscow’s core interests is a big improvement from what we have or could have had if Clinton had won.

Along with the appointment of a secretary of state who at least understands Russia and is trusted by President Putin, and assuming he is approved by the Congress, investors are factoring in greater optimism that we may see the start of a staged reduction in sanctions by the middle or end of the year. Political changes, such as the end of the Hollande presidency in France, and the expected Brexit distraction, should also make it even more difficult for the EU to maintain the consensus in favour of full sanctions extension beyond the next renewal in July.

Russia has also been more successful in building better relations with countries outside of the US/EU and China. Geopolitical, as well as trade and investment, diversification has become a cornerstone of the Kremlin’s vision of Russia’s future. The recent sale of a 19.5% stake in Rosneft to a Qatari-led consortium and Putin’s strong political support for the Saudi Arabian oil production cut initiative are successes from that policy. More recently, the successful visit by Putin to Japan is a major step forward in building a stronger political and investment relationship between the two countries. 

On the other hand, the level of criticism against Russia by the outgoing administration in Washington has intensified. Specific threats, of an almost unprecedented level between two big countries, cannot be ignored and may yet, despite Trump’s comments, lead to some additional confrontation between Moscow and Washington. The Kremlin has been focused on calming the tensions over Ukraine, but it will for sure retaliate against any actions initiated by the US over the hacking allegations.

Growth again

Beyond politics, the trend in the economy offers a solid reason for optimism. GDP contracted by 3.7% in 2015 and is forecast to decline by 0.6% for 2016. That drift is expected to continue and should lead to growth in the first quarter of next year. For the full year, top line growth of between 1.5% and 2.0% is achievable. That should translate into earnings growth of between 15% and 20% for the corporate sector and, on top of a still cheap relative aggregate valuation for equities, should help propel the market higher.

The caveat is that growth will not be uniform across all sectors. Anecdotally, especially in Moscow, there is still a lot of concern about the weakness of consumer spending and low confidence amongst small business. Job losses and business closures are still expected in retail, hospitability and service sectors in early 2017. But, offsetting that, growth should continue strong in sectors which are benefitting from the greater competitive conditions in the economy, including from the cheap ruble.

Domestic politics should not provide any reason for greater risk concerns in the lead-up to the March 2018 presidential election. The announcement that opposition activist Alexei Navalny will contest the presidential election will ensure a more lively coverage of the election by the foreign media, but otherwise should not lead to any surprises. Russia does not do Trump- or Brexit-style surprises.

Very likely there will be a steady stream of changes in personnel in key positions as Putin prepares his team for the next phase of the country’s economic and political transition. So far nothing has happened, but rumoured changes are consistent with the expected shift to domestic economic focus in the next presidential term.

But despite the disproportionate attention on geopolitical and domestic politics and the very valid focus on macro and earnings trends, the two factors which usually have had, and will likely continue to have, the greatest impact on investor perception and asset valuations will be the oil price and the ruble exchange rate.

Well oiled

While some observers point to the Trump effect on equities, ie. almost validating their view that Moscow was involved because “even investors know it”, that is incorrect. The real catalyst for the latest move in the market was the Al-Falih (Saudi’s oil minister) effect. Both MICEX and the RDX Index rose by 4% in the weeks after the US election. But the real kicker came around the Opec meeting as optimism for a deal grew. The RDX has gained 11.5% from the days leading up to the November 30 meeting to the close on December 15. That is on the back of the 24% rally in the price of Brent crude over the same period.

The Central Bank of Russia’s (CBR) ruble policy will be the second most important factor in 2017. Historically the ruble-dollar exchange rate has had a close correlation with the price of oil. That changed earlier this year, as the CBR has effectively blocked the ruble from rallying with oil’s recovery. If the oil price were to fall steeply for some reason, then the ruble-dollar rate would be allowed go with it, tick for tick. But maintaining a weak ruble is at the very core of the government’s localization strategy and its efforts to attract inward investment in the manufacturing and agriculture sectors. The CBR is independent in most respects, but President Putin has made very clear his preference for a “competitive currency”. Over the past two weeks as the price of oil rallied 24%, the ruble only appreciated by 2.6% against the dollar. Without “soft-intervention”, the ruble-dollar rate would be closer to RUB50 at this stage.

Politics is a distraction more often than not. It provides the script which keeps us enthralled and engaged in one of the best real-life soap-operas. But this time next year when we review what drove Russian asset prices in 2017 it will be the actions of Khalid Al-Falih and Elvira Nabiullina, as influenced by their respective bosses Prince Mohammad bin Salman and Vladimir Putin, which will likely have proven most decisive.

Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer.