Russia’s ruble-denominated Moscow Interbank Currency Exchange (MICEX) put in another record high on the first day of trading in 2017, peaking at 2258 points. 

Traders were not popping champagne corks, as the MICEX record is starting to get boring; the index has been setting records regularly since it first crossed its previous all-time high of 2068 on November 10 on the bounceback that followed the election of Donald Trump as US president. Its sister index, the dollar-denominated Russia Trading System (RTS), also crossed the psychologically important 1,000 mark for the first time in two years. As bne IntelliNews reported at the end of last year, Russia’s stock market is on a roll.

MICEX closed at another record high on January 3 at 2293, but has since come off to trade around 2217 near close of trading on January 5.

Russia’s stock market has been recovering for a year now. The RTS ended 2016 with a whopping 51% return, making it one of the five best performing markets in the world. (Ukraine’s WIG index of Ukrainian stocks trading on the Warsaw Exchange, was also up a healthy 41% in 2016, although its market capitalization is tiny by comparison to Russia’s trillion-dollar market).

There are a number of drivers pushing up the price of Russian equities, not least amongst them the belief the Donald Trump presidency that starts in a few weeks will lead to some sort of reconciliation between the White House and the Kremlin.

The underlying improvement in Russia’s economy is also helping. The Russian economy contracted by a mild 0.8% in 2016 according to preliminary estimates, and Rosstat just upgraded the growth result in 2015 from a -3.7% contraction to -3.0%; all in all, Russia’s economy has coped with sanctions, the collapse of oil prices and the subsequent devaluation a lot better than anyone was expecting.

But behind all these immediate factors there is another more fundamental driver. Typically, following a really nasty crisis that sends equity prices to the bottom of the pond – and in crisis years Russia’s equities are usually the worst performing in the world – when the mud starts to settle investors go back into bonds before anything else; bonds are seen as safer and they also pay out coupons, providing the investor with a reassuring cash flow on their investment. However, as confidence builds and risk appetite rises, at some point investors start chasing bigger returns by swapping out of bonds and buying the still massively undervalued equities. That is what happened following the last big collapse in 1998 and again in 2004 following the mini-banking crisis. And it appears to be what is happening now.

“The spread between the implied yield of the Russian stock market (E/P 16.1%) and the Russian risk-free bond yield (UST10 yield + CDS Russia = 3.7%), or the equity-risk premium (ERP), remains above its 10Y average (12.4% vs. 10.1%),” VTB said in a recent note: in other words, the yield on investments in Russian equities are returning 2 percentage points more than the return on investments into Russian bonds.

The key part of this argument is that analysts are now looking at the equity-risk premium – the number they assign as a guess as to how likely there are going to be some unpleasant surprises – and they believe that it is falling back towards the 4-5% discount they used to assign to Russian stocks before 2010. “It is reasonable to expect further normalization of the ratio to that level in the longer term,” VTB said in a note.

While the wider economy is still in recession, the picture at the micro-economic level is very different. The aggregated growth is still weak, but the crisis has been a boon for Russia’s leading corporations. After more than a decade of strong growth, these companies have built up huge financial reserves that they have used to consolidate their position and rapidly expand in an effort to grab more market share while their smaller, weaker rivals are on their backs due to the slowdown. Holding large cash reserves has been a permanent feature of big Russian companies that have never been able to borrow much from banks for capital investment and have only started turning to their equity in recent years as an alternative source of investment capital. In a crisis, having a lot of rubles in your pocket – even devalued rubles – gives these companies enormous market power and many sectors have seen a rapid consolidation.

The effect is most obvious in the banking sector. Russia’s banks earned a total of about RUB130bn ($2.1bn) in profits in 2015, but state-owned retail powerhouse Sberbank earned almost all of that. Last year was much better for the banks, which earned RUB788bn ($13bn) in profits, but again Sberbank earned just under three-quarters of that money. Banking customers have retreated to Sberbank during the crisis, as it enjoys an explicit government guarantee. But more importantly it was able to use its market power to pay less on deposits and cherry pick amongst the best of credit customers to further increase its profitability. Already Russia’s long standing “tourist stock” – the first name any investors interested in getting into Russian equity buys – the bank’s share price has more than doubled in the last year, massively outperforming both of the main indices.

The same thing has been going on with the other blue chips on the Russian market. While Moscow Exchange (MOEX) has some 300 listed stocks, the bulk of all trading is concentrated in the top 20 names or so, many of which have outperformed the market in the last year. Russia is still not a generic investment, but for cherry-pickers there are lots of opportunities. 

The obvious question is: how long will the rally last? Most of Russia’s investment banks think the market still has more room to run, as despite the 2016 rally Russian stocks remain very undervalued by comparison to their emerging market peers.

“We expect the rally in the Russian equity market to continue in 2017 based on five investment themes: 1) an improved geopolitical backdrop, 2) global rotation from credit into equities, 3) macro stability, 4) fundamental undervaluation and 5) outstanding dividend opportunities. Valuation metrics imply ~15% upside for the MICEX Index, but in a re-rating scenario involving the withdrawal of Western sanctions we think the market could rise more than twice as much,” Gazprombank said in their 2017 strategy paper released in January.

Quite apart from the superficial drivers (which could still derail the rally), the bank’s argument rests on the classic one for buying Russia: its stocks are always undervalued compared to its peers, but at the moment there is a big discount on top of the traditional “Russian discount” caused by poor economic performance that is increasingly unjustified – at least at a company level.

The Russian equity market’s valuation on a price/earnings ratio (p/e) rose from 6.2x to 6.9x between September and January, which is still well below its historic high of 7.9x. The same malaise is affecting other emerging markets in trouble like Mexico, where the average p/e ratio is 5x, but Russia remains well below the other BRIC country markets and many developed markets like the US, which mostly have p/e ratios at a 20% premium to historical averages.

Another longstanding trend in Russia’s equity market is that it tends to lag rises in the value of stocks in other emerging markets, but once valuations get too high investors swap into Russia stocks as there is simply nowhere else to go.

In ‘banker-ese’, this trend translates into statements like this one from Gazprombank: “Should risk-on sentiment toward Russian equity risk continue to predominate, we can easily see the Russian market trading with a 5-10% valuation premium vs. historic levels (P/E 17E 7.5-7.9%) and at least temporarily on par with EM peers. This implies technical upside potential of ~15% from current levels.”

Another trend that is likely to support the growth in Russian stocks as the silt settles further is that as Russian companies have become more interested in using their equity as a source of capital to fund investment, and especially M&A deals, some companies have taken to paying out generous dividends. “A key supporting factor for the Russian market in the coming year should again be dividends. Russian stocks are expected to show a 4.9% dividend yield next year, implying a healthy premium (2-4pps) over all main EM peers,” says Gazprombank.

In previous years the dividend paying stocks have consistently outperformed those companies that don't pay dividends, and in a few years since 2008, while the overall market has shown a loss, the dividend-paying stocks have produce positive returns. The attraction is similar to the argument for buying bonds shortly after a crisis ends: you have the potential upside from a revaluation as the country recovers, but more importantly you have a nice steady and regular flow of cash from your investment while you wait.

“The dividend yield on the Russian stock market has grown consistently in recent years and remains the best among peers (4.6% vs. 1.5-3.5%) despite the market’s recent rally,” said VTB.

Last year’s “catch-up” returns are unlikely to be repeated in 2017, but most of the investment banks that have commented on the likely returns this year are predicting another 15-20% gain – possibly more if the Kremlin really can make peace with the White House.