Russian stocks are the cheapest in emerging markets

Russian stocks are the cheapest in emerging markets
By Ben Aris in Berlin June 27, 2018

Equity investors left emerging markets (EMs) in droves in the first quarter as the US Fed tightening cycle pulls them back to the developed world’s bourses and the unstable politics of a looming trans-Atlantic trade war drives them out of emerging ones.

However, the pain of the global EM equity rout has been Russia’s gain. Russia attracted not only football fans in June but also fund managers as Russian stocks have become the cheapest amongst the leading emerging markets after the April 6 round of sanctions imposed by the US on a number of Russian businessmen and their companies.

“Investor dislike for EM equities hit a new multi-year low this week,” Vyacheslav Smolyaninov, the chief strategist at BCS Global Markets said in a note. “The sell-off may be overdone, if the world economy emerges from the trade wars unscathed, which is our base case.”

EMs had their worst week since November 2016 when outflows from all EM equity funds reached $5.2bn, the most in a week since Donald Trump was elected US president.

Active funds were largely unaffected as the bulk of these outflows ($4.1bn) left exchange-traded funds (ETFs). As a result, the weekly combined outflows from Russian stocks nearly hit $0.5bn — the worst since early 2014, BCS GM reported.

The fund flows are out, but many funds were already overweight Russia and maintaining their bets. Although the weight of Russia in the MSCI Emerging Market index is only 3.5%, fund managers have increased the weight of Russian stocks in their portfolios to overweight again. The same story was true in 2016 when the economic recovery got underway and investors’ attention was caught by an attractive combination of low valuations and rising earnings amongst many blue chip names, both in the political sectors like oil and gas as well as in the non-political like retail. The Russian equity market returned just over 50% that year between January and December making it the best performing market in the world.

The Lazard Emerging Markets Fund invested almost 10% in Russia, and Templeton Emerging Markets and Fidelity Emerging Markets is overweight with more than 8% of its portfolio in Russian stocks, Vedomosti reports.

The oil and gas sector has been particularly attractive as the average oil price this year is well over the budget assumption of $40 per barrel and closer to $60 so far this year.

The weight of energy companies in the MSCI Russia index exceeds 50% and the result of the meeting of OPEC+ on June 22-23, at which it was decided to increase production by 1mn barrels per day, should drive these stock up further, analysts speculate. According to Bestinvest, the ratio of capitalisation to profit amongst Russian companies is currently 6.5 compared to the global average of 18.5.

Price trumps politics in the mind of managers, as the impact of sanctions on the Russian economy is limited, thanks to Russia’s large internal market and very low levels of external debt.

Adding to the appeal of Russian shares are the increasingly attractive dividends Russian companies are paying: the average 5.5% dividend yield is more than twice the 2.6% global average yield, according to Bestinvest.

However, equity investors remain unsettled by the pending trade war between Trump and the rest of the world that will drive up prices for everyone and could slow global growth.

“As trade tensions escalate, fund investors have taken refuge (and sought opportunity) in US assets. These now represent 58% of global fund portfolios—the highest level since 2016, prior to the presidential election,” the Institute of International Finance (IIF) said in a note.

Investors have added a total of nearly $50bn to US equity funds this year to date and Russia was several weeks of outflows in the order of $250mn-$500mn per week earlier this year. In all $10bn has flowed out of EM markets since April, cutting a full percentage point from EM allocations.

“Withdrawals from European equities, for example, amounted to some $17bn in May-June. And despite a relatively dovish tone from the June ECB meeting, and QE extension, European bonds have also seen $8bn of outflows,” the IIF added.

In this light the overweight in Russia looks out of place and makes it something of a safe haven, or a high-risk gambit, for the managers that are overweight Russia. On the other hand countries with high levels of FX debt, such as Poland and Hungary, have been seeing sell off in the expectation that a trade war could force them to devalue their currencies in defence, a problem that Russia doesn't have thanks to its low levels of debt.

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