More than two and half decades on from the collapse of the USSR and Russia’s economy is starting to look “normal”: inflation is at an all time low and interest rates have fallen into single figures and will keep falling. That is making a fundamental change to the way ordinary Russians think about their life savings. Traditionally they simply plunked their nest egg in a bank deposit account for the high interest rates, but now the returns are dropping, people are starting to look around for alternatives that have a juicier return.
“It's a process rather than a one time structural shift. We have been in disinflation for quiet a while. Inflation is lower than in the US and the ongoing decline in bank deposit rates along with the bond yield rates shrinking, so people are starting to ask where can they get more yield. But it's a process that will take time. There is a lot of built in conservatism in the Russian market and the economy because of several emerging market crises. It’s been a boom and bust so people are much less willing to take risks to get a couple of extra percentage points. But the average Russian retail investor’s behaviour is changing even if we are far away from the western investors’ attitudes,” says Vyacheslav Smolyaninov, chief strategist and deputy head of research at BCS Global Markets, the biggest brokerage in Russia.
Russia has reached a tipping point where thanks to falling inflation interest rates have become real for the first time in almost two and a half decades. Having lost their life savings in the 90s, when savings were hyper-inflated away in a matter of months, most Russians have become very sensitive to both interest rates and inflation. Unlike in the west, the point of their investments was not to make money, but to protect the value of their savings from the ravages of inflation. Even when real interest rates were negative the game was to find the highest bank deposit rate possible to keep the losses to a minimum. Being able to make a real return on an investment is a whole new way of thinking.
“This is the line of thinking for international investors and institutional investors. But the babushkas are less inclined to think in real terms. Recently the oil prices were very high and gasoline prices are increasing so the average person is feeling less sure that inflation will continue to fall. We believe from the macro perspective we are at the point of reversal in consumer price inflation (CPI) trends and it will increase to 4%, but the most affluent customers of Russian investment banks think in real terms and are looking for higher returns. The same is true of the international investors that were attracted to the bond market in particular by the very high real interest rates in Russia,” says Smolyaninov.
Although inflation currently has been at a record low of 2.2%-2.3%, economists and the Central Bank of Russia (CBR) expect it to rise again over the rest of this year to around the central bank’s target rate of 4%. However, polls have found that the population are even more pessimistic and expect inflation to go even higher.
That makes the low deposit rates at banks a problem. Commercial deposit rates are somewhere between 5% and 8% at the leading commercial banks, which means deposits are still earning real returns, but with the CBR surveys suggesting some Russians are expecting inflation to rise above these rates, consumers are on the look out for better returning investments.
Financial literacy remains low in Russia and due to the string of crises Russia has been through, investments into stocks and bonds have never been very popular. President Boris Yeltsin tried to get the ball rolling in 1997 by setting up the so-called PIFs, Russia’s answer to mutual funds, which coaxed legendary investor Mark Mobius into the Russian market for the first time. But the financial system went into meltdown a little over a year later. Likewise, the “people’s IPO,” which raised over $1bn for the listing of state-owned VTB Bank’s IPO in 2007 was equally ill starred and investors were mashed in another financial crisis again a little over a year later. But despite the serial car crashes, BCS has launched a string of products targeting retail investors which have been growing fast.
“We have a number of products offered by BCS and structure notes are very popular or specific strategy like the dividend basket,” says Smolyaninov. “We track how the investment base is doing on the stock market – increasing loans or increasing short positions. BCS has 25% share of the turnover on MOEX, the largest broker by far. Our discussions with clients and investors tell us that people are shifting from the bond market into equity market and looking for yield. And the dividend story is still strong. Russia is yielding close to 5%, which is more than double the level of the benchmark MSCI EM Index. Plus you can get a handful of stocks – some 10 stocks – that our analysts recommend as Hold or Buy with a strong fundamental case, but the yields over the coming years are expected to be 6%-plus.”
“BCS Dividend basket has the top five dividend earners in Russia. The average yield is never less than 9%. We are talking about stocks like Norilsk Nickel, Severstal or Novolipetsk Metallurgical Kombinat (NLMK), which yield in excess of 10% and if you take into account the weak ruble and market to market then the real yields are closer to 15%. We realise fully that it was also a result of the disinflation over the last three years. So yield matters,” adds Smolyaninov.
“The average investor has many different products into which they can put money – including bank deposits. The long position of our investor in Russian stocks has been on the rise for most of this year. I have give kudos fro them for cutting those positions in January, due to the sell off in EM markets. Now they are picking up again,” says Smolyaninov.
“In general, our clients, including large Russian asset management companies, if there is no dramatic shake up of the market, no shocks, we expect $3bn-$5bn of Russian money that is now under the mattresses or in bank deposits to be hitting their various products in the Russian financial market with a focus on listed Russian securities – both bonds and stocks,” says Smolyaninov. “The reality is that Russia, like other EM markets, is driven by international flows. To say that Russia has developed a domestic investor base that can hold instruments, irrespective of if the weather is good or bad outside, that has not happened. Things have improved, but the game has not been changed.”
The government is playing its part in developing the financial markets and encouraging the population to invest for their old age. The mattress money pool is huge, but largely unavailable to the economy, so the state has introduced various incentives to coax this cash out into the light of day. Investment accounts and “people’s bonds” are two of the biggest schemes to date.
“The investment account is a government initiative to give a tax break for people who invest from three years on who invest at least $7,000 per year. That has attracted people into various instruments. You can invest in bonds, stocks, most listed products out there,” says Smolyaninov.
“There have been few examples of the people’s bond. It has been successful, but to say that it is a product that is taking off is a bit early,” says Smolyaninov. “We see an increasing number of those bonds being placed. So far the central bank and state banks that are placing them are testing the water. It’s like trying to learn a bicycle by riding a tricycle first. They are precisely targeting an audience that is new to the financial market. It is not the classic investors that we were talking about before.”
Russia’s capital markets are coming back to life. The bond market has become an investors’ favourite in the last few years thanks to the high yields, rock solid macro fundamentals and weak currency that has created the conditions for a very attractive carry trade. But more recently the equity market has started to attract money too. This year has seen a sell off of emerging markets in general and Russia was hit by a double whammy as there was a bout of selling following the April 6 round of sanctions as well.
“The EM got a little ahead of themselves at the start of this year. There was this idea that economic growth is synchronised as strongly as it has never been across the globe since the 2008 crisis. That lead to US rates being driven higher and the weakest EM markets – Argentina, Turkey and maybe Brazil – were hit. Now we are seeing some contagions and investors are taking some money off the table,” says Smolyaninov.
“But to say these stories are done is wrong. However, some sort of adjustment to the new dollar and interest rates and the outflows of the hottest money that came into these markets since the start of this year is something you should expect. We will muddle through with heightened volatility to the end of the year,” Smolyaninov adds.
“Our discussions with clients make it clear that people see a difference between Russian bonds and stocks. The attraction of the stocks is superior growth and Russia has issues with that for the time being: the consensus is 2% growth this year and next year, while the other EMs are growing faster than the global average,” says Smolyaninov.
“However, for the bond investors the situation can’t be better. Very high oil prices and a weak ruble only help the budget. All the extra revenues from oil are going into the state coffers. So the ability and willingness of the Russian government to fulfil its international debt obligations are not in question,” says Smolyaninov.
Thanks to the rising oil prices – over $75 at the time of writing – this means the economic outlook for Russia has improved. One of the big questions for the country is how the Kremlin is going to fund the new spending programme announced by President Vladimir Putin and the associated May Decrees that have a RUB8 trillion plus bill attached.
“The devil is in going to be in the details. We need to see the details of the plan before we can work out what its effect on GDP will be. In the short to medium term I don't think GDP growth will be dramatically impacted,” says Smolyaninov.
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