Russia Outlook 2018

Russia Outlook 2018
By Ben Aris in Berlin January 7, 2018

Russia needs a new economic model and 2018 is the year that one will be chosen - or not. First the country needs to get through a presidential election in March (that will almost certainly be won by president Vladimir Putin). After that the Kremlin will turn to making reforms, but the effects of any reforms that do happen are unlikely to kick in until the second half of the year. 

Political outlook

• Presidential elections

Russian politics will be dominated in the first quarter by the presidential elections slated for March.

The elections themselves are a non-event as President Vladimir Putin is bound to win; the latest poll by independent pollster the Levada Center found 67% of Russians would vote for Putin, with his nearest competitors, nationalist firebrand and head of the Liberal Democratic Party of Russia (LDPR) Vladimir Zhirinovsky, as well as anti-corruption blogger and opposition leader Alexei Navalny both polling at a meagre 2% of the vote.

Overall, Putin’s popularity rating remains above 80% and 57% of the population think that Russia is moving in the right direction versus the 27% who don't.

But the elections will be exciting as despite his likely shoo-in Putin needs to balance several factors if he is not to allow unrest to mount in his final term (at least according to the terms of the Russian constitution).

• Enthusing voters to turn out

The Kremlin’s first task will be simply to get people to vote. To the average Russian there is no one else to vote for, so why bother? Even Navalny – who has been on a six-month tour of Russia’s regions to rally locals against the Kremlin, and has drawn large crowds wherever he has gone – has failed to convince voters to abandon Putin even if his message resonates with them.

The Kremlin’s original 70/70 strategy (a 70% turnout that delivered a 70% vote for Putin) had to be ditched after regional elections in 2017 resulted in record low turnouts for incumbents. It is not clear how Putin will spur voters to turn out but keeping the campaign as short as possible allows for an intense circus that may bump the turnout up.

• Dealing with growing social gripes

The second challenge Putin faces is how to deal with growing social dissatisfaction. While the president retains his personal popularity, Russians have become more vocal in their criticism of regional and federal government for failing to preserve their quality of life. This has lead to some genuine opposition leaders winning a few regional seats. The fact that the Kremlin let these results stand is a sign of its fear of sparking wider public protest if it tried to force out these elected leaders.

Despite the millpond appearance of Russian regional politics there is clearly a growing tension. The fact that the authorities have largely failed to thwart Navalny’s regional tour, after a few ham-fisted attempts, is evidence again that the centre’s grip on regional politics is slipping.

This social unrest is being fuelled by the marked deterioration in the standard of living Russians have suffered. Polls in December found that one in three Russians have cut their expenditure and prefer to save rather than spend. Income levels have fallen by about 40% since 2014 in dollar terms, and the proportion of spending on food has risen steadily from a low of 35% of total income in the boom years to circa 60% as of the end of 2017.

Having said that, the polls show that Russia remains a long way from mass social unrest, with only 21% of respondents to a Levada poll believing protests with political demands are possible (in which only 11% would participate), and 26% believing protests with economic demands are possible (14% would participate).

The people are hurting, but the survey and others strongly suggest Russia is not yet ripe for widespread social unrest. After a Putin victory in March he urgently needs to address these issues and restore some of the prosperity Russia enjoyed in the noughties, as failing to do so will almost certainly lead to increased unrest.
Another recent survey by the Carnegie Endowment for International Peace found that Russians are evenly split on the need for radical change: 41/42 for/against. Despite the falling living standards of living in recent years, the last decade and a half of growth has created a significant cushion. The poor are the most in favour of radical change whereas the middle classes prefer the status quo. Interestingly, the youth (c.24 years old) are the least keen on radical change, irrespective of the young faces that have appeared in Navalny’s crowds this summer.

• Managing regional ambitions

As the previous election campaigns run from the centre are clearly not going to work in this election, the Kremlin has been forced to turn to regional leaders to produce a decent turnout and muster the required votes, but that comes at a cost of shifting the balance of power towards the regions.

The Kremlin’s hold on power is actually quite tenuous. While Putin won the 2012 presidential elections convincingly, voting across the regions is very uneven, best illustrated by the parliamentary elections, where two thirds of regions voted 40% for United Russia and a third of regions voted 30%. United Russia won just over 50% after 12 of the 85 regions produced votes close to 100%, enough to push the party into an overall majority.

Over the last two years there has been a large-scale reshuffling of regional governors and the Kremlin has now delegated the task of getting out the vote to these governors.

That has also has handed more power to the regions, which are in return demanding their pound of flesh from the centre. Economic growth has lifted many regions and more progressive regions such as St Petersburg, Kaluga and Tatarstan have provided a role model to the rest, which have begun to embrace reforms at a regional level and aggressively compete with their immediate neighbours for investment.

As federal funding has dried up following the collapse of the oil price, regional governors are even more acutely focused on the need to make their regions work and so are pressuring the centre for what support they can get. Just how these changes will play out is not clear but they are potentially seismic in nature.

• Placating the elite

Putin needs to win – and win big. He needs massive support as it makes him invulnerable to a palace coup. The important constituency in Russia is not the people, but the elite.

Putin took over an oligarchy from Yeltsin and he has largely co-opted it for his own purposes. Originally he tried to marshal all the oligarchs into a ZAO Kremlin with his regular one-on-one meetings with the captains of industry, before forming a circle of favoured second-generation oligarchs such as Oleg Deripaska and Mikhail Prokhorov, as well as installing loyal allies at the heads of state-owned giants such as Gazprom and Rosneft.

However, following the failure of these younger oligarchs to produce the dynamism the economy needed (and simply following their own interests), Putin has progressively retreated into an ever smaller group of state-sponsored oligarchs, or “stoligarchs”, most of whom are childhood friends from St Petersburg. But this has left a much wider group of powerful oligarchs who have been disenfranchised and represent a potential threat if Putin shows signs of weakness.

In December there was a spate of articles speculating that Putin was “tired” and may step down, or that this election is all about Putin’s successor, as he will be something of a lame duck in his fourth term. Neither of these scenarios are likely, as Putin cannot think about stepping down until he has secured his legacy and provided himself with protection from prosecution in a similar deal he cut with Yeltsin to ensure a smooth transition of power. (The main feature of the Yeltsin deal was that Putin retained many key Yeltsin-administration personnel in his own presidential administration for at least the first year.)

The question of a successor is also moot as the main weakness of an oligarchy is that it has no established principle of succession and so how Putin manages the transition of power is going to be a very tricky issue indeed.

There was also talk of changing the constitution in December to extend Putin’s term in office to life. However, this is also very unlikely. If Putin were going to change the constitution he would have done it in 2008 when he took a huge political gamble by giving up the most powerful job in Russia to his ally Dmitry Medvedev.

The push for a change in the constitution is driven by oligarchs close to Putin, as while the president can guarantee his future with a Yeltsin-like deal, they cannot. Given they control the richest parts of the Russian economy, they will almost certainly be immediately replaced by allies of the new president and as part of that process could easily end up in jail. For the existing elite the safest course of action is to keep Putin in the presidency forever.

• Post-election reforms

Putin is expected to launch deep structural reforms after the elections are over and a lot of work has already been done in working out plans of action led by three main groups.

Former finance minister and co-head of the presidential council Alexei Kudrin has been the most prominent proponent of reform. He favours cutting spending and concentrating on promoting productivity through investment into infrastructure, education and social services.

The second group is the Stolypin Club, fronted by Russia’s Ombudsman for Business Boris Titov, which favours borrowing heavily and spending heavily to kick-start a virtuous circle of growth and investment.

The third force is a circle of Kremlin insiders led by Minister of Economy Maxim Oreshkin, who has risen to prominence in the last year. This is a hybrid view that embraces liberal economic policy, but also the stoligarch system of public spending on government priority projects. It splits the economy into the apolitical where free market rules reign, and the political where the Kremlin dictates the rules.

An example of this hybrid approach is CBR governor Elvira Nabiullina’s aggressive banking sector clean up, which is now touching even the wealthiest businessmen. At the same time both Gazprom and Rosneft have defied direct government orders from the Ministry of Finance to hand over half their profits to the state as dividends. In December their exemption from the rule was formalised as policy.

There is a fundamental tension in policymaking as Russia’s economy is increasingly being split into two: amongst the massive state-owned cash cows controlled by the oligarchs there is no policy at all, only a desire to grow their empires; however, the rest of the high volume, low margin “normal” economy is being left to its own devices and regulated by the liberals, who are doing their best to square this circle.

The key will be how successful the liberals are in making some changes. Currently most of the money generated in Russia is in the hands of the politically-connected oligarchs. If the apolitical part of the economy can be made to grow – and its potential remains enormous – it will dilute the negative effects of the political part and drive reforms by necessity, as it did in the boom years. But without growth and reform, Russia will drift towards a stagnation that could last decades.

Macro-economic outlook

• Growth

Russia’s economy is out of recession with the economy putting in three consecutive quarters of growth in 2017 and likely to end the year close to the government’s target of 2% growth. But the recovery remains uneven, with most hopes placed on consumption driving faster growth in 2018.

The petro-fuelled growth model was already exhausted in 2013 when growth fell to zero (see chart). Without major reforms to unblock structural restraints, growth will be constrained to around 2% for the foreseeable future, which for an emerging market means virtual stagnation.

In addition to reforms Russia needs major investment, but the toxic political atmosphere caused by sanctions makes an upswing in inbound investment unlikely.

Foreign companies that have already invested into Russia continue to reinvest in expansion, but few new players are entering the market. Foreign direct investment (FDI) was up in 2017 to $17bn from a low of about $6bn during the crisis years, but that is still a fifth of its peak in the boom years and most of it is Russian flight capital returning home via offshore havens such as Cyprus.

Fixed investment was also rising at the end of 2017, but again this is largely driven by the state’s investment into a few mega-projects such as the Power of Siberia gas pipeline, linking Russia and China, or the Ketch Bridge linking the Crimean peninsular to the mainland.

The bottom line is Russia’s economy continues to tick over, fuelled by the residual income from raw material and hydrocarbon exports.

• Inflation

Inflation halved over 2017 from 5% in January to 2.5% in December – a post-Soviet low. The rapid fall in inflation in the last quarter was largely driven by food price deflation that comes on the bank of an all-time high harvest. These conditions are not guaranteed to repeat themselves in 2018 and the Central Bank of Russia (CBR) has retained a cautious stance, expecting inflation to return to its target rate of around 4%, which is also the official forecast for 2018.

Russian inflation expectations remain volatile. According to a CBR survey, one-year ahead expected inflation picked up to 9.9% in October (from 9.6% in September). The regulator believes that the people do not believe in the low inflation levels yet and upcoming seasonal price growth will also push the rates up.

• External sector

Until relatively recently Russia ran a triple surplus (federal budget, current account and trade) and while the federal budget has been in deficit for two years now, the current account may soon slip into deficit on the back of falling oil prices and rising machinery imports.

Still, trade expanded in 2017, with exports in the first three quarters up by almost a quarter to $255bn, or some $52bn more than the previous year. Exports have been improved by the higher than expected oil prices that have hovered over $50 for the second half of the year. The outlook for both the current account and trade balances has improved after the OPEC+ oil production cut deal was extended throughout 2018 in December. This should keep oil prices in the $50-$60 band – a level at which Russia Inc is almost in profit.

While trade with Europe has fallen by €100bn over the last three years to €228bn, this has been offset to a large extent by growing trade with other emerging markets. Trade with China was expected to end 2017 at $80bn and will hit $100bn in the next two years. The mutually expressed goal is to reach $200bn by 2020.

• Retail

An improving consumer environment in Russia should provide support for the country's retailers and consumer goods companies in 2018, Fitch Ratings said in December. However, any turnaround will be moderate at best and the benefit for local producers could be partially offset by increased competition from imports.

Retail sales started to grow in the second quarter for the first time since 2014, with both non-food and food sales positive. But money is tight and consumers are very price conscious, with a third preferring to save rather than spend, according to polls in December. Consumption is at best anaemic and is only expected to pick up in the second half of 2018.

The frugal mood favours the big retail chains that have been aggressively offering promotions and discounts to win more market share. There has been a consolidation in the retail sector, boosting the revenues of the leading players. Sanctions imposed on EU imports have also favoured local producers that continue to invest and build up their business.

While falling inflation has led to a rise in real wages, real disposable income (excluding food and utility bills) is flat. Disposable incomes are expected to grow in 2018, but modestly. There will be no return to the consumer-driven boom that was the hallmark of the noughties.

• Banks

The banking sector is coming out of the other side of three years of hell, and has now chalked up two years of profit.

The summer of 2017 was marred by a near-miss banking crisis after two major private banks, Financial Corporation Otkritie and Binbank, went bust and had to be bailed out. While that caused the entire sector to record a whopping RUB322bn loss in September m/m, the profitably of the whole sector was still ahead of the previous year.

But there are still many problems with the banking sector. The CBR is still only half way through its clean up of the sector and increasingly taking on the larger, well-connected banks, which are too big for even the CBR to bail out.

Also the vast majority of the profits are being earned by state-owned retail behemoth Sberbank, which enjoys considerable monopolistic advantages.

Falling interest rates have improved net interest margins (NIMs), allowing banks to earn their way out of trouble, but the credit business remains depressed.

Consumer lending has recovered and was growing in double digits by the end of 2017 but has still not made a noticeable impact on retail turnover, which remains anaemic. By October the rate of growth of consumer lending was 10% – faster than the rate of growth of incomes – worrying the CBR, which said it may introduce tighter limits on consumer loans in 2018 to slow the pace of growth before a bubble appears.

Whereas in 2016 retail lending accounted for only 15% of nominal growth in retail trade, by September the contribution of retail lending to annual growth of retail trade had risen to 80%, which resembles the situation in 2012-13, after which the CBR introduced the first round of tighter regulation of retail lending. Average household indebtedness was also up to five months of average salary from two months in 2009.

Corporate lending on the other hand has stalled, as the cost of borrowing is still too high in the face of weak domestic demand. Still, corporate lending should pick up in 2018 as the CBR continues to cut rates.

Sberbank has been outperforming the bank sector by a wide margin. In July-September, the lender posted a stunning 64% year-on-year increase in net IFRS profit to RUB224bn ($3.8bn), beating consensus expectations by 16%.

In 2018 a new problem may start to make itself felt: the slowdown has led to a concentration of assets and revenues in fewer hands and the same is true for the banking sector. Large Russian businesses and domestic banks have become closely and dangerously interdependent, according to rating agency Standard & Poor's. The ratio between loans granted to the 20 largest borrowers and own-capital is one of the largest in the world at 226%, S&P noted. A default of one large borrower could send shockwaves through the whole banking system.

And finally the summer’s crisis means that the share of state banks in the sector has risen again and is now 70% by assets. At the same time the depressed state of the equity market means the prospects for more partial privatisation of state-owned banks remains unlikely.

• Industry

Industrial production moved back into growth mode in 2017, but it remains very fragile. That bodes badly for 2018 as the economy has not built up any momentum for a recovery and industry at least is still living hand to mouth. Industrial production growth in September was only 0.9%.

The service sector on the other hand is showing robust growth and put in a steep rise in November, with an increase in new orders and business activity growth accelerating to their strongest levels since January, according to the IHS Markit report of December 5. The IHS Markit Russia Services Business Activity Index hit 57.4 in November, up notably from 53.9 in October, and still comfortably above the 50-point mark indicating expansion. 

"Overall, the IHS Markit Russia Composite Output Index indicated a stronger increase across both manufacturing and service sector firms, with growth in the latest survey period at an eight-month peak," Markit economist Sian Jones commented.

The results are more evidence of a patchy return to health unevenly spread across the economy. In general the apolitical parts are improving thanks to stiff competition and a process of consolidation that has concentrated limited resources in the hands of the leading companies. However, the political parts of the economy are suffering from the lack of structural reforms.

The stand out industrial story in 2017 was the return to growth of the automotive sector where car sales grew 10 months in a row through to the end of the year following two years of contraction.

• Oil and gas

Russia and Opec decided to prolong the coordinated oil supply cuts to the end of 2018 at a meeting in Vienna on November 30, with Russia maintaining its 300,000 barrels a day cut.

Russia’s oil production has been constrained by the deal at just under 11mn barrels a day, with a result that is good for the price of oil (and so the budget), but not so good for the producers, which have been bitterly complaining.

The Opec+ deal helped Russia to accumulate more fiscal reserves to cover the budget deficit, gaining an additional RUB0.7-1 trillion in revenues due to higher oil prices.


Telecoms, media and technology remain by far the most dynamic part of the Russian economy. The essentially global nature of the business and Russia’s strong reputation as an innovator and developer mean the sector has been the least affected by sanctions.

Online commerce is benefiting from the “leapfrog” effect; as the existing infrastructure is of poor quality, companies are going straight to state-of-the-art solutions. With internet penetration more than 100% and the online retail community larger than that of even Germany, e-commerce makes any successful business extremely lucrative. While the real estate sector is on its knees, warehousing is the exception thanks to demand from e-commerce companies, helping boost the volume of new space by more than 50% in 2017.

E-commerce was up by 22% year-on-year to RUB498bn ($8.6bn) in January-June. The sector is expected to maintain this growth in 2018 and is already starting to disrupt traditional retail as shoppers turn from malls to phones to shop.

Telecom is one of the most mature sectors in the economy and is marked by fierce competition that has been catalysed by falling incomes. Russia's mobile phone operators were preparing for price wars at the end of 2017, and 2018 will be marked by companies’ search for innovative products and services to maintain their revenue. Data has already overtaken voice in 2017 as the main source of income and the sector continues to evolve very fast.

The bugbear for all TMT companies in 2018 is the infamous "Yarovaya Law" data storage requirements that could impose costs of up to RUB100bn ($1.7bn) per operator over a three-year period. The government is insisting that companies bring all their information on their Russian clients onshore and keep recordings of everything for six months, which would require massive investment in new storage facilities by all TMT companies. The requirements are still being debated but some requirement is likely to appear in 2018.

Also, the 5G telecoms spectrum is likely to be launched in 2018, distributed via cash auctions, which will put an additional funding load on the leading companies.

Real estate and construction

The real estate sector is both one of the three main economic drivers (investment and consumption are the others) and the sector has been hardest hit by the crisis.

2017 saw a 15-year low for construction, according to JJL, but appears to have reached bottom now and will start to recover in 2018. While the residential sub-sector has been propped up by government-subsidised mortgage loans, there was only one new class A office completion in Moscow in 2017 and no large-scale commercial development completions at all.

However, as companies start growing again, rental rates are rising and vacancy rates have already fallen to 14% in 2017, down 3.5pp from the end of 2014, according to a study by JLL that predicted vacancy rates will continue to decline to 11.5% by 2021. These factors combine to bolster developers’ confidence and 2018 should see the launch of new commercial and office projects.

Residential development looks even more attractive. Russian consumers reacted positively to the green shoots of economic recovery by increasing their spending on large-ticket items, with the housing sector among the first to benefit. Residential developers have been seeing a fairly resilient recovery in consumer demand since mid-2016, driven by the steady rise in mortgage borrowing. More CBR rate cuts will only add to the demand over the next two years.



Fiscal policy outlook

The cash-strapped Russian government has spent much of the last two years casting about for new sources of revenue following the collapse of oil prices in 2014. Spending has fallen by 12% between 2014 and 2017, but it has resisted raising taxes on companies or the population for political reasons.

The federal tax authority completely overhauled its IT system, improving efficiency and even enabling a cosmonaut on the International Space Station to pay his taxes online from space for the first time ever.

A key part of government fiscal policy is the indexation rate it sets for public wages and pension payments. Both these payments were severely curbed after 2014, with indexation set below the level of inflation, but both are creeping up again as the presidential elections in 2018 loom.

The state has also been driving investment with numerous large projects and this will continue in 2018. Fixed asset investment grew at 4.2% y/y over the first nine months of 2017, dominated by the state.

In November, Gazprom's management board approved a RUB1.27 trillion ($18.3bn) investment programme for 2018. In 2019, the gas giant's investment is supposed to go up by another 10% to RUB1.4 trillion, which makes the total value of the company's investment over the next two years comparable with its market capitalisation, which currently stands at RUB3.2bn. Much of this will be spent on developing new energy resources and building pipeline infrastructure to link Russia’s gas distribution network to China.

These projects, led by the state champions, are likely to continue in 2018 as in December the government relaxed the demand that all state-owned enterprises pay out 50% of profits as dividends, saying the amount the biggest companies have to pay will be decided on a case-by-case basis.

Monetary policy outlook

Since the CBR hiked overnight rates to 17% in the midst of the 2014 ruble meltdown the regulator has been steadily cutting rates, and at its regular meeting in October, the CBR cut its key rate again by 25 basis points to 8.25%.

The CBR’s job has been made easier by the rapid fall in inflation, driven by food price deflation, to a record low of only 2.5% in November, easily blowing past the CBR’s 4% target for the full year.

The central bank is committed to cutting rates and has a medium-term target of 4-5%. While more cuts are expected in 2018, analysts do not expect this target to be hit in 2018 and the consensus forecast is for rates to finish the year at 6.95% as the central bank worries that inflation will return.

Consumers remain unconvinced that the current low inflation is here to stay. Food deflation in the second half of 2017 was partly due to an all-time record harvest of 331mn tonnes of grain, but there is no guarantee that the 2018 harvest will be as bounteous.


Markets outlook

• Ruble

The outlook for the Russian ruble is uncertain in 2018 as its value remains dependent on the price of oil. So far the signatories to the Opec+ production cut deal have been sticking to their promises and the value of oil rose from the $40 per barrel range to the $50 range in 2017, propping up the value of the ruble. The deal was renewed for another six months in November 2017 so the short-term outlook for the ruble remains good and the currency was trading at about RUB60 to the dollar at the close of 2017.

However, the value may fall early in 2018 if the US follows through on a threat to impose sanctions on foreign investors buying Russian domestic sovereign debt.

“It is extremely difficult to foresee how the market might react in terms of the size and timing of the potential outflows from RUB sovereign debt, and the consequent pressure on the RUB. Nonetheless, our rough estimate is that should restrictions be placed on new debt purchases, the potential outflow from OFZs could be RUB220-440bn ($4-8bn). An initial reaction in USD/RUB could be a slide to around 65+, depending on the level of market panic and whether local investors also participate in the capital outflow,” Aton said in its annual strategy report.

At the same time Russia’s current account surplus has been shrinking from a $26bn surplus in the first quarter to marginally positive in the middle of the year. This makes the value of the ruble a lot more vulnerable to small changes in capital flows, and if the trade balance becomes negative on falling oil prices, or a poor harvest, then this could pull the value of the ruble down as well.

However, the Central Bank of Russia (CBR) and Ministry of Finance have already started interventions in the market again to smooth the fluctuations in the currency’s value, a policy that is expected to continue in 2018. The “budget rule” has been reintroduced that requires excess revenues to be sent to the National Welfare Fund when oil prices are over $40. In 2017 the finance ministry bought $15.5bn because of the rule, but in 2018 assuming an oil price of $55 the rule means it will buy some $28bn to add to gross international reserves (GIR).

• Stocks

Russia’s stock market re-rated in 2016 as the recession ended, political tensions eased somewhat and the best names became too cheap to ignore. The dollar-denominated Russia Trading System (RTS) index gained 52% in 2016 on $1.2bn of inflows thanks to a “Trump bump” after the election, making it one of the world’s best performing markets. Investors were convinced that the new president would quickly remove sanctions on Russia, which did not happen.


In comparison 2017 has been the worst year for Russian equities since 2013, with Russian-dedicated funds seeing a $1.4bn outflow YTD as of December 1, 2017.

The year started with a sell-off in the first quarter of about 15% and the indices have spent the rest of the year trying to claw back their early losses. As 2017 drew to a close the markets were down only a few per cent on January and will probably end the year flat, or up mildly. As of the end of the year, Russian stocks were trading with a 12-month price-to-earnings ratio (p/e) of 8.4x, versus a 21.3x p/e average for global emerging markets. Russia has seen cheaper p/e multiples and is close to the long-term average for prices, limiting upside for the index to around 15% for 2018, says BCS.

The RTS has been range bound for most of 2017, fluctuating around the 1,000-1,100 mark – less than half its May 2008 all-time high of 2487.

The problem is investors have been spooked by the toxic geopolitical environment and have avoided Russian equities, although that was beginning to change as the year wore on with two IPOs and a string of SPOs attracting investment from overseas.

In 2018 the market is likely to remain range bound as little is expected to change and indeed the US sanctions regime on Russia may even be tightened somewhat, although these sanctions will focus on individuals close to Putin rather than corporate names. BCS expects the RTS to trade in the 1,050-1,250 range, which represents a small upside for index trackers. The consensus forecast is for the RTS to end 2018 at 1,300, a 13% upside from December levels.

However, at the corporate level things are very different and the best performing stocks have seen their share prices double. The crisis has caused a consolidation across many sectors and the leading companies have dramatically improved their market shares and seen revenues rise strongly as a result. At the same time, with poor domestic demand due to the slow rise in real income levels, companies have also switched from expansion to focusing on improving efficiencies and profitability, which has also driven up earnings.

These trends will continue in 2018, with earnings expected to grow by 15% on aggregate as economic growth continues (assuming $65 oil and 1.8% GDP growth), before slowing to single digits again in 2019 as the catch-up growth peters out.

It remains a stock pickers market, with the state-owned retail giant Sberbank by far investors’ most popular choice again this year. Even after Sberbank took in record-breaking profits in the third quarter of 2017, the bank forecasts that profits will reach RUB1 trillion by 2020. The bank’s stock price doubled in 2017 and VTB Capital (VTBC) estimates the bank’s share price still has a 43% upside from December levels.

Similar stories can be found in most sectors. Banking, construction and oil and gas are the most popular sectors for portfolio investors, followed by technology and retail, and some good individual stories in steel and utilities. However, no broad-based growth in the index is expected until large-scale reforms are implemented or sanctions lifted, neither of which are expected to occur in 2018.

Finally, investors continue to focus on companies that are returning profits to shareholders. Russian companies now sport the highest dividend yields in the world, paying out a 5% yield on average, twice the MCSI EM average. These companies have continuously outperformed the market for several years and are expected to continue to do so in 2018.


Russian 12 month dividend expectations >5%




Price, RUB/s


Enel Russia





metals & mining



Rostelecom pref.




Norilsk Nickel (DR)

metals & mining




metals & mining



AFK Sistema*








Federal Grid Co.








Tatneft pref.

oil & gas
















oil & gas








oil & gas








Metals & mining



Moscow Exchange




LSR Group

real estate



Etalon Group

real estate








oil & gas




metal & mining



* high uncertainty  Source: Bloomberg, BCS



• Bonds

Russia’s domestic bond market has been flying as the combination of high yields and macroeconomic stability has been irresistible to international investors.

The share of Russian treasury bonds held by foreign investors reached an all-time high at the beginning of November, according to the CBR, as foreigners’ share in ruble-denominated OFZ bonds climbed to 33.2% as of October 1 from 31.6% on September 1.

Foreign investors increased their holdings of Russia sovereign Eurobonds to $14.562bn as of October 1, which accounts for 36.6% of all the Russian Eurobonds. As of July 1, foreigners’ share in Russian Eurobonds was at 31.7%.

Russia’s solid macroeconomic background, supported by higher oil prices, and the shrinking supply of Eurobonds mean that these instruments will remain attractive in 2018. The total volume of the Russian Eurobond market is around $173bn and it continues to shrink as the state has reduced its borrowing programme and companies are redeeming their bonds faster than they are issuing new ones. That said, more sanctions and a collapse of the OPEC+ oil production cut deal remain key risks.



The main danger to the OFZ market is that the US might extend the sanctions regime to include limits on foreign investors buying Russian domestic debt, which would be extremely painful. The Kremlin clearly takes this danger seriously and has already started preparing the ground for yuan-denominated issues to provide a mechanism for switching to Asian markets if these sanctions appear.

With reduced access to international capital markets thanks to the financial sanctions, the state and corporate are dependant on the domestic market for funds.

At the start of 2017 the Ministry of Finance said it would cover the federal budget deficit by issuing RUB1.1 trillion of OFZ treasury bonds each year for the next three years, ensuring plenty of supply. But as the economy performed better than expected the ministry had already cut the issuance target for 2017 to around RUB600bn by the end of the year and similar reductions are expected in 2018.

That will leave more room for corporate issues, which have also been growing steadily thanks to the falling cost of borrowing. In October alone a total of RUB280bn ($4.8bn) of bonds was placed by Russian companies, a 250% increase year-on-year.

CBR's plans to cut the key interest rate even further in 2018 will encourage more issues, but as inflation may return to its 4% average in 2018 from the end of 2017 record lows of 2.5%, the conditions in the bond market may not be as benign in 2018 as they have been in 2017.

Russia’s Eurobonds have been going in the opposite direction. In October, there were only two Eurobond placements by Russian companies for a total of $426mn, compared with seven placements for a total of a total of $2bn in September and six placements for a total of $3.2bn in October 2016. The Eurobond segment is oversaturated as it doubled in January-October to $18.5bn, year-on-year.