The Russian equity market has been doing very well this year, but a late breaking “Santa rally” kicked in in the last month of the year and analysts at Sberbank have upgraded their end of 2020 target for the dollar denominated Russia Trading System (RTS) to 1,800 – its highest level in over five years.

“The [Russian equity market] is the best performer by far this year, and is not overheated yet,” Cole Akeson, an analyst with Sberbank CIB, said in a note on December 17. “The Russian equity market has delivered a 47% total return in 2019 versus 12% for emerging markets.”

Due to seasonal factors like tax payments and a rush by government to spend budgets before the end of the year, Russia’s stock market usually rallies some 20% in the last months of the year through to around Easter the next year, returning a consistent 20% to investors in what has been dubbed the Santa rally.

The rally this year has been fuelled by fading fears of new and harsh US sanctions on Russia, as Washington is increasingly distracted by the impeachment process of US President Donald Trump and a scandal centred on his dealings with Ukraine.

However, as bne IntelliNews wrote in a recent piece for Russia Matters, more important than politics is the improving fundamentals of Russian companies, benefiting from an ongoing economic recovery since the crisis years of 2014-2016, albeit a modest one.

This year's rally has been based on various one-off effects like sanctions fears and also big increases in dividend payments by leading state-owned enterprises (SOEs). Gazprom unexpectedly doubled its dividend payout in May to almost the mandatory 50% of profits, as ordered by the Ministry of Finance; its stock soared 30% overnight. Shares of the gas behemoth have been amongst the best performing on the market this year, up some 76% as of the start of December, but the stock is unlikely to rise as strongly next year, despite another mooted increase in dividends to reach the 50% of profits payout.

The entire market has been through a re-rating as investors realise that most Russian stocks had become “too cheap to ignore” as on top of receding political risk problems, companies' earnings per share continue to improve thanks to a consolidation of the economy caused by the crisis years. The buying began with X5 Group, Russia’s biggest supermarket chain, in 2017, which saw its share price double that year, and has continued through to this year when the biggest SOEs are now re-rating, although they carry the very biggest political risks.

The equity capital market has been trapped in a trading band of approximately 900-1,300 for most of the last five years since sanctions were imposed in May 2014 following Russia’s annexation of the Crimea. But now the market appears to have definitely broken out of this band and fundamentals are starting to take over again in investors’ calculations of what a stock is worth.

“Still, it would be a stretch to describe the market as an investor darling,” Akeson wrote in a note. “The growth has come from a very low base following the events of 2014-15 and is well backed by fundamentals. We calculate that only a third of the market's 2019 return can be attributed to improved sentiment, while two thirds is down to pure fundamentals, such as earnings upgrades and lower interest rates.”

As bne IntelliNews has been reporting all year, both bank and corporate profits have been rising steadily this year after taking off in the middle of 2018.

And company earnings are likely to continue to improve in 2020. Russia has just finished the third quarter earnings reporting season and as bne IntelliNews reported two thirds of the leading stocks reported income that surprised on the upside, beating management guidance.

The RTS has rallied strongly this year, but stepped up again to have returned 40% YTD as of December 13 to reach 1,497 – its highest level in six years. The last time the RTS was above 1,500 was on October 23, 2013.

But now Sberbank has made the bold prediction that the RTS will end next year at 1,800, a level it hasn't seen since May 8, 2011, almost a decade ago.

“We set our end-2020 RTS target at 1,800 points. Rapid disinflation is set to bring down the cost of debt. The CPI plunging to around 2.5% in early 2020 is likely to push the CBR to deliver more rate cuts in an attempt to meet the 4% inflation target. The key rate could fall to 5.5% or even lower. We also expect the equity risk premium to continue normalising toward the historic average of 6%. Thus, we project some 250 bps of contraction in cost of equity, which translates into a P/E expansion from 6.7 to 8.0 (+20%). A 7% dividend yield increases the anticipated total return to 27%,” Akeson said.

On the last point, Russian companies are already paying twice as much as the average benchmark MSCI EM index stocks as dividend yields this year, but analysts are expecting this year’s Russian average dividend yield to rise slightly from 6.7% to 7% next year that will help lift the market a little bit higher.

External factors could also help lift Russian shares in 2020. Fears of a global recession that were worrying investors in the third quarter receded somewhat following the annual IMF meeting in October, according to the Institute of International Finance (IIF), and although the world’s economy will slow, it will probably avoid a recession.

“Developed and emerging economies alike are witnessing very low inflation by historical standards. Meanwhile, the global economy is going through a synchronised slowdown, with countries producing 90% of global GDP seeing lower growth in 2019 than in 2018. In such an environment, policymakers could launch new stimulus programmes without fear of meaningful negative side effects. However, with near-zero yields in many developed markets, the hunt for yield should support EM local currency bonds and equities,” says Akeson. That will help Russian stocks and bonds thanks to the high yields both are paying relative to the rest of the world.

But as the current Russian rally is driven more by a re-rating to the new realities of fading political risk and investors adjusting to the improved earnings per share the leading Russian companies are reporting, rather than a fundamental improvement in the Russian economy – with growth expected to end 2019 at about 1% and not rise above 2% in 2020 the Russian economy is still stagnating – investing in Russia remains a stock picking exercise.

This year the outperforming sectors were banks (especially Sberbank and Tinkoff, which remain investors’ darlings) and utilities, a sector that is currently going through a big reform. In the last months of the year telecoms have rallied strongly as well. The dogs have been the consumer sector held down by six years of decaying real incomes and the metal and mining sector after metal prices collapsed this year because of falling demand from China.

Sberbank says that the main themes for 2020 will continue to be investing into the stocks with the highest dividend yields, which have consistently outperformed the market for all the last five years, and risk premium compression.

“Cheaper stocks with strong free cash flow generation and rising payouts are set to benefit more than others. Our top picks include oil companies Lukoil and Tatneft, leading metal producer Norilsk Nickel, Russia’s top internet company Yandex and real estate developer LSR Group,” says Akeson.

But political risks remain significant as US politics have become so unpredictable under Trump and other analysts are more cautious. At the same time analysts seem divided as to how important the rise of earnings are vs the reduction in the political risk premium. And there are always the oil prices, which following a new OPEC+ deal in December look like they will be supported, but oil prices are impossible to predict.

Julian Rimmer, a veteran trader of Russian stocks, warns investors to make use of the rally to unwind their overweight positions as the year comes to an end. “Russia is due a duff year,” Rimmer said in a note emailed to clients.

BCS Global Markets advises investors to play the swings, buy on the down days and sell on the upswings.

“The 1370-1490 range corresponds to a fundamental Hold zone for the Index through mid-2020,” BCS GM said in a note. “Hence, the Buy territory is below 1370 and the Sell zone is above 1490. The mid-range for the Hold zone is 1430, which we also reiterate is a fundamentally justified profit taking point in our view.”