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Emerging Markets

Investing in Russia

Five reasons to be optimistic on Russian equities in 2019

January 2019

Hugo Bain, Senior Investment Manager

Russian equities outperformed Emerging Markets in 2018. In our view, we may see a repeat in 2019.

1. The sanctions threat is not as bad as many think

We have long argued that it is very difficult to effectively sanction Russia. And although sanctions can have an impact on Russian asset prices this tends to hurt western investors more than it does Russians, who tend to have relatively little exposure to their domestic equity market.  

For sanctions to really have an effect on the Russian economy, the West would need to restrict the country’s hydrocarbon exports. This is highly unlikely given the degree to which Europe relies on Russian oil and gas.

Bizarrely, I would argue that the complete removal of sanctions would be a bigger headache for Russian institutions than dealing with the current restrictions. Sanctions have paradoxically helped keep the government’s budget in surplus by keeping the rouble weak, because its expenditures are in the depressed local currency while revenues are in hard currency. Easing of sanctions could lead to a significant appreciation of the rouble – which is the opposite of what Russian policy makers want.

2. There is some good geopolitical news

Until recently we were expecting a significant escalation of tensions in the Syrian city of Idlib, where Russia is heavily involved in helping the Assad regime to dislodge Islamist rebels. However an agreement between Russia and Turkey that seeks to avoid a military offensive is a cause for hope, even if it proves only temporary.

Of course, there are other risks, notably that the UK imposes further sanctions on Russia-linked individuals and businesses in response to the Skirpal poisoning and that the US ratchets up its own attacks if it unearths evidence of Russian interference in the 2018 mid-term elections. Conflicts with Ukraine have also mildly escalated recently, but we are convinced these do not have an impact on economic or corporate fundamentals.

Furthermore, in our view Russia looks set to continue its participation in the OPEC+ cartel, which should stabilize oil prices in the coming year. The success of the fiscal rule and prudent monetary policy during the recent period of high oil prices has helped the rouble de-couple from oil prices, by building up foreign reserves. As a result and as demonstrated by the chart below, the rouble has not fallen with the oil price since October 2018.

Fig.1 - Sanctions and the Ministry of finances "fiscal rule" have decoupled ROUBLE and OIL

USD/RUB exchange rate plotted again USD price for a barrel of Brent crude.

Oil Price
Source: Pictet Asset Management, Factset, data as at 30th November 2018

3. Domestic economic picture is bright

Russia’s fiscal and monetary policies are exceptionally prudent. Both the finance ministry and the country’s central bank have pursued sensible policies over the past few years. Russia’s debt to GDP ratio is low, and the government’s budget is in surplus, thanks in part to sanctions as already mentioned.  One would be very hard-pressed to find an economist in disaccord with Russian monetary and fiscal policy.

4. Always focus on valuations and fundamentals

The figures speak for themselves. As illustrated in the chart below (Fig.2) below, the Russian equity market pays around 7 per cent in dividends compared to the 3 per cent yield on offer from emerging markets more broadly. This is a historically high premium.
Fig.2 - Russian dividend yields are at record relative levels

Forward 12 month consensus for dividend yields across major markets, in percentage

Russia dividend yield
Source: Pictet Asset Management, Factset, data as at 30th November 2018

Russian exporters are currently in a sweet spot for free cash flow generation, benefitting from a weak rouble and relatively favourable commodity prices. On top of this, and in large part due to sanctions, capex programs have been by and large curtailed and distributions policies are highly favourable to minority shareholders.

As for domestic firms, there are great businesses with solid fundamentals trading at near distressed valuations, and it is not unusual at all to find companies with double-digit dividend yields.

All segments of the markets are cheap.

 

Fig.3 - Dividend YIELDS are high relative to own history across all segments of the market

Both Russian exporters (energy/materials) and domestics (financials, utilities, IT, consumer) are paying record dividends

DY NTM
Source: Pictet Asset Management, Bloomberg, data as at 31st October 2018

5.  We don't need good news, just less bad news

It’s a dangerous forecast to make, but 2019 could well see fewer negative headlines about Russia, allowing investors to instead focus on the country’s attractive fundamentals. When this does happen, we believe a re-rating will be inevitable.