Low Oil Prices to Weigh on Russian Growth

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The Central Bank of Russia has accelerated its easing cycle.  With oil prices falling to new lows for the year, we think policymakers are becoming more focused on boosting growth ahead of 2018 elections.  POLITICAL OUTLOOK

President Putin remains firmly in power.  He has effectively neutered the opposition and so he is likely to run for and win a fourth term in March 2018.  For instance, the conviction of popular opposition leader Alexey Navalny on embezzlement charges was recently upheld by the courts, making it unlikely that he can run next year.

Despite hints of a possible US-Russia rapprochement, Trump’s stance on Russia remains frosty.  The FBI investigation into likely Russian interference in the US elections remains ongoing.  Meanwhile, relations with the EU also remain strained over Crimea, and this week’s German-Russian summit yielded nothing of substance.  As such, economic sanctions are unlikely to be lifted anytime soon.

Russia continues to support Syrian strongman Assad even as the civil war drags on.  President Putin is speaking with Presidents Trump and Erdogan this week in an effort to break the impasse. However, large obstacles to a deal remain in place and so a viable solution is unlikely to be seen anytime soon.

ECONOMIC OUTLOOK

The economy is slowly recovering.  GDP growth is forecast by the IMF to accelerate to 1.4% in both 2017 and 2018 from -0.2% in 2016.  The OECD is a little more pessimistic, with forecasts of 0.8% and 1.0%, respectively.  GDP rose 0.3% y/y in Q4, the first positive reading since Q4 2014.  However, this most recent swoon in oil prices will likely weigh on growth.

Price pressures are falling, with CPI decelerating to 4.3% y/y in March.  This is the lowest rate since June 2012, and is expected at 4.2% in April.  The central bank targets 4% inflation by year-end, and the speed of disinflation would seem to support the case for further easing.  The central bank cut rates by a larger than expected 50 bp to 9.25% last month.  We think the strong ruble was a major factor in the decision.  The next policy meeting is June 16, and another 50 bp cut is possible then.

Russia has abided by its pledge to curtail output in conjunction with OPEC.  Russian officials have signaled that it would be in favor of extending the deal by another six months, as many in OPEC have advocated.

Given Russia’s dependence on oil for budgetary revenue, the fiscal situation has worsened in recent years.  The budget deficit came in at -4% of GDP in 2016, up from -3% in 2015.  It is expected by the OECD to narrow to -3% in 2017 and -2.3% in 2018.  Given the likelihood of a pre-election spending spree, we see upside risks to these deficit forecasts.

The external accounts remain solid.  Lower oil prices and sanctions have hurt exports, but the sluggish economy has helped reduce imports.  The current account surplus was about 2% of GDP in 2016, down from 5% in 2015.  The IMF expects it to recover to 3.3% in 2017 and 3.5% in 2018.  Foreign reserves rose to $400 bln in April, the highest since November 2014.  They cover 17 months of import and are almost 3 times larger than its stock of short-term external debt.

INVESTMENT OUTLOOK

The ruble continues to outperform.  In 2016, RUB rose 20% vs. USD and was behind only BRL (+22%) and followed by ZAR (+13%) and COP (+6%).  So far in 2017, RUB is up 6% YTD and is behind only MXN (+9%), TWD (+7%), and KRW (+6.5%).  Our EM FX model shows the ruble to have STRONG fundamentals, so this year’s outperformance is to be expected.

The Finance Ministry introduced an FX purchase program back in February.  Officials said the FX purchases were aimed at reducing the impact of oil price fluctuations on the economy and the budget.  The central bank will buy FX when oil is above $40/bbl, and will sell FX when it’s below $40.  Note that the correlation between RUB and Brent oil has been rising recently to almost 0.50.  While down from the high for 2016 above 0.80, the correlation is getting stronger.

For USD/RUB, a break of the 58.12 area is needed to set up a test of the March 14 high near 59.62.  After that is the December 30 high near 61.72.  Official comments suggest that the desired exchange rate is somewhere near 60.

Russian equities have done poorly after a stellar 2016.  In 2016, MSCI Russia was up 47% vs. 7% for MSCI EM.  So far this year, MSCI Russia is -7% YTD and compares to +14% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Russia at an UNDERWEIGHT position.

Russian bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -71 bp YTD.  This is behind only the best performers Brazil (-113 bp), Colombia (-91 bp), Indonesia (-87 bp), and Turkey (-86 bp).  With inflation likely to continue falling, allowing the central bank to cut rates several more times this year, we think Russian bonds will continue outperforming.

Our own sovereign ratings model shows Russia’s implied rating improving a notch this quarter to BBB-/Baa3/BBB-.  S&P and Moody’s ratings of BB+ and Ba1, respectively, appear to have some upgrade potential now.  Fitch’s investment grade BBB- rating now seems to be correct.