Russia Fundamentals Improving But……..

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Russian fundamentals are improving with higher oil prices feeding into the economy.  However, it’s worth noting that the correlations between oil prices and the ruble as well as Russian equities have fallen.

POLITICAL OUTLOOK

The ruling party overwhelmingly swept the gubernatorial races this past weekend.  United Russia’s candidates won in the first round in all 15 regions where governors were elected.  However, voter turnout was very low.

Yet the opposition scored a modest victory.  A pro-democracy bloc won control of district councils in Moscow.  Local press reports that opposition candidates were on track to win a majority of seats in 14 of the more than 100 district councils in the capital.

The next presidential election will be held in March 2018.  President Putin won his third term in 2012 and remains firmly in control.  State Duma elections last year gave an overwhelming victory to United Russia and its allies.  The post of Moscow mayor will be contested in September 2018.  In 2013, opposition leader Navalny almost forced a run-off vote while his supporters claimed voter fraud helped Putin’s incumbent appointee Sergei Sobyanin.

There’s not much doubt about how the 2018 elections will go.  President Putin will likely run for and win his fourth term.  These terms are now six years after changes were made to the constitution in 2011.  Navalny will most likely be barred from running against Putin due to a fraud conviction.

Relations with the West remain strained.  Sanctions related to the annexation of Crimea are unlikely to be lifted anytime soon.  In July, the US congress overwhelming voted to broaden these sanctions and limited the president’s ability to suspend or terminate them.  The US and Russia have since been engaged in a tit-for-tat squabble by ejecting diplomats.

Russia scores surprisingly well in the World Bank’s Ease of Doing Business rankings (40 out of 190).  The best subcomponents are registering property and enforcing contracts, while the worst are dealing with construction permits and trading across borders.  Russia does less well in Transparency International’s Corruption Perceptions Index (131 out of 176 and tied with Iran, Kazakhstan, Nepal, and Ukraine).

ECONOMIC OUTLOOK

The economy is starting to pick up despite the ongoing sanctions.  GDP growth is forecast by the IMF at 1.4% in both 2017 and 2018, up from -0.2% in 2016.  GDP rose 2.5% y/y in Q2, the strongest rate since Q4 2013.  As such, we see upside risks to the growth forecasts, especially in light of firmer oil prices.

Price pressures are falling, with CPI decelerating to a record low 3.3% y/y in August from 3.9% in July.  This is below the 4% target, and came sooner than the central bank expected.  PPI inflation has also fallen sharply, suggesting little in the way of pipeline price pressures.

This supports the case for lower rates, and we believe the central bank will cut 50 bp to 8.5% when it meets this Friday.  Governor Elvira Nabiullina said “We see room to reduce rates, and there will probably be a discussion about cuts of 25 or 50 bp.”  A small handful of analysts look for a 25 bp cut this week.

Banking sector concerns may be easing.  Stresses led the central bank to take over private bank Otkritie last month, the biggest rescue since 2011.  In addition, the central bank said it will provide support for other lenders in an effort to preserve market confidence and so markets have calmed a bit.  Bank Otkritie was the first to be taken over by a government-backed fund set up by the central bank to help consolidate the banking sector.

Fiscal policy was loosened due to low oil prices.  Oil and natural gas revenues account for nearly 45% of federal government revenue.  While both are off their lows, prospects for greater supply of oil and gas are likely to prevent prices from moving much higher.  The budget deficit came in near -4% of GDP in 2016, up from -3% 2015 and -1% in 2014.  It is expected to narrow to -2% of GDP in 2017 and -1.5% in 2018, but much will depend on oil prices.

The external accounts should improve.  Low oil prices have hurt exports, but the sluggish economy has helped reduce imports.  Both of those trends are reversing, but we think the improvement in exports will dominate.  The current account surplus was about 2% of GDP in 2016, and is expected by the IMF to widen to 3.3% in 2017 and 3.5% in 2018.

Foreign reserves continue to rise after falling over the course of 2014 and 2015.  At $420.5 bln in August, they are the highest since November 2014.  Reserves cover over 17 months of import and are nearly 3 times larger than the stock of short-term external debt.  Governor Nabiullina said that the central bank is in no rush to boost reserves, which she noted is adequate by all international standards.  She added, however, that the bank may start replenishing reserves after inflation and inflationary expectations stabilize and the key rate is at long-term equilibrium.

INVESTMENT OUTLOOK

The ruble is still performing well this year after a stellar 2016.  In 2016, RUB rose 20% vs. USD and was behind only the best performer BRL (+22%).  So far in 2017, RUB is up 6% YTD and is compares well to the best performers MXN (+17%), THB (+8%), CLP (+8%), SGD (+7.5%), TWD (+7.5%), and KRW (+7%).  Our EM FX model shows the ruble to have STRONG fundamentals, so some outperformance is likely to pick up.

USD/RUB had seemed to be on track to test the April low near 55.70.  However, the pair has reversed higher after being unable to break below the 56.80 area.  If the dollar’s gains can be extended, retracement objectives to look for from the August-September drop come in near 58.3360 (38%), 58.8150 (50%), and 59.30 (62%).  We note that the correlation between the ruble and oil prices has fallen below 0.40, well below the 0.80 seen in 2015 and 2016.

Russian equities are underperforming EM after a strong 2016.  In 2016, MSCI rose 47% vs. 7% for MSCI EM.  So far this year, MSCI Russia is -4% YTD and compares to +28.5% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Russia at an UNDERWEIGHT position.  We note that the correlation between Russian stocks and oil prices has fallen near 0.10, well below the 0.70 seen in 2015 and 2016.

Russian bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -78 bp YTD.  This is behind only the best performers Brazil (-153 bp), Indonesia (-148 bp), and Peru (-97 bp).  With inflation likely to remain low and the central bank still in easing mode, we think Russian bonds can continue outperforming.

Our latest sovereign ratings model showed Russia’s implied rating steady at BBB-/Baa3/BBB- after improving a notch last quarter.  S&P and Moody’s ratings of BB+ and Ba1, respectively, still have some upgrade potential.  Fitch’s investment grade BBB- rating, which seemed too generous last year, now seems to be correct.