Russia to Cut 25 bp As Oil Prices Soften

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The Central Bank of Russia is expected to cut 25 bp this Friday.  The recent drop in oil prices is concerning, and should keep the bank in cautious easing mode.

POLITICAL OUTLOOK

US-Russia relations remain frosty as more sanctions may be seen.  The US Treasury Department just released a report required by Congress that identifies 210 Russian oligarchs and government officials with ties to the Kremlin.  According to Treasury Secretary Mnuchin, “There will be sanctions that come out of this report.”

Relations also remain strained because of the situation in the Middle East.  Most recently, the US and Russia are clashing over alleged chemical warfare by Syrian strongman Assad.  US Ambassador to the UN Haley said Russia is blocking a UN Security Council statement on the matter.  The ties between Russia and Syria run deep, as the two became allies during the Cold War.

Elections will be held on Sunday March 18.  Opposition leader Alexei Navalny has been banned from running for president.  As such, there is no viable opposition candidate and Putin is likely to win by a large margin.  Indeed, the opposition has called for a boycott in order to highlight the lack of any credible alternatives.  The makeup of the State Duma is irrelevant, as it has become a rubber stamp.

This would be Putin’s fourth term overall, and his second term after presidential terms were extended from four to six years.  A president is limited to two consecutive terms, but there are no limits to the total number of terms.   That’s why Putin was able to run and win a third term after Dmitry Medvedev served as President from 2008-2012.

The problem is that there are no obvious successors to Putin.  When his fourth term ends in 2024, Putin will be 72 years old.  If Prime Minister Medvedev acts like a placeholder again, Putin would be 78 when the 2030 election rolls around.  While a lot can happen between now and then, it seems unlikely that Putin would run again in 2030.

Russia scores well in the World Bank’s Ease of Doing Business rankings (35 out of 190).  The best components are getting electricity and registering property, while the worst are dealing with construction permits and trading across borders.  Russia does much worse in Transparency International’s Corruption Perceptions Index (131 out of 176 and tied with Iran, Kazakhstan, Nepal, and Ukraine).

ECONOMIC OUTLOOK

The economy is finally picking up from a deep recession.  GDP growth is forecast by the IMF to accelerate modestly to 1.7% in 2018 from an estimated 1.5% in 2017.  GDP rose 1.8% y/y in Q3 and 2.5% y/y in Q2, the strongest rate since Q4 2013.  Monthly data so far in Q4 suggest some acceleration and highlights upside risks to the growth forecasts.

The recent drop in oil prices, if sustained, is concerning.  Despite efforts to diversify, the Russian economy is very dependent on oil and other commodities.  For now, Russia is complying with the OPEC-led output cuts that have been successful in boosting oil prices.  Brent oil had trouble sustaining a move above $70 and so perhaps it will trade in a $65-70 range for now.

Price pressures are low, with CPI inflation decelerating to a lower than expected 2.2% y/y in January from 2.5% in December.  This is an all-time low and moves further below the 4% target.  PPI inflation has been accelerating (cycle high 8.4% y/y in December), however, and suggests price pressures are rising.

The Central Bank of Russia is expected to cut 25 bp to 7.5% on Friday.  Indeed, markets are pricing in a year-end policy rate of 6.75%, followed by another 25 bp cut to 6.5% by mid-2019.  With inflation likely to pick up in H2, the central bank will likely front-load its easing in H1.

The fiscal outlook remains dependent on commodity prices.  The budget deficit came in at nearly -4% of GDP in 2016, but improved to an estimated -1.7% in 2017 as oil prices recovered.  The gap is expected by the OECD to narrow to -1.4% of GDP in 2018 and -1.0% in 2019, but the trajectory will depend in large part on oil and commodity prices.

The external accounts should improve modestly.  Over the past couple of years, low commodity prices hurt exports while the sluggish economy helped reduce imports.  Those trends are reversing, with exports growing over 25% y/y in Q4 so far.  The current account surplus was an estimated 2.5% of GDP in 2017, and is expected by the IMF to widen to more than 3% in 2018.

Foreign reserves have continued to recover since the sanctions hit, helped by higher oil prices.  At $453 bln in January, reserves are at their highest level since September 2014.  They cover nearly 19 months of import and are about 4 times larger than the stock of short-term external debt.  Thus, external vulnerabilities are relatively low.

INVESTMENT OUTLOOK

The ruble has done OK after a similar performance in 2017.  In 2017, RUB rose 5% vs. USD and was near the middle of the EM pack.  The worst performers were ARS (-14.5%) and TRY (-7%), while the best were KRW (+13%) and MYR (+11%).  So far in 2018, RUB is +1% YTD and remains in the middle of the EM pack.  The best performers YTD are COP (+6%) and MXN (+5.5%) while the worst are ARS (-5%) and PHP (-2.5%).

Our EM FX model shows the ruble to have STRONG fundamentals, and so it should start to outperform.  The correlation between oil and RUB has strengthened this year, and stands around -0.42 vs. -0.25 in early January.

Russian equities are outperforming EM after underperforming in 2017.  In 2017, MSCI Russia was flat vs. +34% for MSCI EM.  So far this year, MSCI Russia is up 11% YTD and compares to 2% YTD for MSCI EM.  This outperformance should ebb, 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 -35 bp YTD.  This is behind only Peru (-45 bp) and Brazil (-52 bp).  With inflation likely to remain low in H1 and the central bank expected to ease further, we think Russian bonds can continue outperforming.

Our own sovereign ratings model showed Russia’s implied rating steady at BBB-/Baa3/BBB-.  S&P’s and Moody’s ratings of BB+ and Ba1, respectively, appear to still have some upgrade potential.  Fitch’s investment grade BBB- rating now seems to be correct.