Russian stocks surged more than 20 percent from their mid-March lows after President Vladimir Putin spent some time with Ukraine’s newly elected president, Petro Poroshenko, at a gathering of world leaders in France commemorating the 70th anniversary of D-day. To many market observers the meeting in early June signaled that tensions were easing between the two countries and that it might be an opportune time to reenter the Russian market — despite the fact that many forecasters believe Russia’s economy, which contracted in the first quarter, will expand by 0.5 percent or less this year.
“The market was oversold in the wake of the Ukraine-related geopolitical risk spike, and taking advantage of those oversold conditions and much-cheapened valuations — at a time when the rest of emerging-markets equities were already well off their February lows — was totally rational both for fundamentally minded, long-only portfolio managers and momentum investors alike,” explains Dmitry Dmitriev, global head of research at VTB Capital in Moscow. “However, with the economic outlook for 2014 far from encouraging and the key benchmarks already back to early February levels, further inflows are less warranted.”
Paolo Zaniboni, London-based head of research at Sberbank CIB, counters that concerns about Russia’s real gross domestic product expansion may be overstated. “GDP growth is not a major factor in a market where two thirds of the stocks are exporters and many of the others are driven by penetration gains,” he insists. “Investors are attracted by low valuations, high dividend yields and high oil prices.”
Plus, there is cause for optimism on the home front. “While the growth outlook remains clouded, the prospects of some acceleration have improved,” reports Yaroslav Lissovolik, director of Russian company research at Deutsche Bank in Moscow. “This in turn may be driven by the resilience of the Russian consumer as well as deceleration in capital outflows in the second quarter.”
It’s too soon to tell if the renewed investor interest will last, he adds. “The very low valuations, together with the dissipation of political risk, may have led to some short-term inflows, but the issue of the sustainability of this growth without sufficient reform momentum remains significant,” Lissovolik believes.
Asset managers will undoubtedly be keeping close tabs on the still-unfolding political situation as well as the country’s economic progress, and many will look to the sell side to help them view each new development in the proper context. The firm whose analytical insights are valued most highly is VTB Capital, which rises one rung to secure the top spot on the All-Russia Research Team and bumps last year’s winner, Sberbank CIB, down a notch to second place. These firms capture 14 and 13 spots, respectively, in the 12-sector survey. That’s a gain of two for VTB Capital; Sberbank’s total is unchanged from last year.
Analysts at VTB Capital appear in every sector but one — ironically, the firm is absent from Financial Services — and are dually ranked in three others: Corporate Debt, Equity Strategy and Industrials. Sberbank researchers appear in every sector, and two are ranked in Corporate Debt.
Deutsche Bank returns in third place with ten positions. It’s followed by Bank of America Merrill Lynch, holding steady at No. 4 even though its total increases by two, to seven. Two firms share fifth place, with five spots apiece: Morgan Stanley, which picks up one position, and UBS, which failed to rank last year. These results reflect the opinions of nearly 350 investment professionals at more than 240 institutions that oversee an estimated $208 billion in Russian equity and fixed-income assets.
In late May, Elvira Nabiullina, governor of the Central Bank of Russia, disclosed that policymakers would likely lower their forecast for GDP growth this year, to 0.5 percent from 0.9 percent, but she dismissed talk of recession as premature. Many research directors hold similar views.
“The Russian economy is likely to remain under pressure from a tight domestic policy mix and constrained access to external funding in 2014, and we expect zero GDP growth,” says VTB Capital’s Dmitriev. “Growth momentum might start to turn around in the latter part of this year and strengthen further into 2015, when GDP is expected to pick up to 2.6 percent, mainly spurred by state-led infrastructure investment.”
That scenario comes with a few caveats, however. “Reescalation of geopolitical tensions in the region as well as an unexpected drop in oil prices remain the key downside risks to our forecasts,” Dmitriev adds, “while more significant fiscal stimulus and larger capital expenditure outlays by state-owned companies may present upside risks.”
Sberbank’s outlook is comparable, give or take a couple of percentage points. “We forecast 0.2 percent GDP growth this year and 2.3 percent growth in 2015,” Zaniboni says. “Oil prices and reform are the two main factors that impact GDP growth.”
Deutsche’s Lissovolik is marginally more upbeat. “We project Russia’s growth to reach 0.5 percent in 2014 and 2.4 percent in 2015,” he says. “The most important upsides to Russia’s growth outlook in the near term are a significant deceleration in capital outflows as well as the start of new structural reforms targeting micro sector issues, including corporate governance. On the downside an escalation in political risks coupled with higher capital outflows may undermine growth.”
There are other hazards, contends Evgeny Gavrilenkov, who marks his seventh straight appearance at No. 1 in Economics. He is bearish in the near term, for reasons that have nothing to do with the annexation of Crimea and its aftermath. “I downgraded my 2014 forecast in February, before the Ukraine crisis fully unfolded and people started talking about sanctions,” he says, adding that he expects Russia’s output to increase by 0.2 percent this year. “My downgrade was based on fundamental factors.”
Gavrilenkov is an outspoken critic of what he calls “pure macroeconomic policy mismanagement” by the central bank. “If you look at the data — national accounts, for instance — you will see that last year Russia’s GDP was up 1.3 percent while the financial sector grew by 11.5 percent — faster by a factor of nearly ten than the GDP in aggregate,” the economist observes. Output increased by only 0.8 percent in 2013 if the financial sector is excluded, he adds. “This happened despite the fact that the CBR increased refinancing to banks in the second half by a factor of 2.4 — that is, around 140 to 150 percent.”
The scale of Russia’s financial stimulus relative to its economy is far greater than that provided by the U.S. Federal Reserve or any other central bank, Gavrilenkov maintains. “In Russia’s case this money naturally ended up on the foreign exchange market well before the Ukraine saga,” he notes. “The CBR has seemingly forgotten that the ruble is not a reserve currency, and if there is an excess supply, then there is only one channel where the liquidity can go — the forex market.”
He believes the central bank was wrong to introduce any sort of monetary easing last year. “Nominal wages were up by around 13 to 15 percent year over year, and consumer credit expanded by around 40 percent, while economic growth slowed,” he says. “The causes of this slowdown were different, but it wasn’t lack of money. The worst thing was that the CBR started to provide refinancing to banks on a long-term basis against illiquid collateral.”
Another mistake: Unlike the Fed, the European Central Bank and other regulators that turned to quantitative easing after slashing rates to near zero, Russia’s central bank maintained a floor of 5 percent for its benchmark interest rate, Gavrilenkov points out.
“The CBR had several policy objectives that proved incompatible,” he explains. “I don’t mean their intention to target inflation — they pretend to target inflation, but it’s nonsense. If they were serious about targeting inflation at around 5 percent, then they should not have provided gargantuan refinancing to banks!”
The central bank raised its benchmark rate in March and again in April, by a total of 200 basis points, to 7.5 percent, in a bid to bolster the weak ruble and slow inflation. Further rate hikes are unlikely this year, according to VTB Capital’s Maxim Korovin, who advances from second place to finish on top for the first time in Fixed-Income Strategy. “There are some risks for inflation to miss the target even in the medium term, and the policymakers will be closely tracking the [consumer price index],” he says. “Our base scenario is rates on hold until the end of the year, with risks on the upside if the ruble depreciates substantially or if inflation risks materialize on the upside.”
The Russian currency recently strengthened against the dollar, particularly after the second round of tightening, and Korovin believes that “the bulk of its appreciation has been done already. Geopolitical risks remain in place, seasonal factors are playing against the ruble — in particular, increases in tourist services and dividend payments — and the general appetite for emerging-markets foreign exchange has worsened due to technical factors,” he explains. “The fair range for the ruble should be around 35 to 36 at year-end, perhaps closer to the upper end of the range.” It was trading at 34.38 to the dollar in mid-June.
The weak currency helped boost consumer spending in the first quarter, but that’s no longer the case, notes Korovin’s colleague Maria Kolbina, who rises one rung to claim the No. 1 spot in the Consumer sector. “Private consumption demand returned to a trajectory of moderating growth in April as retail sales growth slowed to 2.6 percent year over year,” says Kolbina, who also finishes third in Real Estate. “Looking ahead, we expect spending to continue to slow in line with choking income growth and a pickup in the household savings ratio following a slowdown in consumer credit and an increase in retail deposit rates.”
She is urging investors to focus on food retailers as a defensive play, with convenience store and supermarket operators Magnit and Dixy Group among her recommended stocks. “We believe Magnit is the best company from an execution standpoint, justifying demanding valuations — 30 percent and 10 percent premia to its emerging-market peers on 2014 enterprise value to earnings before interest, tax, depreciation and amortization and price-to-earnings ratio, respectively — and see strong quarters ahead,” Kolbina says. “We also flag Dixy. It’s the cheapest Russia food retail stock while demonstrating a consistent improvement of margins and balance sheet.”
Money managers are less likely to reap rewards from the $400 billion contract recently signed between Gazprom, the world’s largest natural-gas supplier, and China, says Oleg Maximov, No. 1 in Oil & Gas for a sixth year running. “One has to differentiate two potential beneficiaries from the China gas deal: Gazprom’s minority shareholders — that is, portfolio investors — and majority shareholders, namely, the Russian state,” the Sberbank analyst explains. “We believe the break-even gas price for this massive project is higher than the contract price. At the same time, the Russian state will benefit via the 30 percent export duty extracted from Gazprom, income taxes, jobs, economic development and so on. So, net-net the deal is positive for Russia Inc. But as generally happens in the Russian oil and gas sector, the benefits and cash flows are highly skewed toward the state, not the portfolio investors.”
But there’s money to be made elsewhere. Kingsmill Bond, who jumps from third place to first in Equity Strategy, advises clients to focus on homebuilders, Internet-related companies and retailers. He predicts the Russia Trading System index, which stood at 1,357 in mid-June, will close the year at 1,500. “Perhaps surprisingly, our target level has not changed,” the Sberbank strategist says. “The deterioration in Ukraine is offset by higher oil prices and the China gas deal.” • •
