After a plunge in oil prices, economic sanctions, a sharp devaluation of the rouble and a recession, the Russian market is showing strong performance. Russian equities have outperformed the MSCI Emerging Markets Index and the S&P 500 year-to-date (chart below) and next year the economy is expected to move to growth from recession.
“The economy clearly has bottomed out and will be back to growth in 2017, perhaps reaching 2%,” Moscow-based Umberger told FSA. “Inflation came down massively. It was at its highest a year ago at 15% and now it’s below 7% and will be below 6% toward the end of the year.”
He said the central bank has managed monetary policy well, sharply devaluing the ruble to US dollar beginning in mid-2014.
In 2017, the ruble may not appreciate to the dollar, but he dispelled the concern that it will have a large depreciation.
“If inflation continues to go down then the current interest rate from the central bank of 10% still offers a very high real interest rate. That means it provides cushion for the currency.”
If the central bank proceeds with an interest rate cut, it will support the fixed income and equity markets, he added.
“The market has done well since 2014, but it is still the cheapest emerging market. Not only because of market specifics – Russia has a large number of energy companies – but it has low volatility sector-by-sector compared with other EMs. Companies are trading at a significant discount to EMs and to developed markets.”
In regards to oil prices, Umberger believes the risk is skewed to the upside. “Higher oil prices mean higher equity markets in Russia.”
Sector picks
East Capital’s Russia Fund portfolio has several overweights relative to the benchmark – industrials, real estate, consumer staples and information technology, according to its latest factsheet.
In the consumer sector, the firm is invested in X5 Retail Group, Russia’s second largest retailer, with a 4.6% overweight against the MSCI Russia 10/40 Index benchmark. Also, M.Video, a consumer electronics retail chain, gets a 3.3% overweight.
“There is an enormous difference between companies within the sector,” Umberger explained. “Some companies have been getting stronger, taking marketshare from the competition [during the economic recession the past couple years]. They have become much more apparent now.”
Another sector the firm likes is real estate and the portfolio has an overweight on real estate development and construction company LSR Group.
Umberger said the interest rate has declined and for the first time the mortgage rate in Russia is below 10%.
“It will significantly boost real estate demand in spite of the fact the economy is not booming. Russia has pent up demand for real estate. There is a lot of old housing and people want better conditions and we expect this area to grow.”
In the materials sector, he mentioned steel companies. When commodity prices move higher, he believes Russia’s large vertically-integrated materials producers will be more competitive than global peers that are not vertically integrated.
“Inflation should support commodity prices and the competitive companies have strong cash flows,” as well as paying dividends, he added.
Political wild card
Much speculation surrounds the development of the political relationship between the US and Russia. Donald Trump and Vladimir Putin in the media have suggested a warming of relations. Some analysts believe economic sanctions imposed on Russia for the annexation of Crimea in 2014 could be loosened or even lifted after Trump takes office in January.
“The political question is much more complicated,” Umberger said. “Trump’s win suggests some sort of reconciliation between Russia and the US and the mood of investors in Russia became positive after the election. It is not difficult to see they will have some common understanding on political goals.”
However, he doesn’t think there will be one major deal to remove economic sanctions, but possibly it could happen in several steps. The removal would not have a significant impact on the economy, Umberger said. But it could have a positive impact on the market of perhaps up to 20% upside, he estimated.
“The lifting [of sanctions] would be very important for sentiment toward the Russian market. Right now, a large part of institutional money globally — for example, US pension funds — is still prevented from investing in the market, and this could obviously change.”
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Two of East Capital’s Russia funds vs the MSCI Russia 10/40 (their benchmark index) and the MSCI Emerging Markets and S&P 500 indices, year-to-date.
The surprise is that within emerging markets, Russia has clearly been an outperformer. Oil prices and global politics are macro factors that will influence future performance.
