Why Russian equities can offer deep value in emerging markets
Central bank's decision to allow rouble to depreciate prevented catastrophic financial meltdown
Russian equities trade at the lowest valuation multiples among the major emerging markets due to the dominance of oil, gas and metal companies in the benchmark indices and pervasive investor distrust of an autocratic regime in the Kremlin still under Western sanctions for its military intervention in eastern Ukraine and Syria. Russian cyber-espionage in the US Presidential elections has destroyed hope of "reset" in relations with Washington under President Donald Trump. The Russian stock market has been a loser in 2017 and not participated in the 25 per cent rally in the MSCI emerging markets index due to its toxic geopolitical risk. Yet George Soros advised the prescient investor that "the big money is made when things go from godawful to just plain awful". This could well be the case in Russia in the last four months of 2017.
Russia suffered a succession of political and economic shocks in the past three years. In March 2014, Vladimir Putin invaded and annexed Crimea, the home of the Soviet Black Sea fleet, that Nikita Khrushchev had arbitrarily assigned to the Ukraine SSR. This resulted in international outrage, economic sanctions and a free-fall in the Russian rouble. In 2014-16, the collapse of Brent crude oil prices devastated Russia's public finances and cost a $200 billion hit to hard currency reserves. Russia's economy predictably slid into recession in 2015 even as anti-Putin protests erupted in the heart of Moscow and St Petersburg.
However, the Saudi-Russian pact to stabilise oil prices has led to a rise in Brent crude since July and the Russian economy has emerged from two years of economic recession and the largest capital outflows since the fall of the USSR. The rouble has risen from 85 to 60 against the US dollar. The yield compression on sovereign Russian Eurobonds led to a dramatic bull market in Russian debt in 2016. Alexei Navalny has not been able to erode Putin's vast vote banks in the Russian hinterland. Unlike the August 1998 crisis under Boris Yeltsin, the Russian economy did not go into meltdown mode despite the punitive international sanctions, tensions with Washington and Berlin and the collapse in crude oil prices.
The Russian central bank's decision to allow the rouble to depreciate in foreign exchange markets prevented a catastrophic financial meltdown. In 2016, the spectacular bull market in Moscow debt and equities actually attracted capital inflows to Russia. Kremlin and Russian corporates were forced to deleverage on such an epic scale by sanctions that Russian debt fell by 30 per cent or $250 billion between 2014 and 2017. Since sanctions hit trade with the EU, the Kremlin was forced to develop export ties to China and the Pacific Rim's tiger economies. The ban on EU food products has boosted Russian agricultural output. Sberbank, Russia's ultimate "too big to fail" retail bank, has stress tested its capital and liquidity so that it could even survive another collapse in oil prices to $25 a barrel. Mir, the domestic payment platform, has challenged Visa and Mastercard, which had sanctioned Russian banks to the detriment of local clients.
Russia now offers some of the world's highest real (inflation-adjusted) interest rates, a low debt/GDP ratio and derisked corporate balance sheets though the latest new US sanctions will constrain international borrowing for the Kremlin's state-owned banks and oil/gas companies. However, a stock market trading at 5.8 times forward earnings in an economy with a current account surplus just emerging from recession at a time of an admittedly cyclical rise in oil price is an investment strategy I find compelling. As inflation falls, Bank Rossiya will continue to cut interest rates and boost the value of both Moscow debt and equities. The "smart money" in emerging market hedge funds has begun to position for a significant rally in Russian equities in the next twelve months. My favourite Russian blue-chip stock picks are retail megabank Sberbank, the oil firm Lukoil, the retailer Magnit and the telecom MBT. The Russian stock market surged by 50 per cent in 2016 before the latest sanctions/cyber-espionage spat with Washington led to another big chill on the RTS/Micex.
As real wages/consumer confidence rise while interest rates and inflation plunge, Magnit becomes one of the world's most attractive retailers while Lukoil offers the highest free cash flow yield in Big Oil. Sberbank benefits from the increasing digitalisation of Russian finance. Regression to the rodina's government bond yield implies a forward valuation multiple of 7.4 times earnings in Russia. Things will hopefully go from Godawful to just plain awful in the twilight of Tzar Vlado's reign in the Kremlin.
The writer is a global equities strategist and fund manager. He can be contacted at firstname.lastname@example.org.
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