Russian equities: fat-tire bike for riding the bumpy road of the global equity market

Three types of road representing the global equity market

Imagine the various possible movements of the global equity market as types of road.

* Options with low carbon footprint

Let’s assume that a bumpy forest road is the most likely scenario. There are many uncertainties ahead and likely large perceptual swings concerning future economic growth. Riding such a bumpy forest road is best done on a fat-tire bike. Russian equities can be one of the fat-tire bikes you could consider. Russia equities offer strong value investment case and options for boosting growth.

A fat tire bike – Russian equities model

More details on the following pages.

17-minute read. 3-minute skim

Sources: TKB Investment Partners, November 2019

Potential cruise speed: 15-20% a year over next three years

The crucial factor for the potential speed of a bike is its weight. Most people cannot easily pedal a 300 kg bike. In a value equity market, the crucial factor in the return it can offer is the ability of the companies to earn money for shareholders.

The Russian companies in the base case scenario are expected to generate an average sustainable free cash flow yield of 12% a year over the next three years. More than half of this cash is likely to be paid out as dividends. The expected dividend yield for the Russia market is the highest among emerging equity markets.

Russian dividend yields have been on the rise for the last eight years, mainly due to capital expenditure cuts by major companies. For instance, Gazprom has cut its stay in business capital expenditure by 70% since 2011. Dividends have also risen on the back of the government’s effort to force Russia’s state-owned enterprises (SOEs) to pay higher dividends – in 2012 of at least 25% of their net income, and then in 2016, 50% of their net income. Companies have been slowly complying with this recommendation. Gazprom was among those which resisted higher dividend pay-outs until the first half of 2019, when it gave in. The company proposed a record dividend for 2018 and that its dividend pay-out ratio would rise to 50% of net profit under IFRS rules in two-three years. Total dividend payments in the Russian equity market hit a record of RUB 3.1 trillion (USD 47 billion) this year.

Another crucial element for the bike’s potential speed is its gears. The higher the gear, the higher the potential speed. For the equity market, the central bank’s interest rate changes are similar to gear changes. The larger the cuts are, the larger the potential return from the market.

Russia’s central bank (CBR) is quite cautious in its decisions to change interest rates. It cut its rate during 2016-2017, and then in the second half of 2018, it raised the key rate twice, by 50bp overall, in response to the government’s decision to raise the VAT rate at the beginning of 2019 from 18% to 20%.  The CBR also reacted to the rouble weakening in the second half of 2018 on the back of the news that the US could extend financial sanctions to Russian government debt. As at the end of 2018, Russia had one of the highest monetary policy rates in real terms among large emerging markets.

The CBR has cut its key rate further this year, from 7.75% to 6.5% during June-October. Inflation has performed better than the bank initially expected. At the turn of 2018-2019, the regulator feared that VAT could push inflation materially off-track from the long term target of 4%. Indeed, inflation accelerated from 4.3% to 5.3% over the first quarter. However, it has been on a declining path since then and reached 3.8% YoY by the end of October. The Ministry of Economic Development expects inflation to fall to close to 3% by the end of this year and remain there next year. The CBR has lowered its annual inflation forecast for 2019 from 4.0%-4.5% to 3.2%-3.7%.

The real rate of the Russian Central Bank is still one of the highest among emerging markets.

In our base case scenario, we expect the CBR to cut interest rates by a cumulative 100bp-200bp over the next two to three years. This would likely lead to a fall in the cost of equity for the Russian market. A 100bp cut translates to a stock fair price rise of approximately 10%, according to our estimations. On that basis, 100bp-200bp of cuts should lead to an additional 10%-20% rise in Russian share prices.

Speed-boost options: +15%-30%

We all know that electricity can be helpful. For example, people riding bikes can benefit from an electric motor to boost the bike’s speed. With electric bikes you have the option of switching the power off or on. The Russian equity market also has the option of switching on “electric power” to boost its growth. The current market consensus is that the Russian economy will not grow significantly. Should Russia manage to provide an upside surprise in terms of its economic growth rate, there could be an additional boost for the Russian equity market. Using this analogy, the two elements of the “electric power” for the Russian market are:

Infrastructure spending. The state plans to invest close to USD 100 billion in infrastructure projects over 2019-2024. Roads, sea ports, regional airports and high speed railways are planned and work has already started. There is no consensus among experts on the impact of this plan. It is likely that the market has not priced in any material impact from it. For example, the IMF expects Russia’s average annual GDP growth over the next five years to be around 2%. Should there be a material effect on Russian economic growth from the infrastructure projects it will be a positive surprise for the market.

Pension reform. In 2018, the state decided to increase the retirement age over the next 10 years. For men from 60 to 65 years, and from 55 to 60 years for women. The plan is to raise the retirement age

by one year during each two-year period. There is also no consensus on whether this will have any meaningful impact on GDP growth. Some experts see a potential for working-age population growth because of this reform. Should there be any material positive impact on Russian economic growth, it will be a positive surprise for the equity market.

Strong frame

The backbone of a bike is its frame. The stronger it is, the longer the bike will serve you even if you ride rough roads. The backbone of an equity market is the country’s economy. The better the economy is prepared for a tough global macroeconomic environment, the better the performance of the equity market in a “forest road” situation on the global equity market. We believe the Russian economy is robust enough to support the strong value case for the Russian equity market.

  • Net debt is close to zero in the government and corporate segments

The Russian state’s net debt is -1.2% of GDP. Russia is the only large EM country with negative net debt. After 2014, to ensure financial stability, the Russian government set out to accumulate reserves. The country’s international reserves grown by 49% over the last five years. In 2018, the Ministry of Finance purchased foreign currency worth USD 64 billion. In 2019, these purchases were allocated to the National Welfare Fund. The volume of government debt in August 2019 equated to around 15% of GDP. At the same time, the amount of cash in Russia’s deposits with the CBR and commercial banks was around 16.2% of GDP.

In the MSCI Russia index, companies’ average net debt is also close to zero. Many companies have been deleveraging over the last five years. For instance, oil producer Lukoil’s net debt shrank by 94% from USD 10.4 billion in 2014 to USD 0.6 billion in 2018.

  • Budget and current account are in surplus. They are likely to stay this way over the next three

The 50% downward shift in the oil price range in 2014-2015 was a challenge for the state budgets of many oil-producing countries. Saudi Arabia’s budget moved from a surplus of 6.5% of GDP in 2013 to a deficit of 14.8% in 2015. The deterioration in Russia’s budget balance was far smaller, moving from being almost in balance in 2013 to a deficit of 3.4% of GDP in 2016.

The Russian state and Russian companies had learned lessons from a similar strong oil price shock in 2008:

  1. The CBR gradually moved from FX targeting to inflation targeting and a free-floating rouble. Since 2014, this has helped to materially limit the negative impact on the Russian budget from lower oil prices. It has also helped to maintain a current account surplus. The rouble weakening in 2014 resulted in a drop in imports.
  2. The Russian state and Russian companies have reduced their external debt since 2007. Russia’s international net investment balance went from –11% of GDP in 2007 to +6% in 2013 and +22% in 2018.

In 2018 and 2019, Russia’s federal budget went back into surplus

. This was not universal among oil-producing countries, as Saudi Arabia’s and the United Arab Emirates’ budgets were in deficit of 9.2% and 1.8%, respectively, in 2018.

Firm control of spending for many years was one of the key factors behind the relatively quick normalisation of the state finances in Russia[1]. Federal budget spending fell in real terms every year over 2013-2018. The state used some unconventional methods to limit spending. Several heads of large SOEs were replaced, likely due to their appetite for subsidies from the state budget.

[1] Another key factor was the budget rule introduced in 2015

    • Inflation and its volatility are at their lowest levels since the USSR broke up in 1991

Modern Russia started its history in 1992 with four-digit inflation. By the beginning of the 21st century, inflation was in double digits, remaining in double /high single digits until 2016. That year, inflation entered a new era of low single-digit levels. In 2017, it even fell as low as in the US. Russian authorities helped to start a new era for inflation in Russia:

  • The CBR gradually shifted from FX targeting to inflation targeting during 2009-2014, having the long-term target of keeping inflation at 4%
  • State employees’ annual wage growth has been in single figures since 2015, as has the increase in average pensions
  • Natural monopolies tariffs were frozen in 2014 and have since remained in single figures.

Fat tires

It hurts a lot when you ride a bumpy road on a high-speed sport bike with thin tires. Fat tires are far more comfortable as they absorb most of the impact from bumps. The Russian equity market has two “fat tires” to help absorb most of the impact of global market swings.

1) Exposure to oil price swings is at its lowest in a decade.

Russian equities have always been perceived to have a high beta to the oil market, which was the case between 2008 and 2011. Since then, though, the correlation and beta to oil has been declining.

Oil prices barely changed during 2012-2013 and thus stopped being a significant catalyst for the Russian market. The correlation with oil fell further in 2014-2015 as US/EU sanctions brought uncertainty to the Russian economy in 2014. The market started to react significantly on sanctions news. But then fears over sanctions eased over time and the correlation with oil prices rebounded in 2016-2017. In 2018-2019 correlation dropped to a relatively low level again, this time coupled with a drop in beta. The rouble also appeared to be more independent from the oil market: in 2018-2019 its beta to oil reached 12%. This was due to the implementation of the Budget Rule in 2018, under which the tax income generated from oil prices higher than USD 40/bbl (indexed by 2% yearly afterwards) is stored in the National Welfare Fund (NWF). Prior to this, all proceeds from oil were allocated to the budget spending, making the economy highly dependent on the oil price. With the new rule, the Russian economy exists now in a USD 42/bbl reality and therefore less affected by oil price fluctuations above this level.

When the savings in the NWF reach 7% of GDP, the excess becomes available for government spending. This is likely to happen in 2020. The main question currently remains how to spend the NWF funds and whether 7% is an adequate threshold. There are many suggestions for using the funds, ranging from infrastructure investment to crediting exporters from Russia to boost foreign investment. Spending within the country would stimulate economic growth but it may increase exposure to oil price swings. We can say with a high degree of certainty that this should not lead to the restoration of oil price exposure to pre-rule levels. Only 15%-20% of the excess savings of the fund will be invested in order to keep oil dependency under control.

2) Correlation with other EMs is at its lowest in a decade.

Russia is the only strong value story in the growth EM universe. For example, the US-China trade war has not hit the Russian market as hard as it has hit broader EMs. From January 2018, the month when the first tariff in the trade war was imposed, up to the end of October 2019, the global EM index lost 13% while Russia’s equity index gained 29% in USD terms.

Sanctions news and perception of future sanctions have also reduced the correlation with other EMs. Though the sanctions do not carry any material fundamental effect, they add to short-term volatility of returns. In April 2018 the US imposed sanctions on Rusal and EN+. The MSCI Russia index dropped by 14% in two days in USD terms while the MSCI EM index gained 0.6%. Some weeks later, the US claimed to be considering lifting the sanctions if Deripaska reduced his stake in Rusal. This led the MSCI Russia index to rise by 6% during the following three weeks, outperforming the MSCI EM index by 8%.

Experienced mechanics

There are handmade bikes. The better the quality of the mechanics who assemble and fine-tune the bike, the better the bike. The quality of the post-purchase service of a bike also depends on the qualification of the mechanics from whom the bike owner seeks help. Similarly, different state officials fine-tune the economy. As a general rule, the better the quality of the key officials, the better the characteristics of the economy. The key mechanics for the Russian “fat-tire bike” are:

Elvira Nabiullina, Governor of the Central Bank of Russia since 2013

In 2015 Euromoney named Ms Nabiulina Central Bank Governor of the year. “Euromoney commends Nabiullina for efforts to combat the macroeconomic storm engulfing the Russian economy through prudent policy measures.”[1] From Euromoney article. She was the only Russian women in the Forbes 2018 list of World’s 100 most powerful Women. Most of her career since 1991 has been in state service or institutions close to state authorities. During 1994-1998, 2000-2003, and 2007-2012 she was in the Ministry of Economy/Ministry of Economic Development. She became Minister of Economic development in 2007 and held that role until 2012. During 1999-2000 and 2003-2007, Ms Nabiullina worked at the Center of Strategic Research, a non-profit think-tank which aims to support the development of the Russian economy.

Anton Siluanov, Minister of Finance (since 2011) and First Deputy Prime Minister (since 2018)

Mr Siluanov has spent all his career in the Ministry of Finance since graduating from the Moscow Finance Institute in 1985. He thus followed in his father’s footsteps. Mr Siluanov was appointed Minister of Finance in 2011 after the resignation of Alexei Kudrin. He was deputy Minister of Finance between 2005 and 2011. He is the key person who limits increases in federal budget spending. “Regardless of having already curbed 2015 spending, we will ask parliament to cut all expenditure apart from defence spending by 10%,” said Mr Siluanov in January 2015.

Maxim Oreshkin, Minister of Economic Development since 2016

Mr Oreshkin started his career at the Central Bank of Russia in 2002 while still in the Higher School of Economics University. In 2006, he moved to Rosbank, where he gradually rose to the executive director position. In 2010, he switched to the investment banking sector. During 2010-2013, he was at Credit Agricole CIB (Moscow branch) and then at VTB Capital, where he focused on the macroeconomic analysis of Russia and CIS. In 2013, he moved to the Ministry of Finance as head of the strategic planning department. He was promoted to Deputy Minister of Finance in 2015 and kept this post until 2016.

Alexei Kudrin PhD, Chairman of the Accounts Chamber since 2018

Mr Kudrin was Minister of Finance during 2000-2011, the longest tenure of this post in the post-Soviet era. He created a Stabilisation fund, which greatly helped the Russian economy during the crises of 2008-2009 and 2014-2015. There were other notable accomplishments during that period of his career. In 2010, Euromoney named Mr Kudrin Finance minister of the year. “For many years, Alexei Kudrin was known as a survivor. As the oil price climbed to dizzying heights, bringing with it the Russian economy, the soft-spoken finance minister battled endless attempts to reach into the country’s suddenly deep pockets and spend as if there were no tomorrow.” From Euromoney article. After 2011, he headed think-tanks, including the Center of Strategic Research (since 2016).

[1] Euromoney’s decision is based on three factors: the opinions of a committee of Euromoney’s senior editors, chaired by the editor; the views of some of the world’s leading bankers, which Euromoney’s editorial team seeks out in background meetings; and the analysis of the contributors to our service Euromoney Country Risk (ECR), which has more than 400 economists around the world contributing on a regular basis, as well as data sourced and compiled by ECR.


Authors: Vladimir Tsuprov, CIO; Gennady Sukhanov, Deputy Head of Equities & Head of Research; Egor Kiselev PhD, Head of International Business & Investment Marketing; Marina Tsutskiridze, Junior Investment Specialist; Aleksandra Kuznetsova, Junior Investment Specialist

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