Russian Outperformance Likely to End as Oil Drops Further

Ruble, Brent, and the FedRussia continues to struggle under the weight of ongoing economic sanctions and low oil prices. With sentiment on EM likely to remain negative, Russian assets are likely to start underperforming after a period of some outperformance.

POLITICAL OUTLOOK

President Putin remains firmly in power, and so the domestic political risks remain minimal. The large-scale popular protests of 2012 are a distant memory, and a demoralized opposition has had little success gaining traction again.

On the international front, relations with the West remain poor. Russia seems to be softening its stance on Ukraine, this week offering debt restructuring that Putin claims is better than what the IMF requested. An uneasy peace has developed in Ukraine, but the West shows no sign of backing down from sanctions.

The outlook is complicated by Russia’s actions in Syria, one of its few Middle Eastern client states. In September, Russia began air strikes on rebel forces, reportedly at the request of President Assad. Prior to this, Russian aid consisted mainly of supplying the Syrian Army. While the Russian intervention so far has not benefited Assad that much, it risks an even more drawn out saga in Syria.

ECONOMIC OUTLOOK

GDP has contracted y/y for three straight quarters. Q3 GDP contracted -4.1% y/y, and consensus is for a full year contraction of -4% followed by modest 0.2% growth next year. Oil remains the key driver for Russia, and the news here is not good. Both WTI and Brent oil are on track to test their August lows. With global oil inventories still rising due to increased supply, those August lows could be breached.

CPI rose 15.6% y/y in October, down only marginally from the 16.9% peak in March. The central bank has kept rates on hold at 11% since the last 50 bp cut back in July. The next policy meeting is December 11, and no move is seen then. Governor Nabuilina said after the last policy meeting in October that it would resume cutting rates if inflation slowed as forecast. Currently, she sees inflation falling below 7% by October 2016, which seems too optimistic.

The external accounts remain in decent shape, with plunging imports compensating for falling exports. The current account surplus is expected around 5% of GDP both this year and next, up from 3% in 2014. Private capital inflows have been surprisingly strong, interrupted only by a -$5.3 bln outflow in Q3, the first outflow since Q2 2010. After floating the ruble, foreign reserves have stabilized around $360-370 bln.

The poor economic performance coupled with low oil prices have taken a toll on the budget. The deficit is expected to rise to nearly -3.5% of GDP this year from less than -1% the past three years. 2016 could see further deterioration.

The worsening budget outlook supports our view that Russia remains subject to strong downgrade risks. Our own sovereign rating model shows Russia as a BB-/Ba3/BB- credit. We thus see downgrade risks to actual ratings of BB+/Ba1/BBB- that should push it deeper into sub-investment grade territory. Fitch’s investment grade BBB- rating is clearly too high.

 

INVESTMENT OUTLOOK

The ruble is in the middle of the pack in EM, -12% YTD against the dollar. This compares to -31% for BRL, -23% for COP, and -20% for both MYR and ZAR. However, we note that RUB was the worst EM performer in 2014 at -44% vs. USD. The ruble is well correlated with Brent oil, at around .77 on a rolling 60-day basis. With oil on target to test the August lows, USD/RUB is likely to test the year’s high near 71.70 from August. Our EM FX model shows the ruble to have some of the weakest fundamentals in EM.

Surprisingly, Russian equities are outperforming within EM. MSCI Russia is up 1.5% YTD, and compares to -15.2% YTD for MSCI EM. However, we note that for 2014, MSCI Russia fell -45% vs. -5% for MSCI EM. Our EM Equity model has Russia at a VERY UNDERWEIGHT position based on the underlying weak macro factors.

Russian bonds have held up remarkably well this year. The yield on 10-year local currency government bonds has fallen -312 bp YTD. This is the best in EM, with runner-up China falling only -48 bp. Compare this to the worst performing group that includes Brazil (+310 bp), Turkey (+182 bp), Peru (+165 bp), and Colombia (+117 bp). However, we again note that this follows a terrible 2014 performance for Russian bonds. With inflation unlikely to fall significantly until 2016 and thus keeping the central bank on hold, we think Russian bonds are likely to start underperforming. This is especially so if we see ratings downgrades, as our model predicts.