Russia: A market poised for the spotlight

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Now is a good time for investors to consider accessing Russia’s positive trends

After two years of economic difficulties triggered by trembling oil prices and international sanctions, we believe Russia’s economy is firmly on the road to recovery with real GDP growth expected to have reached 1.7% in 2017, according to the World Bank. While there are, of course, challenges that the economy must overcome, we forecast that the positive momentum that began in 2017 will build over the year to come.

Last December, President Vladimir Putin formally announced his candidacy for a fourth term and we expect him to win a new six-year mandate. There is no real opposition since Russia’s Supreme Court confirmed on 6 January 2018 a ban preventing opposition leader Alexei Navalny, a 41-year-old blogger and political activist, from running for president because of a previous fraud conviction. With no credible opponent, what will be an important indicator of the country’s future path is how Putin potentially wins. According to Levada Centre polling, eight out of 10 Russians have a positive opinion of their current leader – a high level of approval that is partly due to the military intervention in Ukraine in 2014.

Recovering from the pain of sanctions

In response to the Ukrainian crisis, the United Sates and the European Union enforced sanctions against Russia in 2014. Travel bans and asset freezes were imposed on designated individuals and entities; access to financial markets was restricted for selected Russian state-owned companies (particularly in the banking and energy sectors); and restrictions were introduced on the trade of several goods and services such as dual-use goods, military technologies and oil technologies.

In the meantime, from January 2014 to December 2015, the oil price lost half its value and, with around 40% of Russian exports coming from the energy sector, the ruble collapsed with it. Russia entered a vicious circle as the falling currency drove inflation higher and forced the Central Bank of Russia (CBR) to tighten its monetary policy. Recession ensued between 2015 and 2016. By 2017, with energy prices more than doubling over the course of the year, Russia’s economic contraction came to an end and real GDP growth came back in at a modest 1.7%.

A rebound worth watching

As we watch for evidence of the government’s will to enact the reforms that Russia needs over the longer term, from a medium-term point of view, we expect the economy to continue expanding. In 2018, this growth is likely to come on the back of better business confidence and improved credit conditions, which should support consumption and investment. Inflation dropped from 16.9% in March 2015 to 2.7% in December 2017, reaching its lowest level since the collapse of the Soviet Union in 1991. With inflation below its 4% target, the CBR recently lowered its key rates to 7.75% per annum, from 16.9% a year earlier, and the gradual easing towards a neutral monetary policy should continue in 2018. Ultimately, we think current monetary conditions are adequate to keep inflation at a low level without compromising the economic recovery.

Several other indicators also make the case for Russia’s macro stabilisation. Supported by firming oil and gas prices, fiscal revenues increased last year, leading to a reduction of the government deficit from 3.9% in 2016 to 2.1% in 2017. Because of the price effect, the current account improved to 2.1% in 2017 and the country still has a low and stable public debt that represents 10% of its GDP. Lastly, the federal government announced its commitment to further fiscal consolidation with tighter expenditure controls and the creation of a new fiscal rule that should shield the budget from the influence of volatile energy prices. For instance, oil revenues will now be budgeted using a conservative assumption of around USD 40 a barrel, saving additional revenues for challenging periods.

While we are confident that the economy will continue to perform well for now, Russia still faces numerous vulnerabilities in the longer run. Indeed, on top of the well-documented overdependence on commodity prices, the strong interventionism of the state and weak institutional environment weigh on productivity and competitiveness, effectively capping private and foreign investments. Structural reforms will also be needed regarding taxes and pensions to ensure the sustainability of the long-term fiscal trajectory amidst an ageing population and a new equilibrium of lower oil prices (we expect Brent to remain relatively stable in 2018 at around USD 65 a barrel). Finally, an escalation of geopolitical tensions could harm the recent economic advances, while an imminent wave of more stringent sanctions from the US could deliver a short-term blow.

Conclusion

We remain constructive on emerging markets in general and we think investors should consider accessing the positive trends expected in Russia in 2018. In a nutshell, we believe that Russia will continue on its macro-stabilisation route, with moderate growth and low inflation. However, 2018 will not merely be a replay of 2017. Russia will undoubtedly be in the spotlight this year – if not for its presidential elections, then for the football World Cup; either way, we think 2018 could provide a good opportunity to enhance international relations with the West. We are also monitoring the possible extension on imposed sanctions. While we remain highly selective with regards to equities and corporate credit, we see a buying opportunity in local government bonds given that domestic inflation is falling, energy prices are stabilising, fiscal consolidation should mitigate the commodity-price risk and the ruble continues to be, in our view, slightly undervalued.

Source of all market and economic data: Bloomberg, unless otherwise stated.