Weekly commentary from Wells Fargo Investment Institute on international topics in the news.
Peter Donisanu, Investment Strategy Analyst
Is it Time to Buy Russian Equities?
- Not all news surrounding Russia has been negative this year as its economy appears poised to post a solid rebound in 2017.
- While Russia’s economic recovery raises our fundamental view on the country, we expect energy prices to play a notable role in the country’s economy and equity markets.
What it may mean for investors
- Stretched valuations and range-bound crude oil prices suggest that now may not be the time to add to Russian equity positions. We recommend exposure to the country through a regional equity allocation to the Emerging Markets (EM) Europe, Middle East and Africa (EMEA) area for which we maintain our unfavorable rating.
Stories about Russia, particularly those surrounding the U.S. presidential-election campaign and sensitive U.S.-Russian foreign relations, have weighed on the country as an investment destination (in certain circles). Politics aside, recently-released indicators of economic activity have highlighted some good news—that the Russian economy may be on the mend following a two-year recession. Some investors have asked whether now is the time to add to Russian equity exposure (given recent economic improvements). Our response is: not yet.
While economic fundamentals are improving, the outlook on energy prices—a key component of Russian corporate earnings—is a little less certain. Additionally, we believe that a recent run-up in equity prices has made Russian equities expensive; therefore, we maintain our unfavorable rating on Russian equities as part of a diversified exposure to the EM EMEA region. Nevertheless, we believe that a more favorable view on the region may be warranted as energy prices stabilize, earnings rise and equity prices moderate.
We believe that economic fundamentals in Russia are improving, and one key indicator that we track to this end has been falling interest rates. The Central Bank of Russia (CBR) has been in the process of lowering its key policy rate as inflationary pressures in the country have eased. High prices on goods and services were initially triggered by a multi-faceted breakdown in the value of the Russian ruble in 2014 (Chart 1). This development came as the international community placed economic sanctions on Russia following its annexation of Crimea and military involvement in eastern Ukraine in early 2014.
The collapse in crude-oil prices in late 2014 further weighed on the value of the energy-sensitive ruble. International sanctions on exports to Russia, coupled with capital outflows and falling energy prices, led to a halving in the ruble’s value versus the U.S. dollar, and causing the cost of imported food, electronics and automobiles to double in some cases. As a result, the rise in Russia’s headline consumer price index (CPI) increased from 6.1 percent at the start of 2014 to nearly 17 percent by early 2015 (Chart 2). The CBR responded aggressively by raising its policy interest rate from 5.5 percent at the start of the year to 17 percent by year-end 2014.
The same events that had prompted the CBR to hike rates had an adverse effect on domestic economic growth. Rising interest rates made it much more expensive for Russians to borrow money, while higher prices of goods on store shelves put downward pressure on household spending. Sanctions also had an impact on foreign investment, causing some international firms to curtail activity in the country or quit Russia altogether. Finally, falling crude-oil prices depressed activity in one of the country’s largest industrial sectors: Energy production.
Nevertheless, the CBR’s proactive policies, coupled with a government campaign of domestic substitution and fiscal austerity, arguably set the stage for the country’s economic recovery. During the second half of 2016 and the first quarter of 2017, economic conditions in Russia strengthened as energy prices stabilized and the global economic outlook improved. We anticipate economic growth in Russia this year to expand for the first time in two years, but expect the implications for its financial markets to be mixed.
The MICEX index, a key equity-market index of Russian stocks, has exposure of more than 50 percent to the Energy sector. This compares to a six-percent exposure to Energy for the S&P 500 Index. What this means is that any improvements in Russian corporate earnings are more likely to come from stable-to-rising Brent crude-oil prices than from domestic economic conditions. We expect Brent crude-oil prices to trade in a flat range this year between $45-55 per barrel.1 It is likely that Russian corporate earnings may recover meaningfully if Brent crude-oil prices remain stable, while domestically-oriented sectors gain from a rebound in domestic economic growth. That said, risks remain to the downside in our outlook on crude-oil prices.
From a price perspective, the news cycle has helped pushed Russian stocks to relatively expensive levels. For example, the MICEX Index largely tracked modest gains during the first 10 months of 2016, following a broader trend in emerging markets as energy prices stabilized. After Donald Trump’s surprise win in November 2016, however, Russian stocks surged 13.5 percent in a few short weeks through year-end (Chart 3, left clip). This rally was largely attributed to speculation over friendlier U.S.-Russia relations and the potential reversal of economic sanctions.
Nevertheless, positive market sentiment quickly dried up as Donald Trump took office as president and Russia-friendly campaign rhetoric was replaced with policy ambiguity that resembled the status quo on U.S.-Russia foreign relations. As a result, year-to-date through March 20, the MICEX index pared 8.6 percent in value compared with an 8.2 percent gain in the broader MSCI Emerging Markets local-currency index. The sentiment-induced rally in Russian stocks this early in the earnings recovery cycle has left valuations stretched when measured against the five-year average (Chart 3, right clip).
We believe that improving economic fundamentals could be positive for Russian stocks, but near-term headwinds persist. Developments in global energy markets are likely to have an outsized influence on Russian corporate earnings. For now, we expect crude-oil prices to remain flat through year-end; a scenario that is likely to weigh on corporate earnings. Additionally, the recent run-up in equity prices has made Russian stocks rich on a historical basis.
Stretched valuations and range-bound crude oil prices suggest that now may not be the time to add to Russian equity positions. The Russian economy is the most important market in the Eastern European equity markets. Our unfavorable view of the Russian equity market therefore extends to Eastern Europe. More generally, our advice covers regions, and we find the emerging Asian region to be favorable, compared to the other emerging-market regions—Eastern Europe, the Middle East, Africa, and Latin America.2
1For more information on our crude oil outlook, please see our Global Real Assets Strategy report: “Good News on the Oil Front”, March 9, 2017.
2Please see our March 2017 Asset Allocation Strategy Report for more information on our regional rankings.
Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors.
Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
An index is not managed and not available for direct investment.
Russia MICEX Index is cap-weighted composite index calculated based on prices of the 50 most liquid Russian stocks of the largest and dynamically developing Russian issuers presented on the Moscow Exchange.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
The MSCI Emerging Markets Local Index is a free-float weighted equity index that captures large and midcap representation across Emerging Markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country. Changes in the index price are calculated in local currency terms.
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The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
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wow, seemed so obvious
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