Is The Russian Bear Out Of The Woods?
Summary The Russian economy is still depressed, but may have found its bottom. Valuations are reflecting a collapse, which is no longer realistic. First signs of returning investor appetite and technical picture brightens. For risk-prone investors, it may be the moment to add Russia in their portfolios through RSX and RSXJ. Shortly after the publication of my previous article on the Russian market, we witnessed nothing less than a crash on August 24. The Russian stock market, the leading Market Vectors Russia ETF (NYSEARCA: RSX ) and its small-cap family member the Market Vectors Russia Small-Cap ETF (NYSEARCA: RSXJ ) saw a sharp drop during that day but failed to hit new lows compared to the previous ones in December 2014 (more on the charts later on). Since that day, the Russian market recovered, like most other stock markets, also helped by a recovery in commodity prices. So, did the August 24 turbulence mark the end of the bear market in Russia and thus for the above-mentioned ETFs? Let’s take a look at the underlying fundamentals and the technical picture. Economy in dire state Compared to two months ago, the Russian economy did not change for the better. According to Russian Deputy Economy Minister Alexei Vedev, in September, Russia’s gross domestic product (GDP) dropped 3.8% compared to last year. He added that preliminary data points to a 4.3% drop in GDP during the third quarter. Prospects for economic growth remain suppressed too. The International Monetary Fund (IMF) expects GDP to decline 3.8% this year. Next year will see a flat development at best. More likely is a small contraction before the economy can return to rates close to 1.5% in the next years. Compared to the previous recession, during the financial crisis, a sharp recovery is less likely since commodity prices are now low for an extended period of time. In the words of IMF’s Russia representative Gabriel Di Bella (source Reuters): “What we had in 2009 were shocks that were more temporary in nature and what seems to be the case right now is that the shocks are… not very short term,” Di Bella said. “They’re shocks that are more persistent.” Recent underlying numbers are close to miserable. For instance, retail sales dropped 10.4% YoY vs. -9.3% expected, and capital investment declined 5.6%, although this was better than the -6.9% expected. Also, real wages figures were slightly better than expected, but -9.7% is still poor. Compared to the nominal wage growth of 4.5% in September, it’s clear where Russia’s main problem lies. Inflation still troubling The biggest challenge for Russia is the current high inflation and expectations that are unanchored. Consumer price inflation (CPI) came in at 15.7% in September, far from the Central Bank of Russia’s (CBR) long-term target of 4%. The CBR aims to return to a CPI rate of 4% by the end of 2017. But roughly 70% of the Russian population doubt the institution will succeed in bringing down inflation to that target and this group is growing in the recent months. On the other hand, the IMF’s Di Bella and some analysts do see a slowdown in inflation in the coming months, partly due to a base effect. The problem is that the CBR’s key policy rate stands at 11% and is too restrictive for the current shape of the economy. But with inflation rate this high, a cut in the next monetary policy meeting (October 30) is tricky. The IMF calls the CBR to hold rates during the next meeting, but analysts of ING expect cuts of 50 basis points during the next two meetings (source: Bloomberg). According to CBR Governor Elvira Nabiullina, cutting the level of capital requirements may be another option to spur additional lending to the economy. The banking sector is stable and Governor Nabiullina said the sector would see a profit of around RUB 100-200 billion (USD 1.5-3 billion) this year. Companies show encouraging numbers Sberbank ( OTCPK:SBRCY ), which is the 2nd largest holding of RSX, was able to show a 9M-2015 RAS net profit of RUB 144.4 billion (USD 2.2 billion), although this was 50% lower than last year. This was mainly due to a 16% drop in net interest income. Net fee and commission income rose 6%. For a better picture, we have to wait for the IFRS numbers. The retail sector shows numbers which seem in contrast to the dire state of the Russian economy. Despite the poor aforementioned retail sales, listed retail companies showed encouraging numbers. For instance, discounter Magnit, a top 5 holding of RSX, was able to increase its revenues 27.2% YoY to RUB 690.4 billion (USD 10.6 billion) during the first nine months of 2015. Net income rose 27.6% to RUB 43.2 billion (USD 0.7 billion) during the same period. Supermarket-chain X5 Retail Group, also included in RSX, reported that its Q3 revenues grew 28.6% YoY on the back of a 13.1% like-for-like revenue growth. But also net income showed a decent increase with a plus of 21% YoY. To remind ourselves, Russian companies are still heavily undervalued compared to peers from other emerging and developed markets. For instance, Magnit is trading at a price/earnings ratio of 12.7 (2015e) and X5 Retail trades at a P/E of 12.8 (2015e). The average P/E of RSX is 5.9 and lists at a price-to-book ratio of 0.8. Its smaller family member, RSXJ, quotes a P/E ratio of 7.5 and a P/B of slightly below 0.5! First signs of a reversal The low valuations accompanied by relatively healthy company fundamentals are luring a growing number of investors back to the Russian market. Earlier this week, retailer Lenta, known for its budget hypermarkets, successfully sold new shares and raised USD 150 million in capital. The company intends to use the proceeds from the share placement to speed up store openings and aims to open at least 40 new hypermarkets in 2016, a number upped from the previous planned 32. For 2017, the company seeks to open a similar number of stores, or even more. Bond investors are returning to Russia as well and seek new or additional exposure. However, this is not because of the sound macro-environment surrounding Russia, but more so due to initial fears of a collapse accompanied by a wave of defaults did not materialize. Many investors who cut their exposure reenter due to attractive valuations. According to Reuters, USD returns on Russian bonds yielded 12% thus far in 2015 and corporate bonds even 20%. The country saw net capital inflows in the third quarter. What does the trick is that Russia and its companies have very low debt levels. Therefore, a number of asset managers are willing to rotate part of their funds back into the country. Though, it should be said that emerging peers, such as Brazil, have a much bleaker outlook which helps the move (back) to Russia. Stock market may have found the bottom Investors should realize that most of the gains are made when moving in front of the curve. Waiting for the economic turnaround may be too conservative and one could miss out on the big move. When looking at the charts of the main ETFs for the Russian market, one for the large caps and one for the mid and small caps, we notice that despite the crash of global markets on August 24, new lows stayed off. This is an encouraging sign from a technical point of view. Not hitting a new low on the selling pressure during August 24 may indicate that the remaining supply can easily be picked up by demand at current levels. RSXJ had a rougher day but set a double bottom pattern. In the field of technical analysis, double bottoms are regarded as the best chart patterns (see also Thomas Bulkowski thepatternsite.com ). Both ETFs are close to their 200-day moving average but already crossed the 50-day moving average. However, a so-called ‘Golden Cross’ has yet to appear, although this mostly will occur after a strong rally. An investor waiting for that sign may miss a large chunk of the move. (click to enlarge) When comparing RSX with the MSCI Russia Index, we see something interesting. The RSX is able to outperform the MSCI Index, despite the annual fees of 0.6% (see chart below). The outperformance amounts to 5% during the last four years. This highlights why RSX is a solid instrument to play the Russian market. Unfortunately, during the measured period, a loss of 37% was recorded. Risks remain, but the brave may enter The Russian economy continues to struggle. The government may be forced to finance its budget deficit by taking USD 35 billion from the International Reserves, managed by the CBR. But that’s why these funds are created for, and with reserves totaling USD 377.3 billion (as at October 17), there’s ample room. Next to that, Russia’s debt-to-GDP is still at a very low 17%. Nonetheless, the government should proceed with reforms. Encouraging is that government officials acknowledge that the country cannot navigate on oil prices. Oil prices stabilizing at around USD 50 or even rising to USD 60-70 will not be enough for a full-scale recovery. Russia’s budget is based on an oil price of USD 50. The government seems to realize that more taxes is not the solution. It is finally considering to raise the retirement age, although this may be a highly unpopular measure. The country is also strengthening its ties with China and overtook Saudi Arabia as China’s main oil trading partner. Nevertheless, China is known to prefer balanced ‘market shares’ when looking at its oil imports, so the upper bound in China exports might be near. Additional government initiative could be the last stage before an economic recovery can take off. The Russian financial market is now valued at distressed levels. So from that point of view, there’s a lot needed to push valuations even lower. It may be time to (start to) add Russia in the portfolio. As described in my previous article on Russia, small- and mid-cap companies should be preferred in a recovery, which points to RSXJ. Investors should be advised that the order book of RSXJ can show large spreads and, therefore, investors should make sure to check the NAV on the site of the ETF provider to prevent paying too much when placing an order on the screen. In addition, shares of RSXJ have limited liquidity and total assets of RSXJ is only USD 40 million. RSX may, in that case, be a better option (1x spread and ample liquidity, assets of USD 2 billion). But either choice could show a lot of potential for the long term. If an investor is interested in the Russian market and comfortable with the country-specific risks, this might be the time to enter.