Russia’s Stock Market Rallies But Still Not a Source of Long-Term Capital

Western and Russian press reports have lauded Russia’s stock market as one of the best performing globally this year, calling it “the world’s hottest major stock market” and saying it gave investors “the highest returns in the world.” Indeed, the country’s leading indices broke free of the range they’d been trapped in since Western sanctions befell the country after the 2014 annexation of Crimea.

This uptick is part of a rerating that has been going on for about two years, but it is not rooted in any fundamental change in the market’s potential, in my view. Instead, the factors driving the most recent upward trend in Russia are largely one-off: receding fears of harsh new U.S. sanctions; big, consolidation-driven gains in large Russian companies; and new rules about dividends for state-run firms. None of these can address the long-term lack of confidence that has stymied Russian economic development for years.

The Numbers

Three major Russian stock indices have shown impressive growth this year, with at least one outpacing both emerging markets and developed countries in terms of return on investment. The dollar-denominated Russia Trading System (RTS) Index, the preferred platform for most international investors, hit 1,471 as of Nov. 7, its highest level in six years, and has returned 36 percent this year to date (YTD). The ruble-denominated MOEX Russia Index crossed above 3,000 last month for the first time since its creation in 2003 (dropping back a little since then) and has returned 26 percent since the start of the year. In early November, the benchmark MSCI Russia Index, which includes 23 major Russian companies, was up 44 percent YTD in terms of returns (including dividends), well ahead of the MSCI Emerging Markets Index growth of 12 percent, and showing double the growth in developed countries' markets (22 percent), according to a Sberbank analyst cited by RBC. As of Nov. 29, returns from the Russia index were 30.5 percent.

Before bouncing back, the RTS had underperformed both the world as a whole and Russia’s emerging-market peers over the last five years, but in the last six months or so the Russian stock market has performed very well, surpassing other emerging markets as a group (see chart below). Since May 1, 2014, shortly after the U.S. and European Union imposed the first round of sanctions over Russia’s actions in Ukraine, the RTS has returned 16.2 percent, whereas the MSCI AC World Index has returned 31.4 percent and the MSCI Emerging Markets Index has returned 23.3 percent; but index returns on the Russian market are up 14.7 percent over the same period, versus downturns of 23.7 percent in South Africa and 9.5 percent in Brazil. The star performer over this period has been Asia, with 18.8 percent gains and a Chinese market that has lifted the value of securities in the whole region

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RTS RETURNS vs MSCI INDICES, 2014-2019

Political Pressure Relaxing

One factor that has spurred investors to turn back to Russian stocks is the easing of Western political pressure on Moscow, in part at least because Russia’s integration into global markets has made it difficult to impose targeted sanctions without inflicting collateral damage on U.S. businesses. As recently as September 2018 Russia’s Central Bank was worried enough about new U.S. sanctions causing currency instability that it prophylactically hiked its key overnight rates by 25 basis points in anticipation of the effects. Early this year, around the time that the Mueller report was released, analysts had called new U.S. sanctions “likely” and said to expect them “before the year is out, if not significantly sooner.” But the sanctions never came. Thus far, major punitive U.S. legislative initiatives like DASKA and DETER have stayed on the drawing board, not least because of pressure from U.S. business lobbies with billions of dollars on the line. Meanwhile, public attention in the U.S. has switched to Ukraine and its connection to the possible impeachment of President Donald Trump.

At least two specific sanctions-related cases illustrate the collateral-damage problem. First, when the U.S. Treasury Department tried to sanction Russian aluminium producer Rusal and its parent company En+, in April 2018, the move caused chaos on international metals markets and threatened to cost U.S. investors holding the company’s stocks and bonds hundreds of millions of dollars. This led the Treasury first to postpone the measures and eventually, in January, to drop them completely after Oleg Deripaska agreed to reduce his stake in En+ to 44.95 percent—the first time any sanctions on Russia had been withdrawn since 2014. Similarly, when the second round of sanctions connected to the poisoning of Russian spy Sergei Skripal in the U.K. came due in August this year, the threat of targeting Russia’s sovereign bonds failed to materialize. Perhaps the most important of the bonds were the ruble-denominated OFZ treasury bills, which are currently crucial to U.S. pension funds needing to meet pay-out obligations in the face of low interest rates. (Foreigners hold 32 percent of all OFZs, some $40 billion worth.) In the end, U.S. investors were banned from buying Russian sovereign Eurobond issues on the primary market, but there was no ban on buying the same assets on the secondary market, and the OFZs were not mentioned at all. It is hard to image a more painless sanctions regime if you tried.

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Big Companies Benefiting

In parallel to the easing of political pressures, another factor driving up the Russian stock market indices has been the growing attractiveness to investors of Russia’s leading companies, which have emerged strong from the crisis years. (Apart from sanctions, Russia went through an oil-price collapse in late 2014 and an attendant crash of the ruble.) While economic growth in the last year has been lackluster, with GDP expanding by 2.3 percent in 2018 and on course to grow by only about 1 percent this year, at the microeconomic level things look a lot rosier: Profits in both companies and banks have been rising strongly and have more or less doubled each year for the last three years (see charts below).

One reason these big companies have become more profitable is that they have benefitted disproportionately from a rapid and comprehensive consolidation in most sectors of the Russian economy, which took place from about 2013 to 2016. As Russian corporates have never relied heavily on credit to pay for investments, most have built up big war chests of retained earnings. The biggest companies used their deep pockets to grab market share by slashing prices or simply buying up their smaller rivals. Although ordinary Russians’ real incomes, by some counts, have fallen for at least five of the past six years, the earnings and profits of Russia’s leading companies—most of them publicly traded—have grown strongly.

Another reason for the interest in Russian corporate giants’ stocks is that around 2016 some of the best ones simply became “too cheap to ignore” for portfolio investors. Immediately following the introduction of sanctions, the seemingly high risk kept buyers away from Russian stocks and their prices fell. But at some point, those willing to take a risk realized that these dirt-cheap stocks belonged to lucrative businesses and started buying, kicking off a new trend. In 2016, for example, the shares of the leading supermarket chain, X5 Retail Group, doubled in value as it overtook its nearest rival, Magnit, to become Russia’s biggest retail company in terms of revenue—a more than $10 billion-a-year business. (It is not surprising, incidentally, that Russia’s overall rerating—which hinges on a perception of lower risk—began in retail, as that sector is seen as the least exposed to sanctions and politics.)

Sources: Russia’s Federal State Statistics Service (Rosstat) and Ministry of Economic Development

RUSSIA'S GDP GROWTH (%, year on year)

Source: Rosstat

RUSSIAN CORPORATE PROFITS (RUB bn, cumulative, month on month)

Source: Central Bank of Russia

RUSSIAN BANK SECTOR PROFITS (RUB bn, cumulative)

Dividend Boost

In the past couple of years, another driver has pushed up Russian stocks even more than the increasing monopolization by big companies: new dividend rules for Russia’s sprawling public sector. After a near-miss budget crisis in 2016, resulting from the oil-price collapse and sanctions, the Finance Ministry rushed to impose a raft of reforms to improve tax collection and find new sources of revenue. One of these was to demand that state-owned enterprises pay out 50 percent of their income as dividends—a lucrative incentive for would-be shareholders.

While smaller state-owned companies obeyed, most of the largest resisted the change; however, this summer, in an embarrassing climb-down, the management of state-owned gas behemoth Gazprom finally gave in, hiking its dividend payments twice in a week to double the amount it had been paying, to almost 50 percent of profits, with the full 50 to kick in next year. Investors were taken by surprise and Gazprom’s stock soared 30 percent overnight. Altogether the company’s stock has gained 74 percent YTD, making it one of the best performing stocks on the market and Russia’s most valuable company again. (Sberbank, another major Russian state-owned company, is also due to get its dividends up to 50 percent next year.)

Russian corporates are currently paying double the dividends, on average, as other emerging markets: an average 6.7 percent as of early November, according to the benchmark MSCI Russia index—twice the MSCI Emerging Markets average.

But the dividends rule is a one-off gain. Next year’s market performance will almost certainly be more modest and depend on a general economic recovery and the growing earnings per share of the leading non-state companies. Furthermore, despite their effect on markets, the rising dividend payments among all companies—both private and public—are not necessarily a good thing, as they mean that owners are paying out cash to shareholders rather than investing profits into increasing productivity and otherwise growing their businesses.

This focus on short-term gain over longer-term investment compounds a major problem, which I described last year: Russia has been plagued by a crisis of confidence and attendant capital flight for most of the last three decades. Since the collapse of the Soviet Union, there have only been two years when Russia experienced a net inflow of capital: in 2006 and 2007, when Russian businessmen brought circa $133 billion home at the height of a brief economic boom. In those two short years, optimism reigned. But the global financial crash of 2008 splashed cold water on the business elite and $131 billion left the country the same year.

Since then, Russia has continued to bleed money, but instead of the classic scenario where oligarchs whisk cash offshore to some balmy safe haven, the capital flight has been driven, in my view, by banks and companies paying down expensive debt. Sanctions acted as a catalyst for this extreme fiscal responsibility, as they had effectively closed off access to capital markets. At the state level, President Vladimir Putin, too, pursued a “fiscal fortress” policy of paying off debt as fast as possible and building up gross international reserves—both of which Russia has successfully done.

Sources: MOEX, BCS Global Markets, VTB Capital

KINGS OF THE CASTLE: RUSSIAN STOCKS' MARKET CAP (USD mn, end of period)

Stuck in the Fortress?

The fortress mentality now pervades Russia. The government has forgone fast growth for security. Business owners are content with their well-developed companies and prefer to accumulate cash rather than leverage and risk what they already have. The established businesses continue to grow, become more efficient and capture more market share, as what else are they going to do?

I believe that 2020 portfolio investors will still be able to make significant returns. My prediction is that just investing into the stocks that pay high dividends will return more than the long-term 8 percent average that equity investments usually make. But the market will remain a stock pickers’ story. And without an improvement in the investment climate, the economy will continue to stagnate unless Russia can be made attractive to Russian businessmen again, let alone to foreign investors.

Russia Matters

RUSSIAN STOCKS BY SECTOR, YTD RETURNS (%)

(Author: Ben Aris, editor in chief and co-founder of bne Intellinews)

The opinions expressed in this article are solely those of the author.