Stabilizing Factors Emerge

While Russian macroeconomic conditions have continued to deteriorate, with negative news on both industrial production and fixed capital investment, we see several stabilizing factors that should allow the Russian market to outperform in the near term and close the massive discount gap between Russian and emerging market valuations. Stabilization of the oil price and continued ruble strength mean MSCI Russia has outperformed the emerging markets by a wide margin so far in March.

We monitor the following five indicators for signs of stabilization in the Russian market: the oil price, 60-day realized volatility, CDS spreads, the ruble and a set of leading indicators. The first four indicators have a strong long-term correlation with the RTS index, with the exception of realized volatility. However, we believe that a decrease in volatility from unprecedented highs contributes to market stability.

In the past month, four of our indicators have exhibited positive signals while BAS-ML leading indicators of macroeconomic activity have declined at a slower rate. The oil price has stabilized, the ruble has strengthened, while both realized volatility and CDS spreads have trended downward. Positive news from financial institutions in the U.S. has also contributed to better global sentiment. This should at least stabilise the market in the near term, and allow Russia to close the massive valuation gap from MSCI emerging markets.

Three additional factors should contribute to the near term outperformance. First, Russia remains under to neutral weight in Global emerging market portfolios. Second corporate governance fears are starting to subside. Third, as central banks around the world are resorting to quantitative easing, demand for real assets and commodities increases, which is also positive for the Russian market.

The risks to our bullish near term Russia call stems from the continuing problems with the banking sectors in Russia, increasing NPLs and the contagion effect that those problems might mean for the real economy.

Our top picks for the near term are Norilsk Nickel, LUKoil, RusHydro, Uralkali, Pharmstandard, MTS and CTC Media.