Home > Russia, Ukraine > Pragmatism and Oil Should Cut Russia’s Risk Premium

Pragmatism and Oil Should Cut Russia’s Risk Premium

June 24, 2014

by Chris Weafer, Macro-Advisory Ltd

“The second half of this report is a review of the trends and risks in the oil industry. We have upgraded our second half oil price assumption to US$115 p/bbl and see a greater threat of a spike to US$120 p/bbl than a retreat to US$105 p/bbl for Urals crude”.

Despite the continuing violence, serious sanctions risk has eased.
Despite the continuing violence in eastern Ukraine, the addition of several individuals to the US sanctions list on Friday and the threat of so-called scalpel sanctions later this week, we believe that the available evidence shows the emergence of political pragmatism in Kiev and Moscow. President Vladimir Putin needs to avoid a move into more serious trade and economy disrupting sanctions and President Petro Poroshenko has a long list of difficult tasks ahead. Despite the Kremlin’s public response, the peace-plan tabled by President Poroshenko covers most of the concerns voiced by the Kremlin. Ukraine will sign a trade deal with the EU on 27 June.

Overly optimistic to expect an end to fighting anytime soon.
A scenario where there is a long-lasting low level, or sporadic, fighting in eastern Ukraine is entirely possible and that will keep investors nervous and the self-sanctions we have seen over the past three months in place for the rest of this year.

Russia wants to limit any further self-sanctions.
We do not expect the more damaging self-sanctions to end anytime soon and most foreign investors and banks will likely remain wary of Russia risk for the rest of this year. However, despite the tough rhetoric from some EU leaders, we do not see any further appetite to move beyond sanctioning individuals or minor use of the “scalpel sanctions” Certainly nothing to materially further disrupt the economy. If anything, the escalating fighting in northern Iraq and the threat of the conflict spreading across the region, has reminded the EU that the real threat to energy security is not Russia and that alternatives to Russian energy imports are actually very few.

Expect equities to (cautiously) rally further.
Russian equities are trading at a 52% discount to the MSCI EM based on a 2015E P/E. The more appropriate medium term valuation gap is 33%, which implies approximately 22% upside for the market relative to the MSCI EM. However, we do not expect the valuation gap to reach 33% this year – instead we expect to see the RDX ($DR) Index to gain another 10% relative to the MSCI EM over the remainder of this year, most likely in the autumn when investors will be more assured that sanctions risk has ended.

Investors will remain cautious this year.
For a full move to the 33% valuation gap, investors will need to be sure that the economy is recovering strongly, that external political risks have permanently abated and that the government remains focused on business reforms. In this note we list the factors that should reduce the P/E valuation gap to 33% against the MSCI EM P/E and the longer-term factors that might justify the Russian market P/E rising closer to the EM average.

MICEX has recovered all of the Ukraine losses.
The MICEX Index has rallied 20.1% since the mid-March low and is now down only 1.1% YTD, which compares relatively well with the YTD gain of 4.1% for the MSCI EM Index. The RDXUSD Index, which tracks the performance of liquid DRs, has rallied 23.5% since mid-March and is down only 6.4% YTD. However, most of the big EM investment funds have not yet returned to Russian equities and they are unlikely to do so until the trend in the economy and the extent of various risks become much clearer. That may emerge in the autumn if oil and political pragmatism hold firm, or in the fourth quarter as investors look at the better economic and earnings growth for 2015. Most of the money “playing” the rally since mid-March has been from traders and ETF flows.

Demand for long-term quality names still strong.
The expectedly successful placing of US$400 mln of QIWI DRs, which has already been underwritten, shows that demand for quality names in growth sectors of the economy remains undiminished by the recent crisis. It also shows that while there is a current reluctance to commit to the general market, investors remain convinced that the growth trend is intact longer-term and they will not pass up any opportunity to invest in one of the main growth industries.

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