I must admit that I was surprised when the Russian Central Bank left the key interest rate at 11% in its latest meeting. In my view, the timing was ideal for a rate cut. Oil prices were on the rise, the ruble strengthened and the decision to cut the rate by 0.5% or even 1% would not have sent waves across the FX market. However, the Central Bank was very clear with its message - it wants to battle inflation at all costs. What are the implications of this policy for the Market Vectors Russia ETF (NYSE: RSX)?
Why the Central Bank left the interest rate intact?
The Central Bank believes that inflation is the biggest problem of the Russian economy. The Central Bank estimated that consumer price growth rate was down from 9.8% in January to 7.9% as of March 2016. The regulator's target is to reach inflation of 4% by the end of 2017. It's rather hard to tell to what extent political necessity (Russia enters the active part of electoral cycle with parliament elections in 2016 and president elections in 2018) influences the decision to focus on inflation.
As you noticed, the Central Bank kept the interest rate much higher than its own estimates of inflation to battle inflation. The regulator noted that it was skeptical about the sustainability of the oil price rally and the upside in the ruble. While imports were clearly hurt by the weakness of the ruble, they could still contribute to inflation if ruble remained at the levels seen at the beginning of the year. Higher interest rate helps the ruble and, hence, the Central Bank's inflation targeting.
What are the consequences of this policy for the Russian stock market?
I am a big skeptic of the Central Bank's current policy which prioritize inflation over everything else. There is no inflation in the graveyard, but is this a good result of the policy? High interest rates put significant pressure on businesses and also on consumers who face sky-high credit rates whether they buy or TV or apply for mortgage.
While the energy and basic materials part of RSX holdings depend on global commodity markets rather than on interest rates at home, financials, telecommunications and retail will face significant pressure. Nominal wages barely increase, so it really makes little difference whether inflation is 6% or 9% - people have less real income and can afford less products.
Rising quantity of overdue credit and consumption optimization will put further pressure on non-commodity sectors. Consumption will increase if businesses and their workers earn more in real terms because of economic growth, not because the inflation target is reached. Back in 2015, real wages fell by 9.5% and I expect that this trend will continue in 2016.
As I mentioned in my previous article on RSX, oil prices were the sole factor of the recent upside. If oil price volatility continues, RSX will likely ignore economic developments and will trail the oil price both on the upside and the downside. However, if oil volatility decreases, market participants will be forced to look at the real economy and will have a hard time finding positive developments.
Despite the recent run-up, oil prices are at very low levels that put significant pressure on both the Russian economy and the Russian budget. In my view, this pressure is intensified by keeping rates high instead of trying to re-start the economic growth. The longer the combination of low oil and high rates exists, the more damage is done to the economy.
In my view, we will not see a gradual worsening of the economic indicators and may even witness a kind of a dead cat bounce in industrial production numbers and other important indicators. However, the damage is done every day that the current situation exists, which could translate into real and harsh problems in the longer term.
RSX may be a good speculative vehicle in case of further oil price upside. However, fundamental problems mean that it should not be used as a buy-and-hold target. In my view, the Central Bank policy exacerbates problems instead of solving them. I think that RSX has no upside unless oil prices rally up to $50 per barrel.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.