Emerging Markets: Contrarian Investment In Russian Equities

| About: iShares MSCI (ERUS)

Summary

For the last six years, Russian equity underperformed developed markets.

For the last year, despite the drop in the price of oil and sanctions, Russian equity outperformed developed and other emerging market countries.

Investment in Russian equity is an excellent opportunity for any contrarian investor.

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Russia is the largest country by the landmass and the fourth largest emerging economy in the world. Russia was the most promising emerging market country before the financial crisis in 2008.

One of the reasons the USSR dissolved was a significant economic dependency on the price of oil. Russia has very similar economic model, where 14.5% of the GDP accounts for the exports of the oil and gas.

The price of Russian equity is highly correlated with the price of the oil: a sharp decrease in the price of oil in 1998 led to the Russian crisis and a decline in the equity value.

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Source: Bloomberg Terminal

A significant drop in oil prices and sanctions implemented by the USA and the European Union put the Russian economy into recession in 2014, from which it has not yet recovered.

For further analysis, I will compare iShares MSCI Russia Capped ETF (Ticker: ERUS), the largest Russian single factor ETF, and SPDR S&P 500 ETF(Ticker:SPY) as an opportunity investment for American investors. I will analyze why investors should or shouldn't choose a single factor, emerging market ETF over the well-diversified, developed market ETF.

For the last six years, ERUS underperformed SPY by 18.85%.

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Source: Bloomberg Terminal

What has contributed to the poor performance of the ETF?

Based on the composition, it's not a diversified portfolio with high exposure to unsystematic risk: the core investments (70% of the aggregate composite) in the Energy and Financial sectors, are very sensitive to the price of oil and macroeconomic factors.

For the last two years, drops in oil prices, depreciation of the ruble, and sanctions fueled inflation that decreased the value of the shareholders.

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Source: Bloomberg Terminal

Despite the high dependency of Russia on commodity prices, markets don't believe in the possibility of default: CDS spread has been stable for the last few years and taking into account only 35.67% of the external debt to GDP, Bloomberg model applies a low risk.

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Source: Bloomberg Terminal

With the significant concentration in the Energy and Financial sectors, the sharp decline in oil prices, and sanctions against Russian financial institutions, can one expect even worse performance for the last year?

Despite the overall poor performance, iShares MSCI Russia Capped ETF outperformed S&P 500 Index (Ticker:SPX) by 11.92% and iShares Emerging Markets ETF (Ticker:EEM), the largest well-diversified ETF, by 11.05% for the last year.

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Source: Bloomberg Terminal

What contributed to the outstanding performance of the fund last year if it didn't perform well before?

The increase in the price of the oil and interest rate cuts helped to reduce inflation, boosting the performance of the fund.

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Source: Bloomberg Terminal

The fight with ruble depreciation and inflation cost Russia $140bn in foreign reserves, which is used to cover the balance of payments gap.

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Source: Bloomberg Terminal

Therefore, there is a risk of running out of reserves that prevent the national currency from depreciating and keeps inflation in the target zone, with potential adverse effects on the equity value.

What can investors expect?

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Source: Bloomberg Terminal

Based on the forecasts, Russia is predicted to slowly recover from the recession, with only 1.5% of GDP growth in 2018. On the other hand, inflation is predicted to decrease by 4.5%, while currency is expected to depreciate by 12%.

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The price of oil is projected to increase to $63-$65 per barrel.

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Source: Bloomberg Terminal

All of the above may increase the value of shareholders if the forecast is accurate.

What are the main risks of an investment in Russia?

Russia is a hazardous country for investment, as there are two main sources of risk:

1. Political

For the last two years, corruption has significantly increased based on the EIU Political Risk Score for Russia.

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Source: Bloomberg Terminal

The primary source of political risk is international affairs:

  1. The USA and EU posted sanctions because of the annexation of Crimea and involvement in the conflict in the east of Ukraine. There are possible scenarios with Ukraine:
  • Putin will escalate the conflict, and the USA and EU will implement another set of sanctions that could potentially lead to higher inflation and depreciation of national currency that will result in a decrease in the wealth of shareholders.
  • Russian oligarchs who are tired of losing money due to the sanctions may pressure Vladimir Putin to back off.

2. Russian involvement in the war with ISIS puts a high pressure on the economy, which is in a deep recession. Moreover, the European Union and the USA are considering new sanctions against Russia due to actions in Syria.

3. Russia has a high degree of corruption, meaning that the judicial system is serving the interests of the oligarchs, who control major companies. The legal system will not protect shareholders.

Russia is in the bottom quarter of the Freedom from Corruption Index, which decreased to 22 from 28 for the last year.

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Source: Bloomberg Terminal

2. Economic

  • The recession is not expected to end for the next years even in light of the forecasted oil price increase.
  • The Russian economy is highly dependable on the price of oil, and if the price of oil doesn't rise, the central bank will have limited ability to fight inflation and save national currency from inflation that negatively affects shareholders.
  • Russia is very quick to burn foreign reserves and support target inflation and national currency. To save the foreign exchange reserve, Russia can increase taxes, decrease government spending, or increase borrowing. Increasing taxes or decreasing government spending would deepen the recession.
  • Since the last financial crisis in 1998, Russia has had a low debt level. The reasonable option is to enhance sovereign borrowing, which is currently very low. Analysts expect that Russia will issue $7bn of sovereign debt in 2017 to support economic recovery.
  • Russia Government Debt Chart

    Russia Government Debt data by YCharts

  • The yield on Russian debt is lower than Brazil and Turkey. Brazil is rated Ba2/BB/BB, and Turkey is rated Ba1/BBB-/BB+ by the three leading rating agencies.

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Russian credit ratings:

In light of the degree of political and economic instability, sanctions, and lower credit ratings, the government may have to increase interest rates to attract foreign investors that will put upward pressure on inflation and decrease the shareholder wealth.

The Bottom Line

Investments in a single-factor ETF represent a high degree of country-specific risk due to the high level of uncertainty. Investors interested in investment in Russia may want to consider investing in broad-based ETFs, which eliminate country-specific risk through diversification and limit potential losses.

As for the single-factor ETF, taking into account current economic situation, forecasts, and political and economic risks, investment in Russia will be suitable for the contrarian investor for the following reasons:

  • Most of the market participants are bearish on Russian investments due to the high degree of political and economic risk, but betting against the market could have a great payoff.
  • iShares MSCI Russia Capped ETF (ERUS) has a higher dividend yield, is relatively cheap, and is undervalued to the SPDR S&P 500 ETF(Ticker: SPY) based on P/E, P/FCF, P/B, and P/S ratios.

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Source: Bloomberg Terminal

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  • There is a chance to buy equity cheap during the massive sell-outs. Markets are waiting for the next interest hike, which increases panic in the markets and sales of emerging market debt and equity.

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  • After a recent interest rate hike in December 2014, the price dropped from $17.69 to $11.40 per share. Markets expect the next interest rate at the end of the year will likely lead to another massive sell-off.

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Source: Bloomberg Terminal

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.