Emerging Markets: Investors' Post-Election Outlook On Russian Equity

| About: iShares MSCI (ERUS)

Summary

Since the election, investors’ outlook towards Russian markets has improved. Russian equity markets have experienced inflows and emerging markets outflows.

Investors have changed their outlook because of high expectations over lifted sanctions and the increased price of oil.

High expectations and increased oil prices will boost the performance of Russian equity in the short term.

In the long term, investment in Russian equity is a bet on political risk and oil prices.

In my previous article, I expressed a contrary opinion on investments in Russia.

Election results in the USA hurt emerging markets, which subsequently led to significant outflow; based on IFF data, investors have withdrawn $13bn from emerging markets, $5.8bn from equity and $7.9bn from debt investments.

In this article, I will analyze the post-election effect on Russian markets and determine whether the investment environment and market expectations have changed.

The selection of Donald Trump as president has had a positive impact on Russian Markets: MSCI Russia index (MXRU) grew from $498 to $528.79. Meanwhile, MSCI Emerging Markets Index (MXEF) fell from $905 to $860.

Source:Bloomberg Terminal

Nevertheless, investors are not able to invest in the benchmark, and for further analysis, I will use the largest single country ETF VanEck Vector Russia ETF (TICKER: RSX) and the second single country ETF iShares MSCI Russia Capped ETF (TICKER: ERUS).

Since the election, both funds have not experienced withdrawals like other emerging market single country ETFs but instead, have seen increased inflows.

Source:Bloomberg Terminal

The NAV for VanEck Vector Russia ETF increased from $17.92 to $19.65. On November 15, 2016, issued an additional $4.99mm that reduced NAV from $19.33 to $19.

Source:Bloomberg Terminal

Before the elections, iShares MSCI Russia Capped ETF had reduced the number of shares outstanding from $24.5 to $12.7mm that increased from $15 to $30.15.

Source:Bloomberg Terminal

The mentioned patterns in both funds show the change in investor outlook from pessimistic to optimistic.

The question arises: What has been modified in the Russian markets that has changed the investors' perspective?

  • Political risk

Russia carries a significant political risk compared to the rest of the emerging market countries. The annexation of the Crimea and involvement in the conflict in the Donbass, Eastern Ukraine led to sanctions from the USA and EU. The sanctions were focused on the energy and financial sectors of the Russian economy.

These penalties are one of the reasons for the current economic recession, from which the Russian economy is not expected to recover until late 2017.

Both of the funds hold a significant part of the financial and energy sectors: VanEck Vector Russia ETF holds 53.9%, and iShares MSCI Russia Capped ETF holds 69.35% of securities of the mentioned sectors.

Source:Bloomberg Terminal

In an interview in July 2016, Donald Trump expressed the opinion that Russia didn't intervene in Crimea. This interview led to the view that Donald Trump plans to lift the sanctions, which would make Russian equity very attractive.

The current package of the sanctions are due January 31st, and while EU is not planning to lift the sanctions, it is difficult to know if the new administration will keep or lift the sanctions. Donald Trump's desire to "improve the US-Russian relations" is vague, and considering the temper of the president-elect this may turn in an unexpected direction.

In 2014 Congress passed the "Ukraine Freedom Act of 2014," which supported the Ukraine in the Russian-Ukrainian conflict.

Nevertheless, if Donald Trump decides to lift the sanctions, he will have to get it passed by Congress, which may not be keen on such actions.

  • Oil and gas exports

Oil and gas contribute 63% of total exports, which is 29.53% of the GDP. With a high dependency on oil and gas prices, the sharp decline in the oil price in 2014 hit the economy hard. Russia has one of the lowest costs of production-$19.21 per barrel, which was below the $30 lowest point in January of this year.

The recent OPEC meeting led to the decision to cut output by $1.2 trillion a day by January, which has increased the price of oil to $50.07. In a recent speech, Donald Trump announced that in the first 100 days of his presidency he would deregulate the oil industry and encourage more drillings. The current OPEC deal and increased price of oil will support Trump's efforts to improve oil production in the US and reduce dependence on OPEC imports.

One of the pre-election promises Donald Trump made was to cancel the Iranian nuclear deal and impose sanctions. With renewed sanctions, Iran will have a hard time attracting foreign investments to support the increase in supply. The cancellation of the nuclear pact would limit the supply of oil and support stability of the oil price. Still, the probability of the deal being cancelled is not likely as it would bring instability in the region, which is something Donald Trump would want to avoid.

Markets expect an interest rate hike in the next scheduled Fed meeting, which would strengthen the dollar and set back the demand for oil from the emerging market countries.

The price of oil is determined by supply and demand. Taking into account a potential decrease in the US and emerging markets demand and a possible increase in supply from US production, it is reasonable to believe that the price of oil will stay low, around the low $50s.

  • Currency risk

Depreciation of the national currency reduces the wealth of the shareholders.

Source:Bloomberg Terminal

The exchange rate of the ruble is highly correlated with the price of oil.

Source:Bloomberg Terminal

Source:Bloomberg Terminal

For the last month, the currency was volatile:

  • After the election, it depreciated from 63.80 to 68 rubles per dollar.
  • After November 15th, the currency appreciated from 68 to 64.57 rubles per dollar.

Performance

As a result of the currency appreciation, the performance of the VanEck Vector Russia ETF and iShares MSCIRussia Capped ETF improved in US dollars.

Source:Bloomberg Terminal

Source:Bloomberg Terminal

  • Russian equity is one of the best performers in the emerging markets.
  • Russian equity has experienced an outstanding performance due to the high expectations from investors.
  • The increased price of oil will boost the performance of Russian equity in the short term.
  • In the long term, investment in Russian equity represents a pure bet on lifting sanctions and increasing the price of oil, which will determine future performance.
  • At this point, it's reasonable to believe that investors have overreacted-the sanctions will likely not be lifted, and the price of oil will stay low in the long run, which will negatively affect performance.

The bottom line:

  1. The Russian economy has been hit by the sanctions and declining price of oil. The sanctions were focused on energy and financial sectors.
  2. Investors changed their outlook on Russian equity with the election of Donald Trump, who is expected to improve Russian-American relations.
  3. While emerging markets experienced withdrawals, Russian markets experienced inflows.
  4. The largest single country ETFs has a significant exposure to the financial and energy sectors.
  5. Russia still represents a significant political risk. It is hard at this point to predict what position Donald Trump will take on the sanctions. Nevertheless, even assuming the possible favorable stance from the president, the decision will likely have to face Congress and may be blocked there.
  6. The Russian economy depends on the price of oil, which can be reasonably assumed to stay in the low 50s in the long run.
  7. For the last month, Russian equity was one of the best performers out of all emerging markets due to investors' high expectations.
  8. In the short term, the performance will improve with an increase in oil price.
  9. In the long term, investment in Russian equity represents a bet on the price of oil and lifted sanctions.

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.

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