Why I Was Wrong On RSX This Year

| About: VanEck Vectors (RSX)
This article is now exclusive for PRO subscribers.

Summary

RSX was a good performer in 2016.

I was bearish.

I explain the main reasons why my bearish thesis failed and outline some perspectives for the future.

The Russian market (NYSE: RSX) has been a very good performer this year, and I was bearish. Analyzing successful picks is more pleasant than looking at failures. However, analyzing mistakes is more useful, so it should be done. Here's what went wrong with the bearish thesis and what I think about the Russian market going forward.

The main reason is the interest rate

The Central Bank of Russia continues to keep the interest rate at an absurdly high 10.00% level. According to the Central Bank itself, the annual pace of inflation slowed to 5.6% in December.

The huge difference between the interest rate and inflation makes Russian assets attractive in a yield-starved world. Even the recent rate hike from the Fed did not damage the Russian market and the Russian ruble, as they remain highly attractive due to the rate.

What's more, the Central Bank reiterated multiple times that even if it was going to cut the rate, the cuts would be gradual.

Here's the direct quote:

"Positive real interest rates will be kept at the level which will ensure demand for loans without an intensification of inflationary pressure and will also preserve incentives for savings. The potential of interest rate reduction is limited in the near future".

In other words, the Central Bank guarantees that high rates are not going away no matter what, which leads to upside in both the Russian ruble and Russian shares.

The Russian ruble gained 20% against the dollar (NYSE: UUP) this year. The performance was more pronounced against the euro (NYSE: FXE): +26%. Naturally, the dollar-denominated RSX kept climbing up.

The interest rate factor is going to stay in the next year as the Central Bank tries to reach its 4% target. In my view, the target will be achieved at the cost of burying small businesses and putting consumers under pressure due to lack of growth.

The secondary reason is the OPEC/non-OPEC deal

Not surprisingly, the OPEC/non-OPEC deal led to a significant improvement in oil prices and, therefore, in oil-heavy RSX. Oil prices have already been near current levels two times this year, but it did not lead to such enthusiasm.

It remains to be seen whether the market puts too much faith into OPEC and non-OPEC agreement. Currently, oil-related assets, including RSX, are clearly pricing in continuous improvement in oil prices. If this potential improvement does not translate into reality, oil-related assets will be put under pressure.

Where do we go from here?

At the risk of sounding like a broken record, I must admit that I'm skeptical on RSX perspectives from current levels.

The Russian market has significantly rebounded from its lows, helped by the rebound in oil prices and the high interest rate. One might argue that the sanction regime will become easier in the second half of 2017 (although I am not a proponent of this theory), but restoration of oil prices to end-of-2013 levels looks plain impossible at this point. For this, oil price must increase by almost 100%. I don't think that is possible in the near-to-medium term.

I think a look at the 2012-2014 period in RSX might give a hint of what will happen in the future unless a serious catalyst like a huge rally in oil shows up: a wide trading range with lower highs due to structural problems of the Russian economy which have not disappeared during the current oil price crisis.

The possible white swan events are the removal of sanctions (less plausible) and the rally in oil prices (more plausible). In my view, the current level is certainly not comfortable for a new long position, even if you believe in the positive scenario for 2017 - a pullback is necessary. At the same time, those wanting to short RSX will also be better off waiting. Russia is about to enter long winter holidays up until January 9, so strange moves may happen.

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.