Russia: Too Late To Sell

Summary

• The Russian market returned to the level of a year ago, showing the worst dynamics among the EM countries.
• The economic and geopolitical situation around Russia both have a tendency to improve.
• Long-term foreign investors are not willing to leave this market.

Investment Thesis

The fact that the Russian stock market is clearly oversold means investors will be counting on the growth of the VanEck Vectors Russia ETF (NYSEARCA:BATS:RSX) (a fund offers exposure to equities from Russian) up to the level of $21 in the current year.

For the first half of the year 2017, the Russian stock market demonstrated the worst dynamics among the countries with developing markets with a result of -13%, losing even to Brazil, which was severely affected by the political crisis. The dollar-denominated Russia Trading System (RTS) index is now at the level of June 2016. Therefore, an investor should ask himself: isn’t this market too oversold?

Let's start with the general macroeconomic situation, which, however, only creates the background, but does not determine the dynamics of the Russian stock market.

The growth of the Russian industrial production in May totaled 5.6% YOY showing the best result for the past three years. Partly this was due to statistical and one-time factors. For example, there were 20 working days in May 2017 as compared to 19 working days in May 2016. Abnormally cold weather in May also provided support to the public sector. Nevertheless, it is noteworthy that for the first time in two years, all the key sectors of the economy demonstrated positive dynamics of growth:

It is worth noting that in May, the Russian retail turnover growth accelerated to 0.7% YOY (+ 0.1% YOY in April):

Activity in the non-food segment is confirmed by a surge in sales of new passenger cars. In May, the growth in this segment amounted to 15% YOY (+7% YOY in April):

The domestic demand in Russia is supported by the increase in the nominal (+ 7.9% YOY) and real (+ 3.7% YOY) wages. However, this is insufficient to confidently state that the growth dynamics of the real disposable income of the population is now in positive values territory. Partly, this is because the growth of the real wages occurs primarily due to the lowering inflation, rather than raising salaries. In general, everything indicates that populations continue to save money, and for the moment it's holding back the recovery of the domestic demand in the country. But the situation is likely to improve.

Weak domestic demand hinders the recovery of Russia's economy, but, probably, this can be considered a temporary factor. Generally speaking, the expected Russia's GDP growth this year at a rate of 1% seems quite adequate to boost demand.

The key reason for the current weakness of the Russian stock market is not its economic performance, but the fear of investors associated with the introduction of the new sanctions. That is why, as a consequence of unmet hopes of a quick rapprochement between Russia and the United States, there has been an outflow of capital from funds focusing on the Russian market over the last four months.

However, if you look at the situation on the larger time scale, you can see that there was no large-scale outflow of foreign investors’ funds. Moreover, over the period from June 2016, the cumulative inflow of foreign capital to the Russian market amounted to more than $3 billion. In my view, the long-term investors still have faith in the potential of this market and are unwilling to leave it.

A few words about the political background, which also, in my opinion, has the potential to improve.

The visit of Angela Merkel to Russia in May did not result in any loud statements or breakthrough in relations. But the very fact that the German Chancellor visited Russia almost immediately after the end of Trump's visit indicates the EU's desire to improve their relationship with Russia.

It is interesting to note that, according to insider information from people close to the negotiations between Putin and Merkel, the parties agreed on the opportunity to introduce peacekeeping forces to the East of Ukraine to de-escalate the situation in the region.

Around the same time, the President of Ukraine announced the development of a similar scenario that could resolve the conflict.

It gives the impression that all parties to the conflict, including the EU, are tired and prone to compromise. Therefore, progress may follow.

Moving on. The meeting between Putin and Trump via the G20 ended with the announcement of a ceasefire in the Southwest of Syria within the framework of which Russia agreed to enforce the no-fly zone over the region. The United States was striving for it, supporting the opposition that does not possess aircraft to defend itself. This was not a breakthrough because the agreement was prepared well in advance of the meeting. But it is a formal step towards normalization of the situation.

As we can see, the political context of the situation also has the potential to change for the better. At least, there was no deterioration, compared with June 2016.

PUTTING IT ALL TOGETHER

Any investment is always a balance between the risk and potential. The Russian market remains very risky primarily because of the political factors, but at the same time, having practically returned to the level of one year ago in the last month, it has become even more undervalued.

The country's economy is improving, and the geopolitical situation around Russia is not expected to worsen and even leaves a chance for improvement.

On this basis, I believe that the fact that the Russian market is oversold allows expectations for VanEck Vectors Russia ETF (ETF offers exposure to equities from Russian) to rise to the level of $21 before the end of the year. As such, selling in this market may actually be riskier than buying.

Analyst’s 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.