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THE RUSSIAN EAGLE – 2019 STRATEGY: STANDING AGAINST THE HEADWINDS DECEMBER 10, 2018

Standing Against the Headwinds

GEM equities experienced a spectacular selloff in 2018. Although Russia outperformed all GEMs, we expect the headwinds to continue. The flattening yield curve in the US suggests a fairly high probability of a cyclical slowdown, which would likely lead to earnings downgrades. Against this trend, Russia has a fairly large valuation cushion, which should help the market to continue outperforming, in our view. We expect Russia’s ERP to compress by some 200 bps in 2019 and set our end 2019 RTS Index target at 1,400. Within the market, we prefer exporters, primarily oil and gas stocks. We think the sector is best placed to outperform amid any geopolitical backdrop, as the sector benefits from a weak ruble when tensions escalate, and should they stay the same or ease, the whole market would likely rerate, led by banks, while energy stocks would still deliver good results in absolute terms.

Flat is still good

This year has been a tough one for equities globally. Almost all equity markets are set to close the year in the red. Against this backdrop, Russia’s flat performance is a fairly good result. Moreover, given Russia’s solid dividend yield, the RTS Index has so far delivered a total return of 5%, making it one of the best performing markets globally.

YTD equity market performance

Source: Bloomberg

Just a few weeks ago, it would have been easy to attribute Russia’s outperformance to soaring oil, with Brent peaking at $86/bbl. However, it has since slid to around $60/bbl and is now trading lower than it was at the beginning of the year. So the question is, why is Russia’s outperformance holding up, and is it sustainable? The numbers suggest that the outperformance has been driven by earnings upgrades, as its multiples have been sliding along with the rest of EM amid escalating geopolitical tensions. Russia has become even cheaper, as its 2019E P/E has slid from already depressed levels to just above 5. Meanwhile, the earnings upgrades have offset roughly 15% of the slide in P/E in dollar terms.

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DECEMBER 10, 2018 THE RUSSIAN EAGLE – 2019 STRATEGY: STANDING AGAINST THE HEADWINDS

Decent headline index performance hides a substantial divergence between individual sectors. In fact, Russia’s outperformance has been solely driven by the energy sector, which has been the only one to post gains in 2018. Metals have essentially remained flat while domestic oriented sectors have dropped 20 40% in dollar terms. The weak ruble has been the key reason for this divergence. The ruble has lost 13% YTD on the back of sanction fears and the fiscal rule, which prescribes the CBR to effectively sterilize any increased current account surplus. Domestic sector earnings have been revised downward along with the depreciating ruble, while exporters’ earnings have soared. Given that exporters generate more than 70% of earnings for Russia’s publicly traded stocks, the cumulative impact on index earnings has been positive.

GEM selloff

The GEM selloff has been one of the key events of 2018. Although Russia has managed to weather this storm thanks to earnings upgrades, it cannot remain immune to adverse trends in this asset class, as GEM funds are the largest group of investors in Russian equities. Flows in or out of these funds do matter for market performance. So we need to delve a bit deeper into the GEM theme to make a call on Russia.

The conventional explanation for the GEM selloff is that markets have been reacting to the Fed’s tightening cycle and a potential slowdown in global growth. The Fed has raised rates by 75 bps so far in 2018 and is expected to deliver another 25 bps at its December meeting. Ten year US Treasury yields have risen some 60 bps and the dollar has firmed 5% this year, which clearly looks negative for EMs. The question is whether these interest rate increases will be sufficient to derail global growth.

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THE RUSSIAN EAGLE – 2019 STRATEGY: STANDING AGAINST THE HEADWINDS DECEMBER 10, 2018

CONSENSUS ESTIMATES DO NOT FACTOR IN A SLOWDOWN

The IMF recently downgraded its global growth estimate by 0.2 pp, which does not look bad enough to claim that we are heading into a cyclical slowdown. The IMF anticipates global growth stabilizing at 3.6 3.7%. Of course, the IMF’s forecasts are not the best predictor for cyclical slowdowns. Another option is to look at what is priced in by the market. It is hard to directly derive real growth estimates from the available market data. However, we can take the evolution of revenues estimates as a decent proxy. The data on consensus revenues revisions is depicted in the two charts below. In DMs, revenue estimates have stayed pretty much unchanged throughout 2018, which suggests that markets are not pricing in any meaningful slowdown in global demand. For EMs, revenues have been downgraded by around 7% from the top. This fact can be attributed to EM currency depreciation: the index of EM currencies (weighted by MSCI EM country weights) has fallen by the same 7%. So the downgrade does not reflect any material deterioration in the demand outlook in real terms.

Meanwhile, earnings downgrades in the EM universe have been more material. EPS growth estimates for 2018 have been revised down from 22% at the peak to 10%. This downgrade reflects more than just revised revenue numbers. Margins have been hit as well. However, when we look at sector level margins in the GEM space, we see an interesting picture. Margins have been falling in defensive sectors but have been more or less stable in cyclicals this year. For example, the biggest margins revisions have been seen in the utilities space. This does not look like an anticipated cyclical downturn. More likely, the downtrend in margins in defensive sectors reflects cost pressure from rising commodities prices and weaker currencies.

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DECEMBER 10, 2018 THE RUSSIAN EAGLE – 2019 STRATEGY: STANDING AGAINST THE HEADWINDS

A divergence between margin trends in the defensive and cyclical sectors helps to explain another peculiar phenomenon in GEMs in 2018. After several years of dismal performance, value stocks have finally started outperforming. From what we have seen in client meetings, this has caught many investors by surprise, as institutional investors tend to be overweight growth stocks in GEM. The changing value/growth preference has been positive for Russia, and if persists, it will continue to support the market.

MSCI EM value relative to MSCI EM growth

Source: Bloomberg

OMINOUS SIGNALS FROM GLOBAL FI MARKETS

Our conclusion is therefore that the selloff in EM equities has been primarily driven by the strong dollar rather than a weaker growth outlook. However, other indicators are sending the signal that a cyclical slowdown is likely to materialize over the medium term. The US Treasury yield curve has been flattening throughout 2H18. An inverting yield curve is considered a fairly reliable predictor of economic recessions, and it is also associated with markets peaking, albeit with some lags. High yield bonds have started wobbling as well, with spreads jumping by more than 100 bps recently, also pointing to a possible slowdown.

If the fixed income markets are proved right in calling an imminent slowdown, we could see another wave of earnings downgrades, this time on a global scale, based on revised revenue numbers. However, the prospects for a slowdown mean that the dollar is unlikely to meaningfully appreciate further. With the yield curve flattening, the Fed will exercise greater caution over rate hikes. After all, US inflation remains under control and is not pressuring the Fed to tighten. The futures markets are now pricing in only two rate hikes: one this month and another in 2019.

Alternatively, if “this time is different” and the flattening yield curve does not signify anything and there is no slowdown, the Fed would be free to further tighten monetary policy. This would further support the dollar, sending more shivers across emerging markets.