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Neither option looks great for EMs, but it is worth noting that since derating this year, EMs do not look expensive, trading at a 2019E P/E of 10. This valuation cushion could somewhat soften the impact of earnings downgrades.

CHINA REMAINS THE BIGGEST RISK, BUT THIS IS UNLIKELY TO COME TO A HEAD IN 2019

Another large risk lies on the Chinese side. Markets have been living under a sword of Damocles for years in the form of China’s debt bubble. So far the Chinese authorities have managed to prevent this bubble from bursting by deploying new stimulus programs. However, the credit impulse is fading. In nominal terms, credit origination has faded by a quarter since late 2017. This shift appears to be even starker when considering that a substantial proportion of new loans is taken out simply to service existing debt.

China’s credit stimulus

New loans, CNY bln, annualized

New loans origination, % of total debt stock, annualized (rhs)

Source: Bloomberg, BIS

We do not expect this bubble to burst in 2019, unless there is some external event such as a full scale trade war. The Chinese government is keeping a tight grip and is clearly committed to holding growth to at least its targeted 6% rate, even if that means accumulating further imbalances. However, this risk remains something worth considering at all times.

Domestic backdrop: Solid and boring

The macro backdrop for Russian equities looks solid but unexciting. Investors long ago accepted that the Russian economy is unlikely to return to growth meaningfully above 2%. However, the country’s balance sheet looks exceptionally strong, with an impressive current account and fiscal surpluses, low debt and a cheap currency. Against this backdrop, the Russian market has loitered in deep value territory for years. In 2018, this apparent value has been offset by sanction risks. As a result, the market has seen a further derate. P/Es have contracted across the board, although in some cases, such as the consumer or media space, it has been exacerbated by sector specific or stock specific negative developments.

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

Investors cite two main arguments preventing them from increasing Russia exposure. First is sanctions risk, to be discussed later. Another one is anemic GDP growth, which does not attract growth hungry GEM investors. However, as we have pointed out many times in the past, equity investors do not have a claim on GDP growth; their claim is rather on EPS growth.

Over the past three years, Russia has managed to deliver double digit EPS growth, despite essentially stagnant GDP. This phenomenon does not only reflect strong commodity price performance but also a change in the country’s economic model, which is transferring value from consumers to corporates. We have previously pointed out that exporters are set to be the biggest beneficiaries of this trend, and this call has proven to be right.

Another important thing about the current economic model is that it favors stability over growth. The government demonstrates little appetite to risk macro stability in an attempt to boost growth, or to engage in radical reforms that could shake up the political system. So investors complaining about low growth should not forget that they also gain a higher degree of economic stability as a reward.

The macro stability and low valuations constitute another important feature of the Russian market: it has become much less volatile in recent years. The fiscal rule and a number of other macro developments have effectively decoupled the ruble and most other key macro indicators from the oil price. Russia’s macro story has probably become the most transparent and predictable among all EMs. Being boring and predictable is not the best option in more exciting times, but it helps to weather any headwinds better than almost any other country.

There is no doubt that the Russian market offers deep value. However, this value can only materialize once the geopolitical risk premium has dissipated. Until that time, Russian multiples are set to stay low and the market will be primarily driven by earnings revisions. This is essentially the pattern that has been observed in 2018.

A difficult international political backdrop in 2018 19

The key risk for the Russian market this year has arguably been international political developments between Russia and the West. Arguably, these developments have played a more important role for the market this year than they have had since 2014. Sadly, these events are more often than not unpredictable, and neutral or negative for the market. Meanwhile, periods of reduced rhetoric have allowed Russia’s good fundamentals (and sometimes, oil price strength) to shine through.

Two periods have been important for the market this year, in our view. The first was the April 6 announcement of US SDN sanctions on Rusal, En+ Group and others, after which the RTS fell some 12% in four sessions. The second was a combination of events in mid July to mid August, when the Russian and US presidents held their summit in Helsinki, and in the aftermath US senators drafted and submitted the Defending American Security from Kremlin Aggression Act (“DASKAA,” Senate bill #3336). The day DASKAA was published in Kommersant coincided with an announcement that the US would impose sanctions on Russia due to Russia’s alleged involvement in the attack on the Skripals in March. The RTS ultimately sank 11% during the period, albeit in fits and starts, as shown in the chart below, while the MSCI EM tumbled 4%.

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

Market performance and key international political events in 2018

Source: US Library of Congress, OFAC, Kommersant, Bloomberg, Sberbank CIB Investment Research

Key political events of 2018 to date for the market

Jan 16 DETER formally submitted to Congress.

Jan 30 Publication of the CAATSA "oligarch report."

Feb 2 Publication of the CAATSA "debt report."

Mar 4 Attack on Sergei and Yulia Skripal in the UK.

Apr 6 Sanctions announced by US OFAC on Rusal, En+ and others.

Jul 16 Helsinki summit between Russian and US presidents.

Jul 24 US senators announce plan to submit bill now known as "DASKAA."

Aug 1 DASKAA formally submitted to Congress, but not published.

Aug 8 Kommersant publishes draft of DASKAA before official publication. The same day, US announces it sees Russia as culpable in

Skripal attack and announces first chemical weapons related (a.k.a. "CBW") sanctions.

Nov 6 US State Department states that demands on Russia regarding CBW/Skripal case have not been met

Nov 25 Altercation between Russian and Ukrainian navies at the Kerch Strait.

Source: US Library of Congress, OFAC, Kommersant, Bloomberg, Sberbank CIB Investment Research

WE ASSUME STATUS QUO FOR INTERNATIONAL RELATIONS IN 2019

To state the obvious, we can envisage three major scenarios for international relations next year: an improvement, a continuation of the status quo, or a further decline.

At this time, the market appears to be pricing in that the status quo will prevail, and this includes an assumption that the EU and their other partners will place no new sanctions on Russia that would have a material impact on markets, and that Russia will also not place such measures against these countries in turn. It would not be entirely accurate to describe this as a neutral scenario; rather it is a mildly positive one, as the longer that no new negative events appear on this front, the more investors will be able to return their focus to the decent fundamentals.

We acknowledge that there are several flashpoints to watch out for next year. Sadly, we see no obvious forthcoming catalysts that could improve relations and drive the market to markedly reduce the political discount for Russian assets.

POLITICAL DATES AND STORIES TO WATCH

Although international political developments tend to be unpredictable, there are a few known dates to watch out for next year.

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

█New Congress in January. The newly elected US Congress will likely begin its session on January 3. Although support for CAATSA, the last Russia related bill to become law, was widely bipartisan, the shift of control in the House of Representatives to the Democrats and the regular reconfiguration of committee assignments introduce some uncertainty (even all else being equal) as to how the US’s legislative branch will address Russia. Also, the new Congress will almost certainly have more pressing domestic issues to address early in its term, and even in foreign affairs attention may be elsewhere than Russia, such as on the developing situations with China, Saudi Arabia, Iran and Venezuela.

█Continually delayed Rusal and En+ sanctions. On December 7, OFAC extended the deadlines for Rusal and EN+ sanctions for the seventh time, this time until January 21. The track record of this process suggests that delays will continue until a solution is finally found.

█INF treaty developments by early February. Although the topic has been quite peripheral for financial markets so far, the ongoing public debate between Russia and the US (with occasional contributions from other European countries and NATO representatives) about who is or is not complying with the Intermediate Range Nuclear Forces (INF) Treaty is likely to come to a head before the deadline imposed by the US for early February. While not too relevant for markets thus far, rancor on this topic – like many others – could provoke yet more heated, negative rhetoric that markets would have to consider. In particular, the debate could provoke remarks from members of Congress seeking to weigh in, even if this is primarily an issue for the US executive at this time.

█Skripal/CBW sanctions: Timing unknown. Two events that are due, but with no clear timeframe, are the US decision on the next round of punitive measures related to accusations against Russia in the Skripal case, and the outcome of the US special counsel’s investigation into relations between Donald Trump’s 2016 presidential campaign and the Russian state.

Regarding the Skripal or “CBW” case, the most recent guidance from US State Department representatives in November was that they have informed Congress that Russia has been unwilling to meet the US’s demands, meaning that a second round of measures is technically due. However, the representatives said that the administration’s legal view is that there is no specific deadline for the next measures, and that the administration would consult with Congress before making any decisions. The 1991 CBW law would require the US president to choose at least three of the following six options:

More restrictions on US exports to Russia. Russian Federal Trade Service data show 5.5% of annual imports, or $12.6 bln, coming from the US in 2017, with difficult to replace high tech goods for both business and consumers constituting a large share.

Restrictions on US imports from Russia, which could be written to include oil and oil products. In 2017, Russia exported $10.6 bln to the US, or 3.2% of total exports, with a concentration in energy supplies, according to the Russian Federal Trade Service. Were the US to target imports of Russian hydrocarbons, the event could be highly disruptive to global energy markets over the short term. The US is always concerned with cost and supply of energy, and this administration is more obviously concerned than most, with frequent remarks on the topic on Twitter, hence we see the possibility of this measure as quite low.

Prohibition on US banks (not only the US state) extending credit to the Russian government. The language of these rules is written for financial markets as they existed in the early 1990s, and thus may be open to some more or less problematic interpretations for markets today. At face value, the measures would appear to be insignificant.

Prohibitions on Russian state owned airlines from US destinations, which could affect sentiment toward Aeroflot but would have few meaningful financial implications.

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

US opposition to loans to Russia from multilateral development banks (i.e. the IMF and World Bank). In the current environment, this would be of minimal relevance for markets, as Russia has not taken out such loans for a long time and in most cases these are already banned or highly frowned upon under existing sanctions.

Downgrade or suspension of diplomatic relations.

█Mueller investigation results: Timing unknown, but more likely sooner than later.

Headlines about US Special Counsel Robert Mueller’s investigation into the 2016 Trump presidential campaign and its relations (if any) with the Russian state have been ongoing now for more than 18 months, with just last week major releases of sentencing memos for three close Trump associates who have agreed to provide testimony for the state.

Though any intention on Mueller’s part to wrap up the investigation soon and report back to the US Justice Department and Congress is not publicly known, media sources have been claiming for some time that the investigation’s full report will be due at the end of 2018 or very early in 2019.

To emphasize, there is no indication in public sources as to whether the investigation’s results will directly blame the Russian state or Russian citizens for any criminal wrongdoing that could affect relations. That said, until final results of the investigation are known, even lightly sourced media speculation in the meantime is more likely to be negative than positive for sentiment. Hence, the investigation remains a story to watch for Russia investors.

Summary of political events to watch through year end and into 2019

Dec 31 Ukrainian presidential campaign period formally begins

Jan 3 Earliest date at which the newly elected Congress may convene the new session.

OFAC's SDN sanctions on Rusal and En+ scheduled to take effect. As of this text, the measures on securities and commercial

Jan 21 transactions had each been delayed seven times since their initial announcement on April 6, 2018.

Theoretical 60 day deadline for US demand that Russia return to compliance with the INF treaty on threat of US pulling out. Based Feb 2 on US Secretary of State Mike Pompeo's speech on December 4, 2018.

Mar 31 Ukrainian presidential election

???Imposition of second wave of CBW sanctions.

???Any relevant outcomes from the US special counsel investigation.

Source: OFAC, Bloomberg, Sberbank CIB Investment Research

UKRAINE: THE KERCH STRAIT AND THE MARCH PRESIDENTIAL ELECTION

On November 25, an altercation occurred between Russian and Ukrainian naval vessels that led to Russia seizing three Ukrainian vessels and more than 20 Ukrainian soldiers. The RTS declined nearly 3% the following day but recovered shortly thereafter as it became clear that neither country would escalate the situation into a full political or even military crisis immediately following the event.

However, as we write, the vessels and sailors remain in Russian custody, despite calls from Western countries to return them. Media reports indicate that officials within the US and among EU member states have discussed new punitive measures against Russia for this event and other developments related to Ukraine and the Azov Sea, but that no decisions appear near at this time. President Petro Poroshenko has been appearing on Western television channels frequently requesting support, including calls to impose additional economic measures against Russia.

Moreover, tensions in Ukrainian domestic politics are currently heightened. The next presidential election there is March 31, and the official campaign season starts on December 31. Recent polls have shown incumbent Poroshenko in second or third place with 10 15% support, while the consistent front runner in recent months has been former Prime Minister Yulia Tymoshenko with 18 22%. At Poroshenko’s request, Ukraine’s Verkhovna Rada passed a declaration of martial law lasting until December 27 in regions bordering Russia and Transdniestria; martial law in Ukraine prevents formal political campaigning. To state a basic fact of international relations and geopolitics, heightened domestic tensions can easily make international relations more volatile as well.