Russian assets (local and hard currency) are back on investors’ radar screens

Russian assets are back to the global investors’ radars

According to our 2019 strategy, in 1H2019 emerging markets will perform better than in 2H2019. Given that Brazil (+12%), Chile, Mexico (+8%) and Russia (+7%) have been the best-performing markets YTD, our assumptions seem to be materializing. Suspended sanctions against Russia and ongoing US — China trade talks provide a favourable backdrop for EM growth. A highly accommodative US Federal Reserve is fuelling appetite for risk assets despite US government remaining in shutdown.

The rouble carry trade have got its appeal back. The dollar adjusted return of OFZ is up by 6% YTD, which is the highest amongst its peers with similar credit ratings. We see higher inflation from a VAT hike as the key local risk for the Russian market. Yet we consider it to be overrated and have limited impact on OFZ yields. Sanctions against Russia and efforts by democrats in US congress to block OFAC from lifting sanctions against Rusal is the key external risk.

Global economic and corporate earnings slowdown is the key risk in 2H2019, whereas spike in US dollar rates and geopolitical tensions were the key major risk back in 2018. Meanwhile, chances of the U.S. economy of tipping into a recession may top 50% as early as 2020. According to our assumptions, trade wars and geopolitical tensions will no longer dominate global agenda the way they did in 2018 due to less uncertainty. We therefore believe that targeted approach strategy best meets our needs.

Russian fixed income market

Source: ITI Capital, Bloomberg

OFZ yields are still among the most attractive globally

  • Russian securities are the biggest gainers across dollar-denominated bonds followed by LatAm
  • The rouble carry trade have got its appeal back. The rouble and South African rand (ZAR) in simple return have gained more than 4% against the US dollar — the best performance among major currencies worldwide
  • The rouble carry trade against the dollar has yielded more than 5% YTD, sending long and short OFZ bonds up by 2.5% and 0.6% respectively, and 10Y+ and short notes yields down by 50-60 bps and 30 bps respectively
  • The OFZ bonds have seen demand from both local and foreign investors. The outflow from OFZ market was 9 billion roubles against 46 billion roubles m-o-m, according to November data. The share of non-residents` OFZ holdings dropped by only 0.3% to 24.7%
  • A 10Y OFZ bond auction held on Wednesday enjoyed strong demand from non-residents

OFZ near-term upside potential

  • We believe that OFZ prices on long-end have good upside due to high upside potential as measured before August sanctions over chemical attack. This, in turn, suggests that the current potential for the decline in yield on the curve is 60-70 bps and additional 60 bps if measured before Rusal sanctions level in the beginning of April
  • Local currency sovereign bond yields are the highest among the countries with similar rating and volatility
  • Bond prices prior to sanctions in August suggest that short-medium curve upside potential is 3%, which is equivalent to an 80 bps yields drop (target YTM 7%), while long curve upside potential is ca. 5%, which is equivalent to a 70 bps yields drop (target YTM 7.5%)
  • For the first time in 5 years, the deposit rate came close to the bond yield, narrowing the spread between the deposit rate and the corporate bond curve, and is likely to outstrip the latter. Against this backdrop, major banks, such as Sberbank, have opted to diversify funding by issuing new bonds
  • 1-2Y deposits and loan rates adjustment is almost done, and it corresponds to the movement of government bonds yield curve over this period, head of the CBR’s monetary policy department Alexey Zabotkin said
  • The trend has already affected medium and long-term deposit rates; 3Y lending rates retain some growth potential in the first half of the year due to a possible increase in the key rate on the back of accelerated inflation

Our Q1 rouble outlook

  • We believe that there’s strong potential for the rouble to climb to RUB 65.5/$ by the end of Q1. Over the past decade, the first quarter has traditionally been a positive period for the rouble, given strong current account surplus and low external payments
  • CBR’s FX-purchases will have only marginal impact on the rouble in Q1 (Minfin’s FX-purchases may double in 2019).
  • In January-March, given intra-group lending adjustments, external payments of the Russian majors will fall by 42% y/y, according to CBR expectations
  • Fundamentally, there are good conditions for the rouble’s strengthening, but the level of crude oil volatility that impacts the exchange rate, remains high
  • The purchases suspended in August and a strong current account surplus in 2018 contributed to stabilization of FX-liquidity at a comfortable level, reducing potential risks going forward

Local risks: Inflation

  • Inflationary risks from higher VAT increase the likelihood of a rate hike in February
  • CPI decreased from 0.5% to 0.2% in January 10 — 14 following a spike in January 1 — 9
  • Weekly data suggests, January CPI may pick up to 5% from 4.3% in December. CBR sees January CPI at 5-5.5% in January and 6% in 1H2019
  • Inflation from a VAT hike affects the value OFZ. If January CPI climbs above 1.5% mom, or 5.3% yoy, CBR will likely raise the rate in February
  • The decision will largely depend on January inflation data, due to be released in early February ahead of the next CBR meeting in February. «The Bank of Russia is capable of moving in larger steps if something in the economic situation or in our forecasts changes drastically,» Zabotkin said, suggesting an increased likelihood of a hike above 25 bps
  • We believe that inflation-linked OFZ bonds are attractive on the back of inflation growth, but they look overbought now, given that the yield rate slightly exceeds 3%. 3-month annualized inflation suggests that the current real rate is ca. 4.3%

External risks: Sanctions

  • Tough sanctions against Russia and efforts to block OFAC from lifting sanctions against Rusal pose the key risk to the bond market. Under our baseline scenario, Russia will face moderate sanctions, while sanctions against Rusal will be lifted. On Wednesday, the Senate blocked a Democratic bid to force the Treasury Department to keep sanctions on Rusal, which should be positive for the company's shares. However, restrictions remained in place, and OFAC extended the deadline for wind-down period for transactions with Rusal to January 28, issuing the eighth General License in a row
  • The Republicans seem to extend time to avoid risks for democrats to cancel OFAC initiative with respect to Rusal. Sanctions relief will result in spreads tightening between Russian metal companies (Norilsk Nickel, Alrosa, Evraz and etc) and equivalent EM peers

FX-currency Eurobonds performance

  • Following a solid growth that began in the end of August the upside potential for FX-currency bonds has been weaker than that for the local currency bonds. The 5Y CDS pricing is at its lows now() , i.e. 13 bps above pre-August levels (Salisbury sanctions) and 21 bps above pre-April levels (Rusal sanctions)
  • Sovereign (20 bps) and corporate Eurobonds (25-30 bps) premium in currency is much lower, the rally in Eurobonds prices is over, given that prices have been growing since mid-August
  • All the sanctions considered, it is far below the risk premium for OFZ, amounting to 130 bps: out of them 60 bps are attributable to sanctions against Rusal in early April, and 70 bps — to Salisbury sanctions expectations in August
  • VEB 25, VEB 23, VEB 22, Sistema 19 and Russia 47 have been the best-performing names following the U-turn in end of August. The average price climbed above 10% from local lows in early August, after the US announced restrictions over the Salisbury incident
  • On the back of growing demand for risky assets, the most oversold securities with the lowest default risk (sovereign and quasi-sovereign issues), such as VEB, Gazprom and the long curve of Russia, went up, as it’s always been the case
  • Now we focus on more risky securities, that have the highest upside potential before the price collapse in early August: Alfa perp, VEB 23, Sovcomflot 23, Russia 28, VEB 25 and Sberbank subord 22. Their upside potential slightly exceeds 3%
  • Investors have already skimmed the cream off the market and show less appetite now. Demand is conditional on further sanctions against Russia and Rusal. Under a positive scenario — moderate sanctions against Russia and Rusal sanctions relief (the latter is more likely than the former) — prices may go back to April levels (before Rusal sanctions)
  • Sanctions relief will open the market to more undervalued bonds with higher upside potential (above 5%) and will also result in lower yields in the banking, transport, telecommunications sectors, as well as in the long Russia curve

Trade ideas

Trade ideas

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Source: ITI Capital, Bloomberg

Carry trade (long-short), %, YTD

Carry trade (long-short)

Source: ITI Capital, Bloomberg

Russian deposit rate vs OFZ, %

Russian deposit rate vs OFZ

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Source: ITI Capital, Bloomberg

Russian OFZ yield curve, %

Russian OFZ yield curve

Source: ITI Capital, Bloomberg

Eurobond yield curve Russia and LATAM (Most undervalued ideas) , %

Eurobond yield curve Russia and LATAM

Source: ITI Capital, Bloomberg

Local 10 year YTM

Source: ITI Capital, Bloomberg

Искандер Луцко
21.01.2019