By James Syme, Senior Fund Manager Emerging Markets Opportunities, JOHCM Funds
When we assess a country’s political and governance outlook, the strength of domestic institutions is one of our drivers, and one of the key institutions is the central bank. Our view on Russia’s political and governance environment is unsurprisingly negative, but we do have a very positive view of the Central Bank of Russia (CBR), which contributes some positive elements to Russian equities.
Russia has tended to be a high-beta emerging market, with both the equity market and the currency reacting powerfully (both up and down) to developments in the world economy and world markets. This was particularly true in the 2008-2009 crisis. As well as the Russian economy’s structural exposure to oil revenues, the crisis showed the dependence of Russian banks and corporates to short-term U.S. dollar financing. As those financing flows reversed, the Russian economy and financial markets had a hard landing, with the MSCI Russia Index down 74% in U.S. dollar terms in 2008, driven by a 20% decline in the ruble. Worse, the CBR attempted an unsuccessful defense of the currency through intervention, with foreign-exchange reserves falling by more than $200 billion in six months at the height of the crisis.
In the years that followed, the CBR changed its approach to managing the economy and the financial system. Key reforms included improving the financial infrastructure to make Russian domestically denominated bonds easier for foreign investors to trade, aggressively cleaning up the banking system, and increasing the role of domestic pension funds in domestic financial markets. The most important improvement was a move to an orthodox inflation-targeting central-bank mandate under its current governor, Elvira Nabiullina.
As a second round of economic stress hit Russia in 2014 -2015, with the prospect of higher U.S. interest rates hurting capital flows to emerging markets and an oil-price decline comparable in size to the 2008-2009 decline, the CBR responded very differently. The ruble, floating freely, fell over 50% against the U.S. dollar, unimpeded by intervention, and the CBR addressed the resulting rise in inflation by hiking policy interest rates from 5.5% to a peak level of 17%. This was tough medicine for the economy and equity markets, and the MSCI Russia Index fell 49% in U.S. dollar terms in 2015.
However, through disciplined and sensible policies, Russia is now well-placed to benefit from the recovery in oil prices. Real wages have continued to grow, and signs so far in 2017 are that retail sales are now catching up as confidence in the recovery increases. Industrial production has also been steadily recovering since 2015.
Russia faces some very serious structural growth issues (including corruption, the rule of law, demographics, capital flight and resource dependence), but enjoys a strong cyclical outlook at present, created partly by the CBR’s embrace of orthodox policies, which we believe the market has overlooked. Our portfolio is overweight Russia, and we have increased our weighting in the past few weeks.
The views expressed are those of the portfolio manager as of March 2017, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
