Feb 1, 2017
Global GDP growth, commodities prices and EMs have bottomed out. Major central banks continue to pursue accommodative policies. Rising commodity prices provide reflationary impulse to the global economy. With oil prices hovering around $55/bbl, US inflation could accelerate to 2.5-3.0% in 1H17. Under this backdrop, the 10-year US Treasury (UST) yield could test the 3% threshold over the course of 2017.
Rising interest rate environment bodes well for EM equities/commodities. Based on the study of 8 episodes of rising 10-year UST yields since 1999, EM equities stand out as a clear winner with a 32% average return.
Russia sees an improvement in economic conditions. Recent data on economic activity was better than market expectations. Our base-case scenario for 2017 implies 1.7% real GDP growth and declining inflation assuming an average oil price of $55/bbl.
The disinflationary trend continues in Russia. Inflation continues to slow down faster than the market has expected. The Bank of Russia (BoR) estimates headline inflation falling to 4% YoY by the end of 2017. Headline CPI was reported at 5.4% as of 16 December.
Our top-down and bottom-up DCF models indicate 20-25% equity market returns over the next 12 months. Key points underpinning Russia’s investment case are EPS recovery from a very low base and an eventual re-rating in multiples as geopolitical tensions subside and state-owned enterprises (SOEs) increase dividend payouts. We see ~15% EPS CAGR for 2016-2018 assuming a gradual recovery in the price of Brent to $60/bbl by 2018.
Spread compression in hard currency FI space is hitting its limits. Excess domestic liquidity and limited supply are likely to continue supporting the Russian Eurobond market, but there is less room for further spread tightening. We maintain our core positions in solid credit stories with shorter maturities while focusing on a particular duration and credit selections based on relative valuation and improved credit potential.
Over the next 12 months we expect the OFZ curve to gradually steepen as a result of short-term rates going down. As the disinflationary trend is likely to continue through 2017-2018 the full normalization of the OFZ yield curve (i. e. moving to 150-200 bps; 10Y-1Y positive slope) may take 12+ months. The banking system is about to experience a surplus of ruble liquidity in 2017, which is highly supportive for RUB bonds. The BoR key rate could be reduced by 200-250 bps by the end of 2017, from current 10% to 7.5-8.0%.