Global economy is muddling through with commodities and EMs bottoming out. The world’s major central banks continue to pursue accommodative policies. The US Fed’s tightening is likely to be gradual and economic data-dependent. Increased global economic uncertainty due to Brexit makes the prospects for monetary policy normalization more remote.
Russia is set to see an improvement in economic conditions. Recent data on economic activity was better than market expectations. Market forecasts for 2016-17 are now being upgraded. Our base case scenario for 2017 implies 1.5% real GDP growth and declining inflation assuming an average oil price of $55/bbl.
The disinflationary trend continues. Inflation continues to slow faster than the market expects. The CBR estimates headline inflation falling to 5.5-6.0% YoY for 2016YE and 4% YoY until 2017. Headline CPI was reported at 6.4% as of Sep’16.
The government budget deficit (approximately -3%) will be funded by the sovereign wealth fund, privatization proceeds and higher dividends from SOEs. Privatization plans have been accelerated with a $15 bln target. An increase in the dividend payout ratio of SOEs from 25% to 50% will provide another $6 bln to fill the 2017 budget gap.
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 SOEs increase dividend payouts. We see ~15% EPS CAGR for 2016-18 assuming a gradual recovery in 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 also, 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 flatten as a result of short-term rates going down. If the disinflation trend continues over 2016-17 the OFZ curve could normalize in 2+ years. The banking system is likely shift from a deficit to a surplus of ruble liquidity in 4Q16, which is highly supportive for RUB bonds. The CBR key rate could be reduced by 250 bps till the end of 2017, from 10% currently to 7.5%.