Fixed Income. Russian Sovereigns - Our Thoughts on the Recent Rally

Russian sovereign Eurobonds have rallied strongly this year and in December in particular. Among BBB-rated names, Russia has been a top performer YTD. Driving this, we think, has been a mix of global and local market factors, as well as an improvement in the perception of Russia's credit profile. We think this trend will moderate in 2020, but we do expect Russia to perform on par with or better than higher-rated EMs.> Global factors. Markets are now operating in what could be described as Goldilocks global economic conditions. Recently, macroeconomic data has been positive: US GDP growth unexpectedly picked up in 3Q19, Germany surprised by managing to avoid a recession in 3Q19, the November Chinese manufacturing PMI rose in November despite expectations of a contraction and the global manufacturing PMI recently pushed above 50. Meanwhile, the dot plot from last week's Fed decision showed that FOMC members are not planning the hawkish turn that some investors had been concerned about. All in all, the economy is not too hot, nor too cold, and global monetary policy remains largely accommodative.In addition, comments from Chinese officials and Donald Trump last week that a phase one deal was nearly completed led US Treasuries to price in at least 80% of the deal. The good news is that the move higher in UST yields was contained - the 10y issue is now trading only near 1.95% - which to a significant extent limits the risk of a correction when the deal is formally announced. On top of that, investors have clearly shifted their focus past 2019. Price action in December has been all about 2020.Yields and spreads of long-dated EM sovereign notes have been squeezed globally. From that perspective, there was not much special about Russia's performance in December.> Local factors. Russia, however, did perform well throughout the year - in fact, better than most peers. We think local investors could have played a considerable part in this. Prices may have been pushed higher as a result of their window-dressing strategies ahead of year-end. Another idea is that short sellers, trying to cover their shorts, might have driven the market higher amid an absence of sellers. In addition, there is an impressive FX liquidity surplus in the Russian banking sector (we expect it at $47-50 bln at year-end), some of which has likely been invested in Russian Eurobonds. This array of factors pave the way for a short-term correction in the sovereigns, as some investors may decide to take profit. Nevertheless, should a correction take place, we think it would be modest.> Sources of fundamental support. First, we believe the geopolitical premium has been priced out of Russian sovereign Eurobonds and the Russia CDS this year. Our FX strategists think the same holds true for the ruble. Second, due to US restrictions, the Russian government is not planning any dollar-denominated issuance in 2020. As a result, we see net redemptions of dollar paper exceeding $4.0 bln. Third, the outlook has cleared up and Russia's credit profile looks set to strengthen. We expect GDP growth to increase from 1.3% in 2019 to 2.0% in 2020, the CBR to cut the key rate by another 75 bps to 5.50% by end-2020 and the Finance Ministry's borrowing costs to decline, with the 10y OFZ yield dropping another 50 bps to 6.00%. Moreover, the key rate cuts allow more room for a monetary response to potential external shocks.> Outlook for Russian sovereigns. It seems the recent spike in US Treasury yields put a halt to the rally in Russian Eurobonds that had already been showing signs of fatigue. Given the looming holidays, we view the likelihood of a resumption of the positive momentum before year-end as rather low. We do not rule out a possible short-term correction later in December, but we would expect any correction to be mild. We are even more doubtful about a possible correction in January due to profit taking, as it is not clear what holders would buy if they were to sell some of their holdings.The real risk for Russian Eurobonds, in our view, is a potential further rise in benchmark yields. This risk could materialize due to further positive macro data from the US and/or a US rollback of Chinese tariffs that exceeds market expectations. Having said that, sharp movements in core government yields are not part of our baseline scenario for 2020. We expect the 10y US Treasury yield to finish 2020 near the 2.0% mark, i.e. around where it is currently trading.We expect Russian Eurobonds to perform on par with or better than peers from higher-rated EMs in 2020. If the risks of sharp movements in US Treasuries remain muted, we see a chance for Russia's long-dated issues to outperform as global investors pile in to long-term bonds to secure extra yield. > We also close our recommendation to buy the Russia 29. We think the time is right to take profit on the recommendation we opened in September. The Russia 29 has gained 4 pp, bringing the total return of the position to an annualized 19%.