The Russian Eagle. April 2018 - The Fog of War

> Russia's strong fundamentals are only constrained by ugly politics. Russia outperformed most global markets in 1Q18 on the back of higher oil prices and a stable ruble. Yet, the Russian market still does not look expensive. The RTS trades at a 2018E P/E of 6.5. Falling interest rates and a sound macro environment suggest the market should re-rate, while the broader rally in global and GEM markets has exhausted current drivers. However, international political risks are the key factor impeding a re-rating of Russian stocks. Once the standoff between Russia and the West stops featuring daily on the front pages of papers, investors will have a better opportunity to take advantage of the strong fundamentals.
> Russia's interest rates continue falling amid disinflation. Most global central banks are either tightening monetary policy or considering a hike cycle. Global equities have already started to factor in these headwinds. Russia, however, is not subject to this risk given that the CBR is in a cut cycle and will continue to be so for the foreseeable future.
> Cost of equity has not yet caught up with the fall in the cost of debt. Russia's stock multiples have stayed stable, indicating that the implied cost of equity is not following the interest rate trend, and instead that the equity risk premium is expanding. We do not think the ERP can remain at the current high levels well above historical averages. Once the ERP normalizes, Russia's P/E should expand from 6.5 to around 8.0, a 20% increase.
> Poor state of international relations remains in focus. The diplomatic strife around the Skripal case and media reports of sanctions to come for Russian oligarchs have been dominating headlines. Meanwhile, Western responses to the downturn in relations have so far been very limited from a market perspective. We expect that the most likely outcome of this newest phase of poor relations between Russia and the West will be sanctions against individuals with limited or no impact on publicly traded stocks.
> Top picks. Within the market as a whole, we remain overweight on oil and gas stocks, preferring Lukoil, Novatek, Gazprom Neft and Bashneft prefs. Within metals and mining, we like Evraz and Polymetal. We are warming up to the retail sector but would remain equal weighted there for now; within the sector, we prefer X5 Retail Group and Lenta. We are becoming more cautious on the banking sector, as it is a big overweight in investor portfolios, while the ongoing decline in interest rates will make it harder for banks to deliver earnings surprises. Real estate remains our preference within the domestic space, and we like both liquid names in the sector, LSR Group and Etalon Group. Other top picks within respective sectors include Yandex and Mail.ru Group for their secular growth stories, VEON for its strong FCF generation, Global Ports in transport and InterRAO UES in utilities.