The Russian Eagle. December 2017 - Taking Earnings Over GDP Growth

> Missing the GEM rally in 2017. Russia has missed the 30% rally in the MSCI EM, closing the year flat. The market has failed to perform in the face of negative earnings revisions. Most of the earnings downgrades happened in the oil and gas sector, as the stronger than expected ruble has been eating into exporters' bottom lines.
> Living in a low-growth, low-inflation economy. Tight monetary and fiscal policies have helped to curb inflation but have also impeded economic growth. This environment has been favorable for bonds, but not for equities. Going forward, monetary policy will ease, as the CBR is cutting rates and inflation is likely to pick up from record lows. Fiscal policy is likely to stay tight, so the economy will see lower rates and still-low growth. Meanwhile, the new version of the fiscal rule should weaken the ruble, helping exporters.
> Strong earnings growth amid stagnant GDP. The weaker ruble and lower debt service costs will support corporate earnings. We project 18% EPS growth for the market. This estimate is based on a very conservative $50/bbl oil assumption. If the oil price stays at the current levels, EPS growth could double.
> Falling cost of capital should support the market in 2018. Cost of debt has fallen by some 250 bps over the past two years, while implied cost of equity has stayed pretty much flat. We do not see any meaningful fundamental justification for the rising ERP and expect it to normalize in 2018.
> Expecting no changes in the sanctions regime. At the end of January, the US presidential administration will publish reports on entities and oligarchs who might be sanctioned and an evaluation of the potential impact of sanctions. We expect the new list to largely overlap with the individuals and entities already under sanctions. If we are right, this will remove uncertainty that has been weighing on the market's performance and may become a catalyst for a market rerating.
> Setting 2018 RTS Index target of 1,400. The compression of cost of equity by 200-250 bps along with continued EPS growth could generate 20% upside for the market. This translates into an RTS Index target of 1,400. On top of this, Russia will generate a 5% dividend yield. These numbers are based on a conservative oil price assumption of $50/bbl. Should the oil price stay flat at the current level, the upside could widen.
> Top picks. We prefer exporters, primarily in the oil and gas space, as they are set to benefit from the weaker ruble and the reversal of 2017's negative earnings trends. Within the sector, we like Lukoil, Gazprom Neft, Novatek and, tactically, Gazprom. In the domestic space, we like real estate (LSR Group) for its exposure to falling interest rates, media (Yandex, Mail.ru Group) for structural growth, and transport (Aeroflot, Global Ports).