The Russian Eagle. July 2020 - Now That the Tide Has Lifted All Boats...

Falling interest rates have been the key driver behind the rerating of the Russian market. In this note, we argue that the cost of equity has room to tighten further via both a lower risk-free rate and lower ERP. We also analyze the sensitivity of individual stocks to a potential decline in discount rates.> Win-win macro environment. Inflation remains below the CBR's target amid a decline in disposable incomes and the persistent output gap. This should encourage the CBR to continue cutting the key rate. We expect bond yields to resume falling on the back of this, supporting equity valuations. The risk to this scenario is if inflation were to accelerate, something that is only likely to materialize if the economy begins to recover rapidly. In this event, the equity market would do well anyway.> Influx of retail money driving ERP compression. ERP compression has become another important driver for equities. Retail investors are bringing record amounts to the equity market, as falling rates are squeezing them from the safety of deposits.> Sensitivity of individual stocks to lower discount rates. During the initial stage of the market recovery, declining discount rates were the tide that lifted all boats. But now, the correlation between stock performance has fallen as investors have become pickier. Going forward, we need to understand not only the macro trends, but also how individual stocks might react to lower rates. We have tested our individual stock models to see how they would react to a 1 pp decline in the discount rate, and we conclude that stocks with high leverage and those with substantial capex and growth plans are the most sensitive. Cash-rich companies and those with a high risk premium are less sensitive.> Top picks. We remain moderately optimistic about the Russian market. Inflows from retail investors will most likely continue as banks are still cutting deposit rates fast. Stocks favored by retail investors, such as utilities, tech and high dividend stories in the resource sector, will likely outperform. Our top picks include Lukoil, Tatneft, Gazprom, Yandex, Mail.ru Group, OGK-2 and LSR Group.