The Russian Eagle. October 2017 - The Price of Volatility

> RTS Index volatility has dropped to record lows. Lower volatility comes from multiple factors, including greater ruble and oil price stability. More importantly, corporate earnings have become less dependent on oil, driven primarily by improved macro fundamentals.
> Lower volatility is a global trend, and is rewarded as a rule. The S&P 500 VIX is trading at record lows as well. There are many potential explanations for why this is happening, but for us the most important fact is that investors reward global equities for lower market risk. A decline in VIX goes hand-in-hand with multiples expansion, and the S&P 500's P/E is now trading at multi-year highs.
> In Russia, ERP goes in the opposite direction as volatility. As we highlighted in our latest thematic piece, "Russia's Cost of Equity," disinflation and the bond market rally have driven Russia's cost of debt to new lows. The cost of equity, however, has remained the same, meaning that the equity risk premium has expanded. A higher ERP is clearly inconsistent with falling volatility and improving macro fundamentals, further suggesting a potential market rerating in future.
> The fiscal rule will further reduce the economy's dependence on oil. Starting in 2018, the government will implement the new version of the fiscal rule. The goal of the rule is to force the economy to function as if the oil price had stayed slightly above $40, sterilizing incremental earnings from higher oil in the reserve fund. The rule should further reduce ruble volatility, but it will also weaken the ruble by some 5% assuming $55/bbl oil.
> Top picks. Given the prospects for a weaker ruble, we favor exporters above domestics. Within exporters, we prefer oil companies, first of all Lukoil and Gazprom Neft. We are becoming more cautious on metals and mining since we are not convinced that commodity prices in this segment will stay strong. That said, within the sector, we like Evraz and ALROSA best. Among domestics, we favor real estate, with LSR Group having moved into first place. Top picks in the domestic space include Aeroflot, Global Ports and Yandex.