Two themes have dominated much of the positioning in both the global equity and fixed income markets in 2013:
1) Fears of a China slowdown have hurt the emerging markets and all commodity-related sectors and countries.
2) Speculation about the Fed tapering bond purchases sent long-term bonds considerably higher, leading many to question their positioning for a rising interest rate environment.
Russia has been one of the most severely depressed markets. MSCI Russia trades at a 50% discount to MSCI Emerging Markets (EM) on 12-month forward-looking P/E ratios. These valuations are historically cheap, with levels not seen since the first quarter of 2009, the bottom of the global bear market.
Since mid-June, Russia has displayed some relatively strong performance compared to its emerging market peers. We believe this rally was underpinned by attractive Russian equity valuations, but we also note that the performance coincided with a recent rise in U.S. interest rates. Below, we explore why rising interest rates may coincide with a relatively strong performance for Russia. [Russia ETFs Struggle]
Additionally, the high beta of Russian equities may lead to a cyclical rebound that is greater in magnitude than that of its peers. In Table 1 we look at MSCI Russia’s outperformance against MSCI EM after MSCI EM’s lows of March 2009. We note that in all three periods, MSCI Russia outperformed MSCI EM in its one-year forward returns: by 24.90%, 17.17% and 3.86%, respectively.
Table 1: 12-Month Forward 1 Total Returns Post-MSCI Emerging Market Lows 2
Is the Recent Rebound Credible?
The recent rally in Russian equities is testimony to the ability of its local markets to thrive in an environment of rising U.S. bond yields. With an encouraging second-quarter gross domestic product (GDP) out of the U.S. and a sanguine July Federal Open Market Committee (FOMC) outlook, markets are widely anticipating tapering to occur as early as the fourth quarter this year. While policy rates will remain accommodative for a longer period, steady improvements in the U.S. economy may result in a further increase in treasury yields.
On a relative basis, this may position Russia to perform better than its emerging market peers. From a macroeconomic perspective, Russia has a healthy current account surplus of 2.6% and is thus less dependent on foreign inflows. Many emerging market nations, such as India, South Africa and Indonesia, run large current account deficits and rely on foreign inflows to fund them.
Russia’s current account surplus is especially important in a time of rising U.S. yields. The EM block has experienced outflows, partly due to the narrowing yield gap between the U.S. and the rest of the emerging markets. The closing of this gap renders the EM block less compelling from a yield perspective. However, we feel that Russia is well positioned to withstand the storm, as it is less reliant on external funding and thus better able to keep its monetary policy loose (i.e., low interest rates), while other EM nations tighten their monetary policy—which can slow down their economies—in order to attract foreign flows.
Further, we find that Russia’s equity markets—and the energy sector in particular—are positively correlated with U.S. interest rates 3 (10-year yields).
• Emerging market stocks have been positively correlated to U.S. interest rates over longer periods (three, five and ten years), but Russian stocks have been more positively correlated.
• While emerging market stocks were negatively correlated to U.S. 10-year yields over the last one-year period, Russian stocks (and especially Russian energy stocks) were positively correlated over the same period.
• Given that roughly 50% of Russia’s market is composed of energy stocks, it is not surprising that the overall Russian markets exhibit positive correlations to bond yields.
• The positive correlation between Russian energy sector and interest rates seems to be explained by a connection between higher interest rates and stronger global economic growth, which is supportive of energy prices and the Russian markets.
Table 2: Russian Stocks Display Higher Correlation to 10-Year Bond Yields Than MSCI Emerging Markets 4
Positioning for Emerging Market Rebound and Rising Rates
Sentiment towards emerging markets has been very negative in 2013. If this trend reverses, we believe Russia might be a prime beneficiary. Given that the other major theme dominating the focus of investors is how to position portfolios for a rising-interest-rate environment, the historical correlations of Russian equities to U.S. interest rates—combined with their steep discount to other emerging markets—make them a potentially attractive option for emerging market portfolio allocations.
1 12-Month Forward – 12 month returns post the low points indicated in the table
2 Sources: WisdomTree, Bloomberg, as of 7/31/2013.
3 Sources: WisdomTree, Bloomberg, as of 7/31/2013.
4 Sources: WisdomTree, Bloomberg, as of 7/31/2013.