Russia: generating growth drivers beyond energy

The Russian economy has weathered the pandemic better than many other countries and is making good progress in vaccinating the population with Sputnik V. While we expect, therefore, that the short-term recovery in Russia will be less dramatic than for some developed economies, investors can benefit from the country’s stability and the broader growth across the economy, including the burgeoning technology sector.

Covid-19 cases in Russia surged through the fourth quarter of 2020 but have been falling steadily in recent weeks and are now more nearly two thirds below their peak in late December, allowing local authorities in some regions to start relaxing restrictions, which will help support the economic recovery. Russia has made a reasonable start with vaccinations, aiming to deliver 5.7 million doses by the end of February.

In 2021, the Russian economy should rebound by around 3.5% following a drop of a little under 4% last year. An output gap will remain, which suggests the recovery will likely extend into 2022. The global economic recovery should outpace Russia’s, as the latter experienced a milder recession than most other economies, with the exception of south-east Asia. The key reasons why Russia fared better include low leverage, conservative monetary and fiscal policies before the pandemic, and the limited role of small and medium-sized enterprises (SMEs) in the Russian economy.

Russia has made huge strides in recent years towards a significant improvement in overall macro stability. This is largely a result of the introduction of the Budget Rule, but also due to actions taken by the Central Bank. The Budget Rule has materially reduced the impact that the oil price has on the economy and, by sterilising the surplus revenues, has sharply reduced the ruble correlation with the oil price. Therefore, revenues generated from oil sales above the budget oil price of $43.30 (for 2021) will be transferred first into the National Welfare Fund, and then invested in the long list of National Projects the government has drawn up over the past couple of years. The combination of a weaker ruble and increased investment in other sectors has helped to diversify the growth drivers of the economy and ensured the benefits are felt more broadly.

It is difficult to see the oil price moving materially higher from here although the rally we have experienced has already removed a lot of the stress from oil producing countries. Brent crude prices above $60 per barrel of oil sit nearly 40% above the average price of last year, which will support both the economy and the budget. Even as global demand is expected to increase by over 5 million barrels per day to 96 or 97 million this year (an increase of 6% although it would still be 3% to 4% lower than in 2019), The Organization of the Petroleum Exporting Countries (OPEC+) is cutting the supply by more than 7 million barrels per day from the production levels of early 2020, and how quickly these volumes return to the market will be crucial for the price of oil this year. US drilling has also recovered sharply from the lows of last year and if prices remain above $50 per barrel of oil, we would expect the rig count to continue to rise.

Our preferred exposure in the sector remains in privately rather than state-owned companies, with Lukoil and Novatek being core holdings. Natural gas demand remains strong, particularly in Asia, and will remain an important bridging fuel as the world looks to decarbonise. Novatek is transforming from a domestic gas producer into a global liquefied natural gas (LNG) giant with the launch of Yamal LNG in 2017 to be followed by the even bigger Arctic LNG-2 in 2023 and has a long runway of future projects.

The synchronised global economic recovery and the specific focus on infrastructure in many parts of the world bodes well for other commodities. Most major metals markets have tightened considerably in recent months and copper and iron ore are expected to remain in deficit in 2021. Over the medium term, the surge in the adoption of electric vehicles and the increasing share of renewables in power generation will continue to support copper, nickel and cobalt markets.

Russia’s low-cost producers across a range of metals will see margins expand towards record levels this year. Norilsk Nickel stands out as a clear beneficiary, both within Russia and among global miners, given its world class, low cost ore body and its exposure to the metals vital for decarbonisation in nickel, platinum group metals (PGMs) and copper.

The US election has also increased optimism about the global economic recovery, increasing expectations of further fiscal stimulus. For Russia, our view is that a Biden presidency is positive from a sanctions perspective as well because implementation will move from the legislative to the executive, with the Democrats no longer needing to use Russia as a weapon against Trump. We do not expect any new relevant sanctions against listed Russian corporates, with new measures limited to restrictions on individuals.

In line with this, EU ambassadors have agreed to create a European Magnitsky list, which would place asset freezes and visa bans on individuals and entities deemed to have violated human rights, similar to the US Magnitsky Act. This is further evidence of the shift in the sanctions philosophy in both the EU and US away from market-wide sanctions towards harsher and more targeted measures. Presidents Putin and Biden have taken the opportunity to begin their relationship on a professional and productive note with the extension of the New START treaty (Strategic Arms Reduction Treaty).

We take a best in class approach to the broad market, aiming to find attractively valued companies with sustainable competitive advantages across the spectrum. Given the lack of competition from multinationals, Russian companies across a range of sectors are able to earn returns on capital well in excess of international peers. Russian benchmark indices have been gradually diversifying in recent decades but still remain concentrated, and this creates an environment where active managers can add value. We are willing and able to avoid large stocks in the index (Gazprom being a current example) and take off-benchmark positions such as through holdings in the IT and consumer sectors.

Our holdings in the technology and communications sectors are what we describe as “new Russia”. Technology is important across the Liontrust Global Equity team, and Russia offers a particularly interesting opportunity as many of the world’s largest technology companies are unable to gain a foothold in the market, particularly as a result of Russian protectionism. Not only that, but the country made significant investments in technological education throughout the Cold War, leaving a highly skilled workforce of software engineers in particular. Our holdings in technology include Yandex, Mail.RU and EPAM.

Russian benchmarks continue to be heavily weighted to the energy sector, with many sectors of the economy underrepresented or not represented at all. We continue to provide diversified exposure to sectors that are not present in the benchmark, focusing on corporates that are able to generate value for shareholders and offer potentially attractive returns.

Discrete years' performance (%)*, to previous quarter-end:

*Source: FE Analytics as at 31.12.20.

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