On the scale of 'unpatriotic' things to suggest, there is only one thing worse than a tax inversion for an American to do... suggest something positive about Russia, Russian markets, or Russia's economy. So it perhaps ultimately ironic that none other than Goldman "doing God's work" Sachs suggests Russian bonds are both cyclically and strucuturally under-priced.
Via Goldman Sachs,
Russia bonds are both cyclically and structurally underpriced
The main outlier both cyclically and in terms of what the market is pricing more in the long run is Russia. Cyclically, we expect a deep contraction in domestic demand that will allow the CBR to cut rates sharply. Longer term, we think there are good reasons to believe that the neutral rates should be priced lower rather than higher.
Due the tighter financial conditions and the destabilisation of inflation expectations in December in Russia, the slowdown of the economy is likely to be quite severe and sharper than we had originally thought in the late autumn. While wage growth had already fallen to close to zero in nominal, sequential terms by Q2 and seasonally adjusted wages in January were only 2.5% above the level 6 months ago, inflation over the same period in seasonally adjusted terms has been 12.3%, i.e., seasonally adjusted real wages have fallen by close to 10% in 6 months. While the savings rate initially absorbed a significant part of this slowdown with retail sales in Q4 up by 2.4% in real terms compared to July, this was largely due to purchases of discretionary goods being brought forward in anticipation of sharp price hikes, as the exchange rate was passed through. With those price hikes now behind us, this offset will turn the other way and, in our view, household consumption will fall very sharply and the contraction in retail sales in January is only the first indication of this.
We expect the consumer to slow down sharply in the coming month sequentially by 8% in Q1-15 and 3% in Q2-15 before stabilising in Q3 largely due to the overshoot in inflation. Similarly, investment in Q1 is likely to be affected by the much tighter financial conditions and, hence, fall sharply as well, but with financial conditions already easing we think the fall in investment will be quite short lived, in particular given that export markets are holding up. In this respect, it is interesting that the PMI manufacturing survey already stabilised in February. Thus, what we expect is a very sharp contraction in domestic demand that will leave the country with a sizeable output gap that will keep inflation very low going forward. Clearly, this is a very different cycle from the rest of CEEMEA.
We think inflation in Russia will fall to new all-time lows in 2016 of close to 4% and, hence, we do not only expect an 800bps cutting cycle in the next 8 quarters but we also think that the neutral rate in Russia has actually declined rather than risen.
Decomposing the bond curve into expectations of policy rates and risk premia as we do in the model is admittedly difficult. The rate cutting cycle is heavily dependent on the degree to which the Ruble is supported by oil prices. While the CBR has, in our view, no interest in a stronger Ruble, it also does not want to see it destabilised any further. Thus, the timing (but not so much the extent) of the rate cutting cycle is going to be quite dependent on oil prices not significantly selling off once more. In addition, geopolitical risk clearly remains elevated in Russia’s case. However, we interpret the recent rally in hard currency credit as the market pricing less risk of escalation in the coming months, following the second Minsk agreement, and we think that this is not yet fully reflected in the OFZ market.