Politics

Russian politics are dominated by the threat of new “crushing” sanctions from the US that were due in the autumn, but now have been put off until the first quarter of 2019. However, the consensus is new sanctions are on the way in 2019 and their nature will have a large impact on how the year unfolds.

These new sanctions follow on from four rounds of sanctions in 2018, starting with the “Kremlin list” in February that was little more than the Forbes Russia rich list. Those were followed by sanctions on Rusal and its owner Oleg Deripaska in April. And finally the Countering America’s Adversaries Through Sanctions Act (CAATSA) and Defending Elections from Threats by Establishing Redlines Act (DETER) in the autumn. Apart from the sanctions targeting Rusal, none of these sanctions were particularly painful.

The scope of the 2019 sanctions remains unclear, but the Russian government clearly expects the worst and was battening down the hatches in the last months of 2018. Amongst some of the measures it took in the last months of 2018:

• the Central Bank of Russia (CBR) stopped buying currency to build up a war chest;

• the CBR hiked interest rates by 25bp to 7.75% in a surprise move despite the fact that inflation pressure didn't warrant it, as it was shoring up the ruble ahead of instability in the new year;

• the CBR warned banks to find a back-up payment partner in case Russia is cut off from Swift;

• the Duma put contingency plans in place in case Russia is cut off from the internet; and

• the Ministry of Economy ordered all state-owned companies to switch to Russian software.

By and large Russia is ready for a full scale economic war with the US. It has built up $470bn in hard currency reserves or 23 months of import cover. The government’s 15% of GDP external debt is the lowest of any major economy in the world. And Russia sold off most of its US treasury bill holdings. All this makes the Russian government largely impervious to pressure.

At the same time after four years of self-imposed bans on European agricultural products and heavy investment into domestic industry, Russian is becoming increasingly self-sufficient. Domestically processed foods have already replaced many imports and now the authorities are moving on to replace technology and machinery with homegrown alternatives.

Whether the US actually follows through with harsh sanctions that could target Russian sovereign debt and the ruble denominated treasury bonds, the so-called OFZs, remains open to debate. The attempt to sanction Russian aluminium producer Rusal and ban investors from owning its stock or debt backfired in spectacular fashion by causing chaos on the international metals markets. The US Treasury Department (USTD) was forced into a humiliating climbdown and the sanctions on Rusal were eventually cancelled altogether in December. Russia is a lot more integrated into the global market than the USTD had realised. And that is doubly true for Russian sovereign debt. That said, the consensus is that it will get worse before it gets better.

Prima facie international sanctions have not been effective in that their stated goal is to change the Kremlin’s behaviour and that clearly has not happened. However, the sanctions have effectively stymied Russia growth.

CBR governor Elvira Nabiullina has been praised as being the “most conservative central banker in the world,” but she has a war mentality. The CBR hiked rates in December by 25bp when it didn't need to in order to shore up the ruble before sanctions in the new year. The CBR is running a tighter monetary policy geared to protection not expansion. The current low growth is “good enough”, and for President Vladimir Putin low debt and large reserves are a question of national security, not macroeconomic policy.

The same is true for debt: Russia has one of the lowest levels of external sovereign debt in the world at 15% of GDP. The Kremlin could choose to simply “buy” some more growth by borrowing more, but it has chosen austerity instead as it makes Russia impervious to external pressure. The cost is going to be sub-potential economic growth for as long as the showdown with the west is running — mostly likely until at least the end of Putin’s final term in office in 2024.

Having said that, the government is going to take a tiny risk in the loosening direction and plans to relax the budget rule in 2019-2024. Instead of targeting a zero federal budget primary deficit (at the benchmark oil price of $40 per barrel in 2017 prices), the fiscal rule would now target a deficit of 0.5%. This expenditure increase of 0.5% of GDP would be financed mainly via domestic debt issuance, according to the World Bank.

Economics

GDP

Russia’s economy is expanding again, but since the petro-driven model was exhausted in 2011-2013 growth is capped at around 2% unless major structural reforms are put in place.

Russia is likely to end 2018 with around 1.8% GDP growth and while the predictions for 2019 vary a little, they are all coming in at around the same level for growth for the next few years. This is despite Putin’s May Decrees that call for Russian economic growth that is faster than the global average — a goal Russia is almost certain to miss.

The government started 2018 predicting 2.1% of growth, however, it cut its estimate twice during the year to 1.8%. The international financial institutions (IFIs) followed the same path.

Russia selected growth forecasts
	2018	2019
World Bank	1.6	1.8
IMF	1.8	1.8
Government	1.8	1.4
BOFIT	1.9	1.5
EBRD	1.5	1.5
S&P	1.7-1.8	1.7-1.8
source: bne

The wild card in the outlook is the RUB2 trillion a year the government is intending to invest into the social sphere and infrastructure that could boost growth. But analysts bne IntelliNews spoke to remain sceptical that the state can efficiently carry out such large plans and are waiting to see the details of the national programme before changing their outlooks.

Inflation & rates

GDP growth is slow but most of Russia’s macro indicators have improved substantially and the economy is running if not roaring.

Inflation hit record post-Soviet lows in 2018, bottoming out at 3.2%. however, as the summer came to an end inflation began to rise again on the back of rising food and fuel costs to hit 3.9% in December – just below the CBR’s 4% target.

In 2019 inflation is expected to pick up again and rise above the 4% target but average 4.5% according to the consensus. The CBR warned that inflation could hit a peak of 5.5-6% in March-April 2019, after which it will fall again in the summer.

The CBR started tightening monetary policy again in the autumn after nearly four years of cuts — but that has more to do with the threat of ruble instability caused by new US sanctions than any inflationary pressure.

Bankers are expecting the CBR to go back to cutting rates again in 2019 but they expect very few cuts if any at all.

Industrial production

The lacklustre growth is reflected in Russia’s industrial production which has struggled to gain any momentum in 2018. Russian industrial production picked up in the last quarter of 2018 and had a few good months as the year came to an end. However, after a strong October with 3.7% y/y growth, industrial output moderated again in November to 2.4% y/y.

In 2019 industry will probably suffer from the same weakness as the economy continues to grow, but well below its potential.

Budget & oil

The higher than expected oil prices in 2018 meant that the federal budget ended the year with a 3% of GDP surplus — the first headline surplus in several years — but will probably fall to 2.3% after all the end of the year spending in the budget.

Oil was averaging of $75 in the third quarter, but was hit with more weakness in the fourth quarter and now there is some confusion over where the price of oil will go in 2019.

In December the CBR lowered the forecast for the average annual price of Urals oil in 2019 to $55 per barrel from $63, noting that, thanks to the fiscal rule, a decrease in the price of oil will slightly affect the main macroeconomic parameters.

In November alone budget revenues jumped 46% year-on-year to RUB1.5 trillion, out of which oil revenues were up by 68.4% y/y and non-oil by 23% y/y. The last time the federal budget was in a headline surplus was in 2011 when revenues exceeded expenditures by RUB442bn.

In December the government reduced its outlook for oil from $63 to $50, which is also the breakeven price of the budget, down from $53 in mid-2018.

Still, even with the lower oil prices the World Bank estimates Russia will run budget surpluses from now of 1.8% of GDP in 2019, 1.1% in 2020, and 0.8% in 2021.

Oil prices will be supported in 2019 by a new Opec+ deal that agreed to cut production by 1.2mmb/d from the average October 2018 level. Of this, Russia is to contribute 228kb/d, down from its previous deal promise to cut 300kb/d, but it still producing record amounts; oil production in Russia reached an all-time high of 11.4mmb/d in October 2018.

In keeping with the prudential austerity policies, the Ministry of Finance has used the autumn windfall to cut its borrowing plans. The ministry is allowed to borrow RUB1 trillion a year for the next three years according to the budget but in November slashed it planned borrowing by RUB380bn ($5.7bn) in 2018 to RUB564bn.

And the finance ministry was finding it hard to raise money anyway thanks to the politics. Foreign investors’ share in the workhorse treasury bond, the OFZ, had fallen from a peak of 34% of outstanding bonds to 24% at the close of the year as foreign investors sold some RUB500bn of bonds. The finance ministry had a four-week break in auctions forced on it due to lack of demand, while the rates on the OFZs have soared from circa 7% at the start of 2018 to circa 9% at the end of the year.

Finance Minister Anton Siluanov has said that OFZs will not be placed at unfavourable market conditions, but with a RUB1 trillion borrowing plan for 2019 where foreign investors will account for at least a quarter of the sales, the nature of the new sanctions could heavily impact Russia’s ability to borrow as well as pushing up the cost of money.

Current account

The high oil prices also gifted Russia a very favourable trade balance in 2018. After fears in early 2018 that Russia’s current account may fall into deficit, the surplus swelled in the second half of the year on the back of high oil prices to reach an all time high of $104bn in 11M18.

And this record was despite rising capital outflows. The net capital outflow for the 11 months amounted to $58.5bn (+3.3x) having intensified in November to $16.3bn (from $10.3bn in October) despite the slower exit of non-residents from the OFZ market. For 2019 the CBR estimates capital flight will fall to $20bn.

"Many have asked why next year the balance of the financial account in the private sector will be $20bn outflow if this year it is projected at $67bn. In addition to lower oil prices, the reason is the suspension and then the resumption of foreign currency purchases by the Bank of Russia within the budget rules," Nabiullina explained. In December she affirmed that the CBR will be back in the currency market in 2019. At the same time the sell off in OFZ in 2018 is thought to have ended.

While oil prices are at half the level they were in the boom years of 2000-2008, Russia Inc is a lot more profitable then it was then. With the breakeven price of the budget at only $50, significant cost cutting and higher efficiencies have improved the government position enormously.

In addition the government has found new sources of revenue. Improvements in tax collection contributed about a fifth of the 2018 budget surplus while rising grain exports are playing an increasingly important role in Russia’s trade balance. Grain earned a whopping $20bn in exports in 2018 and is expected to continue to grow in importance in the coming years.

Corporate profits

The economy maybe growing slowly but that is causing a consolidation in many sectors — especially retail and banking — that has seen corporate profits soar as bigger companies reap the benefit of economies of scale.

Russian companies had their most profitable September in three years and Russian banks also made more profits in November than they had at anytime in the last four years. Companies had earnings for the month coming in at RUB1,580bn ($23.7bn). The cumulative profits for the year to date were RUB10,151.7bn, against the RUB7,385.8bn earned in September 2017 and RUB8,099.4bn earned in 2016.

These good results have led businesses to be more optimistic about the outlook for 2019 than they have been in years — although it is the service sector that is most positive, while manufacturers are more sanguine, according to IHS Markit.

“The latest IHS Markit Russia Business Outlook survey indicates stronger optimism among private sector firms in Russia, with all net balances rising to in October. The activity net balance (+25%) is slightly below the global average (+28%), but above the trend for emerging markets (+22%) and at its highest mark for one year. Business confidence is boosted by forecasts of greater client demand, access to new markets, product development and planned investments in business expansion,” Markit said in a press release. “Robust predictions towards future output are centred on the service sector, however, with manufacturing firms noting the weakest degree of optimism since October 2016. Service providers are at their most upbeat in a year.”

Equities

As for equities, despite oil prices and sanctions, the Russian market has out performed most of the other emerging markets by staying flat (MSCI Russia -0.4) in 2018, while the others suffered from the EM sell off (MSCI EM -16%).

What is holding the market up is the extraordinary dividends; add dividend payments into the return on equity investments, and the market is up by 5% in terms of total returns.

Other leading CEEMEA markets were significantly underperforming in 2018, with Turkey (-43%), Greece (-31%), South Africa (-27%), Egypt (-22%), and Poland (-14%) all down substantiall.

The outlook for equities in 2019 is also for an essentially flat market, but much will depend on where oil prices go. VTB Capital (VTBC) said in a note that it sees a baseline scenario with $69 oil that implies the RTS index will reach 1250 in 2019 (flat). The upbeat scenario assumes $75 oil for an RTS index of 1540 (25% gain). And the pessimistic scenario has $60 oil and the RTS at 1000 (19% loss).

Business

On the business front the action is contained in four leading sectors: raw materials, retail, banks and tech.

There is not much to add to the raw materials story other than to say the ruble devaluation improved their profits and as the owners are reluctant to invest many of these companies are paying extraordinary dividends.

Banks

Russia’s banking sector recovery is well underway following a mini-crisis in the autumn of 2017 and several years of zero profits before that.

The sector turned in its best aggregate profit since March in November 2018, and earned more in the first eleven months of this year than it earned in the full year for the last three years, RUB212bn ($100mn). Cumulatively the banks earned RUB1.28 trillion over 11M18, but if the big commercial banks taken over by the CBR last year are counted out then the profits are even higher at RUB1.7 trillion — 1.5 times more than the result for November last year, according to the CBR.

The CBR clean up of the banking sector is in its end game after the number of banks in Russia fell below 500 in November from over 4,500 in the 1990s, which has caused a consolidation and boosted the biggest banks.

Retail

There is a mood of pessimism amongst Russian consumers. 

Real disposable incomes fell in year-on-year terms in 2018 and households are anticipating the hike in VAT from 18% to 20% that comes into effect in January 2019. The Russian population is also likely to print its first full-year decline in a decade, with net migration failing to offset the natural decline for the first time since 2008. Otherwise, the labour market data looks solid, with nominal wage growth exceeding 8% for 14 consecutive months, and unemployment low and stable in the range of 4.7-4.8%.

Real incomes of Russians fell by 2.9% in annual terms in November, Rosstat reported on December 20. The statistical service revised its data on revenue growth in 2017, so the year-on-year comparison also changed; according to a new estimate by Rosstat, in August and September real income fell 1.6% and 3.2%, respectively, and slightly increased in October, by 0.3%.

After the revision, the real incomes of the population in 2017 decreased less than previously estimated — by 1.2%, not 1.7%. But against this background, they worsened over this year: for January-November, revenues decreased by 0.1%, taking into account payments to pensioners of RUB5,000 in January 2017.

If in December real incomes go down, 2018 will be the fifth consecutive year that Russians have reduced their income. In 2014, incomes fell by 0.7%, in 2015 — by 3.2%, and in 2016 — by 5.8%. 

Real disposable incomes of the population are about 2% lower than the 2011 level and 10% lower than the peak values of mid-2014. The real wages of Russians in August 2018 recovered to the pre-crisis level, exceeding the level of August 2013 by 1.1%, but real incomes continued to be behind by 12.4%.

A study by Deloitte found that the number of Russians who believe the economy is in recession has risen significantly over the past year, from 51% to 61%. The number of Russians who expect their purchasing power to fall in the coming year has risen from 22% to 30%. At the same time consumers’ inflation expectations are for a 9% increase in prices, while the CBR is expecting the increase in 2019 to be half that level.

In general retail is growing but will not play the role of economic driver like it did in the noughties boom years. Slower growth and rapidly growing competition from e-commerce means the retail sector is also going through a process of consolidation.

Tech

The most exciting sector in Russia is tech. Online retail is now growing at ten times the speed of the real economy, and given the size of Russia’s retail market (as well as the geographical spread), fortunes can be made from a good idea.

Russia's e-commerce market in 2018 is expected to reach RUB1.5 trillion ($22.8bn), according to estimates by Data Insight. Sales in Russian online stores are expected to increase by 19% to RUB1.15 trillion and in foreign stores by 29% to RUB348bn. This is based on the 18% y/y and 34% y/y increases in the number of orders in Russian and foreign online shops, respectively.

Russian e-commerce has come of age. According to market research company Nielsen, 90% of Russians have made at least one online purchase in the last ten years as a result of a growing consumer trust in online stores.

According to the Russian Association for Electronic Communications, almost two-thirds of the domestic e-commerce increase was delivered by growth at the two domestic sites, Wildberries and Ozon. Wildberries said it is planning to earn RUB120bn in 2018, a surge of 74% year-on-year. Its main rival Ozon.ru plans to grow 70-80% to RUB70bn in revenues this year.

2019 will see more of the same as the heavyweight players get their mass market projects off the ground. The biggest of these is the Sberbank-Yandex tie up to create Yandex.Market, a Russian version of Amazon.