The Russian economy was looking healthier than it has done in a long time in October and the Kremlin is clearly more comfortable as sanction fears failed to appear so the government is changing its policies to focus more fully on growth.

The Central Bank of Russia (CBR) and Ministry of Finance have been building a financial fortress over the last two years to fend off possible economic attacks by the US. But since Russia’s gross international reserves (GIR) topped the $500bn CBR’s comfort level and Ministry of Finance has cut the fat and found new sources of revenue to the point where the federal budget is running a 2% surplus that fortress is now complete.

The change in thinking was most clearly on display with the CBR’s decision of slash 50bp off the overnight rate in October – its biggest cut for years – and another 50bp cut is expected at the last meeting in December. A year ago the CBR hiked rates in September by 25bp in anticipation of ruble instability provoked by new sanctions that failed to appear.

The CBR’s task was made easier as inflation has receded faster than expected following a 2pp hike in VAT rates in January and Russia is likely to end the year with circa 4% inflation – the CBR’s target rate. More interest rate cuts are expected in the New Year as Russia still has very high real interest rates that is smothering growth.

Growth remains subpar with the economy expanding by only 0.9% in the first half of the year and continues to disappoint. The official and IMF forecasts for this year have been revised downwards several time and currently the official forecast is for a mere 1.1% of growth this year.

However, growth should pick up as the spending on the 12 national projects gets under way. The rules on how to spend the RUB27 trillion aimed at transforming Russia have recently be changed and only about 40% of the funds allocated have been disbursed. However, this spending will start in earnest in the New Year and should lift growth. The official forecast is for growth to reach 3% in 2021, but economist remain sceptical.

On-the-ground industrial production posted a surprise 3% growth in September that caused some eyebrows to be raised. However, stronger business activity in Russia’s service sector has compensated for the crash in the manufacturing IHS Markit Russia Manufacturing Purchasing Index (PMI) in September, which just reported its worst results in a decade and the composite PMI was up slightly to 51.4 in September, with businessmen remaining optimistic for the rest of the year. Corporate and banking profits are growing strongly after clearly starting to recover in mid 2018 and are continuing to gain momentum.

The fly in the ointment remains very low levels of investment. Most of the growth is being driven by consumers, but they are borrowing more with consumer loans growing by c.21% year-on-year while real incomes are rising by about 3%. Real incomes did pick up more than expected in September too but bankers report that spending habits have changed with customers preferring to spend than save and the levels of savings are very low.

Fixed investment growth remains too low to drive long-term growth at 20% of GDP but needs to be over 25% is Russia is not going to stagnate. Companies are profitable but they are not ploughing their money back into their businesses, preferring instead to pay off debt and pay out dividends. Russian companies are still paying the highest dividend yields in the world at twice the rate for the MSCI EM benchmark average.

As sanction fears subside and thanks to the large dividends portfolio investors’ interest in Russian stocks has perked up. The RTS index broke above 1400 in October – its highest level in about four years – and the market has returned 29% YTD as of the end of October. Utilities and financials are leading the charge. Analysts don't think the index has much further to do this year, but at the corporate level strong earnings and big dividends are producing lots of story to play on but Russia’s capital market remains volatile and it's a stock pickers market.