GI Macro & Market Research - Market Commentary: Ru ssia – central bank on hold, risk premiums remain wide

• The Russian central bank (CBR) kept the repo rate s table at 7.25%. The bank maintained easing bias, but the potential for interest rate re ductions has declined. We expect the central bank to resume the easing cycle this year and to re duce interest rates three times by 25bps to 6.5%.

• The sanction risk has abated and we see little willingness to impose new sanctions. Especially the EU lacks the motivation to introduce new material sanctions, although lists of sanctioned persons and companies could be expanded, but we see the inclusion of Deripaska's companies as a special case unlikely to be repeated. Still, there are two initiatives pending in the Congress that could resu lt into new sanctions against Russia.

• We see only limited implications of the current dev elopment for the sovereign risk of Russia. The view is shared also by Moody’s. The agency beli eves Russia is able to weather sanctions without a meaningful deterioration in its key credi t strengths

• Russian assets tumbled after the announcement of sa nctions and have recovered only partially since then. We see them as attractive fro m the valuation perspective offering wide risk premiums to investors willing to assume the sa nction risk.

The Russian central bank (CBR) kept the repo rate s table at 7.25%, in line with the market consensus. The CBR’s decision to interrupt the easing cycle was motivated by the recent turmoil. Despite some recovery, the currency is still 7% below the “pre-sanction” level. The bank believes the weaker currency does not create risks of inflation overshooting the target and expects inflation to range between 3–4% as of the end of 2018 and hold close to 4% in 2019. The economic recovery is expected to stay muted with the growth reaching 1.5-2% by year-end. The bank maintained easing bias, but the potential for interest rate reductions has declined. The bank notes that neutral interest rates may be closer to the upper level of the "neutral" range of 6-7%.

We expect the central bank to resume the easing cyc le this year. Firstly, the repo rate is still above the "neutral" range 6-7%. Secondly, we anticipate the market recovery to continue further and currency appreciation should improve the outlook. Altogether, we should see three interest rate redu ctions by 25bps that would bring the repo rate to 6.5%, i.e. in the middle of the neutral range . However, if the ruble fails to appreciate, weaker currency could add roughly 0.5pp to the inflation by year-end bring it close to the 4% target reducing the space for interest rate reductions further. Also, the interest rate outlook is

subject to the changing fiscal outlook. Vladimir Pu tin is going to announce a new six-year plan after his May 7 inauguration focused on raising living st andards by boosting spending on health care, education and infrastructure. The plan is expected to reach RUB 10tn over six years and one of the versions would amount to 2.3% GDP per year. Majority of spending should follow after 2020. Although we don't know the details, the plan will lift the medium term growth outlook with significant impolications for inflation.

Sanction risk eases

US sanctions announced on April 6 led to a market t urmoil that was caused by the imposition of financial and economic sanctions on Deripaska's companies (Rusal, EN+ Gropu, GAZ group) ont he fears that almost any Russian company or government related entity could be sanctioned. Since then, the sanction risk has abated. Firstly, no new US sanctions have been intr oduced and US Treasury Secretary did not recommend sanctions against Russian government debt . Secondly, sanctions against Rusal are being reconsidered . US Treasury indicated it is ready to soften its stance against Rusal if Oleg Deripaska sells his controlling stakes. It also prolonged the period during which the US companies were mandated to wind down their business relations to Rusal from June 5 to October 23. Moreover, Treasury Secretary Steven Mnuchin said the U.S. is considering a petition from Rusal to remove it from the sanction lists. Thirdly, the EU countries have not introduced any n ew sanctions. In contrary, the EU countries have reportedly pressed the US to ease the sanctions against Rusal, as the company is a key supplier of aluminum to Europe. Finally, Russian response to US sanctions has bee n restrained . There is a law initiative pending in the Duma that will be discussed in mid-May that would impose sanctions against US companies. Russian position is difficult, as US imports may be difficult to substitute and would hurt Russian companies and consumers causing with few exemption (like titanium exports) only limited pain to US companies.

Currently, we see little willingness to impose new sanctions. Especially, the EU lacks the motivation to introduce new material sanctions. Still, the lis ts could be expanded, but we see the inclusion of Deripaska's companies as a special case unlikely to be repeated . We think that the decision was closely connected to the aluminum and steel sanctions and Deripaska's problematic background (connections to Putin, business relations with Paul Manafort, he has been already banned from entering the US). Of course, we cannot exclude that new conflicts could arise between the West and Russia in the future, mainly connected to the cyber war. However, we doubt that Russia has motivation to risk such a conflict, as gains from election interference have been dubious at best.

Still, there are two initiatives pending in the Con gress. In the House, Democratic Representative Joaquin Castro of Texas and Republican Mike Turner of Ohio are co-sponsoring a bill that would sanctioned Russian sovereign debt and would impose financial sanctions against government controlled banks. An older initiative in the Senate , Defending Elections from Threats by Establishing Redlines Act of 2018, is sponsored by U.S. Senators Marco Rubio and Chris Van Hollen. It is designed to avoid foreign interference into future US elections . It exactly states what are foreign governments prohibited to do. The bill has a special section focused on Russia. Should Russia once again interfere into US elections, sanctions on major sectors of the Russian economy, including finance, energy, defense, and metals and mining. More specifically: Rusal like sanctions against banks (VTB, Sberbank, Gazprombank and others), and energy companies (Gazprom, Rosneft, Lukoil), prohibition of transaction with Russian government debt freezing of assets certain Russian owned entities.

Asset valuations attractive after the sell-off

Russian Assets tumbled after the annoucement of san ctions and have recovered partially since then. The sanction risk is the main factor behind the ele vated risk premiums, as many investors try to avoid any exposure to Russia, but also other emergi ng markets have shown weak performance in the enviroment of rising dollar interest rates. The fundamental situation has actually improved, as high oil and commodity prices are positive for Russia and its financial strength and Putin’s six-year plan could lift the medium term growth outlook.

Starting with the local bonds , they offer highest ex-ante real interest rates among pee rs and the central banks sees high real interest rates as a way how to achieve its 4% inflation target on sustainable basis. We even see a good chance for moderate capital gains, as the market does not expect much policy easing going forward.

Eurobonds offer a relatively safe way how to gain e xposure on Russia . The spreads have widened substantially and correspond to a one notch lower rating. As the sanction risk retreats, the spreads should tighten again.

Russian currency depreciated to the weakest level in almost two years and the central bank even interupted the purchases of FX reserves for several days, conducted on behalf of Ministry of Finance. We think that Russian currency offers good value in th e emerging markets spectrum. The current account stays in sizeable surplus (2.5% in 2017, +3% in 2018) and may increase further if current commodity prices are maintained. However, the pressure stemming from high oil prices is mitigated by the budget rule and related FX purchases. Also, the risk of sanctions and inclusion on list of sanctioned persons should support capital repatriation back to Russia. Finally, high local interest are also supportive.

Moody’s keeps positive rating outlook

We see only limited implications of the current dev elopment for the sovereign risk of Russia . Firstly, we see only small risk that sanctions against Russian sovereign debt could be introduced. Secondly, the fundamental picture (improving economy, healthy external and fiscal accounts, improving institutional framework) implies even significantly higher rating. This is reflected in the Generali internal rating, currently at BBB+. Recently, Moody’s issued a report that confirmed our view. The agency believes Russia is able to weather sanctions without a meaningful deteriora tion in its key credit strengths and it has not indicated the intention to remove the positive outl ook for the Russian sovereign rating.

Author: Martin Pohl martin.pohl@generali.com

www.generali-invest.com

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Rating OutlookFitch BBB- PositiveS&P BBB- StableMoody's Ba1 Positive