Research Notes

Benchmark RTS: A Forecast Based on Macroeconomic Factors

In our desk note entitled “Stock Seesaw in Recent Years: What's Behind the Peaks and Troughs on the Russian Equity Market?” [1] we reviewed the major economic factors which impact the trend of the Russian stock market and analyzed their correlation with benchmark RTS.

It was established that benchmark RTS has the closest correlation with yields (yield spread) of EM Eurobonds as a whole and Russian Eurobonds in particular (rating A). In turn, Russian Eurobonds yield (and its spread to of US T-bond yield) reflects, on the one hand, interest rates reflect the situation on global markets (the Fed's interest rates), while on the other hand – perception by market participants of the level of country's investment risks.

As a result of the research, global crude prices and liquidity inside the country (money supply) have been specified as factors with high rating of impact on the stock market (high correlation with benchmark RTS, stability of correlation dependence, rating B).

In this report, the forecast of benchmark RTS is built for the period by year-end 2005. In addition, one more factor is added which reflects investment country risks (not only sovereign grade), i.e. risks of conducting business in the country. We have used the political stability index calculated on a monthly basis by Deutsche Bank Eurasia Group (DESIX) for 24 countries with EM economies, including Russia, as such a tool.

Main conclusions:

1. On the basis of current trends, we expect to see strong global crude prices by year-end 2005 (average annual $45-55/bbl, Brent, IPE), a moderate increase in money supply (15-25%) and moderate hikes in Fed's interest rates (up to 3.75% pa by year-end 2005).

2. Record high global crude prices, Russia's strong macroeconomic indicators (despite a noticeable slowdown in GDP since H204), record high level of international currency reserves and anticipated upgrade of Russia's sovereign grade rating offset slightly negative impact of Fed's interest rate hikes on EM economies.

3. We expect to see a gradual stabilization or decrease in investment country risks. However, inconsistency and insufficient predictability of decisions adopted by the state officials, the weak and dependent judicial system, ambivalent statutory norms and declining political stability in CIS countries could hinder improvement of the investment climate in Russia.

4. We view the general market forecast as moderately positive. By year-end 2005 we expect benchmark RTS to be at around 765 (the most probable scenario) or to 812 (the upbeat scenario).

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1. Major factors used for forecasting benchmark RTS

We have forecast benchmark RTS on the basis of four selected factors:

• Liquidity inside the country;
• Russian Eurobonds trend;
• Global crude prices;
• Russia's political stability index (DESIX).

1. Liquidity inside the country (money supply (M2))

Money supply (M2) is used as the liquidity indicator inside the country. All other things being equal, demand for shares and their prices are on the rise (Figure 1).

Figure 1. Benchmark RTS and money supply (M2)

2. Russian Eurobonds trend (Russia-30 yield)

We use Russian Eurobonds (Russia-30) yields to summarize the liquidity characteristics of on international financial markets and the premium for investment sovereign grade rating of. This factor combines the impact of both interest rate trends on global markets (which are dependent, in particular, on expectations of changes of the Fed's interest rates) and investor perception of Russian sovereign grade risks (spread EMBI+ Rus – Russian Eurobond yields to UST bond yields). When Russian Eurobonds rise or fall, the risk-free interest rate is hiked/reduced, which directly impacts the cost of raising capital for all Russian companies and their fair price decreases/increases leading to an downside/upside of benchmark RTS. As shown in the report [1], the correlation between benchmark RTS and Russia-30 yields is -0.91.

Figure 2. Benchmark RTS trend and Russia-30 yields

Figure 2shows that since September 2001 to May 2005, Russian Eurobonds yield declined significantly (from 14% to 5.6% pa). At the same time, benchmark RTS climbed 270%. A decline in Russian Eurobonds yields is attributed both to a general rise in global financial markets and a considerable increase in Russia's investment appeal vs. EM economies on the back of improved macroeconomic indicators. At the same time, the creditworthiness of the state is primarily important for sovereign Eurobonds, while risk of conducting business in the country has no specific meaning here. However, this risk turns into one of key risks for the Russian stock market. For this reason, at present, Eurobond yields can be viewed as a benchmark for trends on international markets and Russia's creditworthiness. However, it insufficiently reflects the general level of country investment risks.

3. Global crude prices (Brent, IPE)

Oil prices impact the Russian stock market (Figure 3) through 2 channels – changes in the market caps of oil stocks, which account for the bulk of benchmark RTS and by increasing/decreasing the net balance of payments and money supply. Recently, the dependence of financial performance of oil companies on international crude market trends has weakened, since amendments to the tax system have resulted in the lion's share of windfall profits from high oil prices being withdrawn to the budget.

Figure 3. Benchmark RTS trend and global crude prices (Brent, IPE)

4. Russian political stability index (DESIX)

A rise in political stability index means a decrease in country investment risks which leads to rising demand for shares and pushes up benchmark RTS.

We have used the political stability index calculated on a monthly basis by Deutsche Bank Eurasia Group (DESIX) for 24 EM countries as a country risk indicator. This index consists of variables grouped by 4 broad categories: the government, the society, security and economy. EM economies are ranked on a scale of 0-100 in this index. The maximum of 100 points is indicative of maximum stability. Since February 2001, Russia's general stability rating has been fluctuating in the range of 52-63 pp, which corresponds to the top level of moderate stability /41-60/ and low level of high stability /61-80/ (Figure 4). In June 2003 – prior to the Yukos case – the value reached a record high of 63 p. In 2004, the value was generally in decline and reached a local record low of 55 p. YTD in 2005, the value has been fluctuating insignificantly (58-59pp).

Figure 4. Benchmark RTS and DESIX stability index trends

Thus, we have considered the factors which will be used for forecasting benchmark RTS

The following two approaches have been used for forecasting:

1. forecasting benchmark RTS on the basis of cash liquidity indicator within the country (money supply) and interest rates on international financial markets (Russia-30 yields).

2. forecasting benchmark RTS on the basis of crude prices and investment country risks (DESIX).

The use of two approaches as an alternative to the single approach to forecasting on the basis of all 4 factors is caused by eventual multicollinearity (correlation dependence) between two couples of formally independent variables “global crude prices – money supply” and “political stability - Russian Eurobond yield”.

A regression analysis of the joint impact of two couples of source factors on benchmark RTS yields the following results:

1. RTS = 507.66 + 0.088*M2 – 3183.09*YTM (Russia-30)
   R² = 0.92
2. RTS = -580.43 + 14.17*Brent + 10.41*DESIX
   R² = 0.64

2. Benchmark RTS scenario forecasts

Input data:

Factor	Date	Value	Change, YTD
Money supply (Ì2), Rub bln	June 01, 2005	4,688.6	+7.5%
Russia-30 yield, % pa	June 2005 (average)	5.68%	-0.9 b.p.
Fed's rate, % pa	June 30, 2005	3.25%	1.0 b.p.
UST-10 yield, % pa	Èþíü 2005 (average)	3.99%	-0.23 b.p.
Spread of Russian Eurobonds to US T-bonds, b.p.	Èþíü 2005 (average)	165	-53 b.p.
Global crude prices (Brent), $/bbl	January-June 2005	50.6	+30%
Political stability index (DESIX)	June, 2005	58	+2

1. Global crude prices

   One of key factors which impact the situation in the Russia and global economy is global crude prices. In January-May 2005, average price for Brent (IPE) was $50.5/bbl. In late May, EDTM's official forecast on the average annual price of Urals was hiked from $39 to $43/bbl for 2005 and EDTM expects global crude prices at $35/bbl in 2006. We expect that average annual global crude prices for Brent, IPE oil could be in the range of $45-55/bbl in 2005. Meanwhile, a mid-term outlook on global crude prices will be determined, in our opinion, by demand from the US and China, geopolitical and military factors, as well as speculative demand for oil futures as a stock commodities asset alternative to investments in overvalued financial assets.

2. Liquidity on the domestic market

   Needless to say, global crude prices will impact changes of money supply in Russia (M2), since the inflow of oil dollars to Russia has prompted CBR to issue rubles to soak up excess currency and avoid sharp ruble appreciation. At the same time, the sterilization mechanism for rubles through stabilization fund resources, which are not spent inside the country, decreases the dependence of the country's money supply on crude prices. In January-May 2005, money supply soared by a mere 7.5% (vs. 9.8% y-o-y). In our opinion, acceleration of inflation in early 2005 (7.3% in January-May given the official annual target of 10%) will urge CBR to tighten control over the increase in money supply and M2 could grow by 15-25% in 2005 (vs. 35.8% in 2004).

3. Interest rates on international financial markets

   In our opinion, the Fed will also consider impact of energy prices on inflation and economic indicators in the US when regulating interest rates. In the event of more expensive crude imported by the US, rising inflationary pressure could urge the Fed to hike interest rates more aggressively. On the other hand, high energy prices throw in jeopardy demand on the part of private and corporate sectors of the US, while tightening the monetary policy in this situation could lead to the recession. The most likely trend now is the policy of moderate interest rate hikes by the Fed (anticipated interest rate range is 3.5-4% pa by year-end 2005 vs. 3.75-4.25% which we forecast in March-April 2005).

   To assess the impact of the Fed's rate hike decisions on the market it is important that the Fed's spokespersons point out that the spread between UST-10 bonds and the cost of federal funds has recently been narrowing. Moreover, despite a hike in the Fed interest rates, UST bond yield is declining. We expect that in the future UST bond yield will grow at a slower pace in the event that the Fed sticks to its policy of measured interest rate hikes. UST-10 bond yield was below 4% in June and will not likely top 4.5% by year-end 2005.

   The spread between Russian Eurobonds and UST-10 has significantly narrowed in 2005 on the back of Russia's record foreign trade surplus, an investment grade rating assignment from S&P in late January and an agreement with the Paris Club of Creditors on premature repayment of $15 bln debt. Expectations of a sovereign upgrade by Moody's after repayment of this amount (June-August) could narrow this spread even further. We view the decline in spread from the current 165-170 b.p. to 150 b.p. as the most likely. However, accelerated interest rate hikes on international financial markets if the Fed's policy becomes more aggressive could adversely impact EM trends and expand the spread of Russian Eurobonds as was the case in spring 2004 (Alan Greenspan's announcement was taken by the market as a signal to interest rate hikes) or in March 2005 (when FOMC announced accelerated inflationary risks which prompted a tightening in monetary policy). Therefore in line with our forecast, the spread for Russian Eurobonds could be in the range 130-180 b.p. by year-end 2005 depending on the performance of the Russian economy and interest rates on international markets.

   On the basis of the above assumptions, we expect Russia-30 yields to fluctuate within the range of 5.3-6.3% by year-end 2005.

4. Country investment risks

   The DESIX political stability index calculated by Deutsche Bank Eurasia Group (DESIX) was 59 in May and was downgraded to 58 in June. Recently, the Russian President and the government have been striving to show the international investment community their aspirations to improve the investment climate in the country which was adversely impacted by the Yukos case and as a result of uncertainty over future relations between business and the state. To date, investors have been cautious about a number of such steps (cutting the statute of limitations on privatization transactions, tax amnesty for flight capital, improving tax administration). At the same time, we believe the impact of the Yukos case will subside in the future. For this reason, in the absence of political havoc, the political stability index will most likely fluctuate in the range of 56-61 pp. The bottom range is in line with the level of autumn 2004 (activization of terrorist attacks, political problems in Ukraine, expectations of the sale of YuganskNG at underestimated prices). The top level of the range is in line with the level of spring 2003 which was relatively good in terms of political stability.

5. Scenario forecasts

   We have considered three scenarios for our benchmark RTS forecast on the basis of the established regressive relationships:

   1. Conservative scenario. Global crude prices will dip slightly vs. the current level and average $45/bbl (Brent, IPE) in 2005. Inflationary pressures both in the US and Russia will ease due to stabilization of energy prices and the Fed will remain committed to its cycle of measured interest rate hikes (up to 3.5% by year-end 2005). UST-10 yields will stabilize at 4%, while spread of Russian Eurobonds will narrow to 150 b.p. on Russia's strong balance of payments and the possibility of an upgrade of Russia's credit rating due to premature debt repayment of $15 bln to the Paris Club of Creditors. Stabilization of global crude prices will enable Russia to slightly increase money supply in 2005 to 15%. The DESIX political stability index will be 56 p by year-end 2005, which would be flat on December 2004 and have a slightly negative impact on Russia's investment climate vs. the current level.

   2. The most probable scenario. Average annual global crude prices will be $50/bbl (Brent, IPE) in 2005. The Fed will hike interest rates to 3.75% by year-end 2005, UST-10 yields will rise to 4.25%, while the spread of Russian Eurobonds Russia-30 will be 175 b.p. (which is nearly in line with the current level). Money supply in 2005 will balloon by 20%, while the DESIX political stability index will remain flat at 58 p.

   3. Aggressive scenario. Global crude prices (Brent, IPE) will spike to $55/bbl average in 2005. Rising inflationary pressure will urge the Fed to hike interest rates more hawkishly to 4.0%. At the same time, UST-10 yields would rise to 4.5%, while spread Russia-30 will broaden to 200 b.p. Record high crude prices will force CBR to issue more rubles, in order to avoid sharp ruble appreciation. Therefore money supply will spike by 25%. The investment climate in Russia will improve, triggering a rise in the political stability index (DESIX) to 60 p.

Based on a combination of the two approaches we have built the average forecast of benchmark RTS for each of the three scenarios.

Òable 1. Benchmark RTS scenario forecasts of as of year-end 2005

	Scenario 1 - conservative	Scenario 2 – most probable	Scenario 3 – aggressive
Brent (IPE)	45	50	55
M2, beg. 2004	4363.3
Ì2, end-2005	5,017.795 (+15%)	5,235.96 (+20%)	5,454.125 (+25%)
Fed funds, %	3.5%	3.75%	4.0%
UST-10, YTM	4.0%	4.25%	4.5%
Spread Russia-30 to UST, b.p.	130	150	180
Russia-30, year-end 2005	5.3%	5.75%	6.3%
DESIX	56	59	61
RTS (1st method – based on Ì2 and Russia-30 yield)	783.51	788.52	790.34
RTS (2nd method – based on Brent price and DESIX political stability index)	640.33	742.43	834.11
RTS (average)	711.92	765.47	812.22

Summary

Thus, on the basis of the current trends, we expect to see global crude prices remain strong (average annual $45-55/bbl, Brent, IPE), a reasonable increase in money supply (15-25%), predictable and measured Fed interest rate hikes (to 3.75% by year-end 2005). Russia's strong macroeconomic indicators, a record high level of international currency reserves and the government's commitment to premature repayment of foreign debt could eventually be considered by at least one of international rating agencies by year-end 2005, which offsets the slightly downbeat impact of Fed interest rate hikes on emerging economies.

We also expect to see gradual stabilization or a decline in investments country risks, however, inconsistency and insufficient predictability of decisions adopted by state officials, the weak and dependent judicial system, ambivalent statutory norms and a decline in political stability in CIS countries could hinder improvement of the investment climate in Russia. However, we view the overall forecast on the market as moderately upbeat.

By year-end 2005, we expect benchmark RTS to advance by some 25% (the most probable scenario). Meanwhile, implementation of the results of our forecast will likely be limited, since the identified set of factors is not comprehensive and only includes those general economic parameters which are quantifiable and subject to statistical research. Among other factors, which are important for the market, but not considered in this report, we would like to mention the moderately positive impact on the market from expectations of the ring fence begin removed around Gazprom shares and the moderately negative impact of feet-dragging in utility sector reform and the privatization of Svyazinvest.

Olga Belenkaya

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