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Russia has been whipped by a wave of woes of late, from low oil prices to a two-year long recession and international sanctions, even if some of these were self-inflicted. Yet investors who have braved the chill winds have been richly rewarded.

Benchmark 10-year rouble-denominated sovereign bond yields have tumbled from a peak of 16.1 per cent in January 2015, and 11 per cent as recently as January this year, to 8.1 per cent, as the first chart shows, delivering a powerful capital gain on top of generous yield by modern-day standards.

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With the rouble having strengthened a little since January 2015, and being up 25 per cent against the dollar from its January 2016 lows, the gains have been compounded for foreign investors, who now hold 25.4 per cent of the Rbs5.3tn market for local currency government debt, the highest figure since July 2014, according to the Central Bank of Russia.

And even though the economy is still contracting, equity investors have also cashed in with the MSCI Russia index gaining 24 per cent in dollar terms so far this year, more than twice the 11 per cent return of emerging markets as a whole. These gains have been outstripped by just Brazil, Peru and Colombia among major EMs, according to data from Renaissance Capital, a Moscow-based investment bank, as depicted in the second chart.

“Since the rebound began in late January, the market is up an impressive 52 per cent,” says Daniel Salter, head of emerging market equity strategy at Renaissance.

The key driver of the rebound in asset prices has been the stabilisation in oil prices this year. This has allowed the rouble to hold steady at around Rb65 to the dollar — the currency did not weaken in August for the first time in a decade, laying to rest a “curse” traditionally driven by seasonal outflows linked to Russian companies’ dividend payments, says Vladimir Osakovskiy at Bank of America Merrill Lynch.

Although this is a far cry from the levels of 30-35 roubles to the dollar prevalent between 2010 and 2013, it has at least allowed imported inflation to fall.

As a result, overall consumer price inflation has fallen from a peak of 16.9 per cent in March to 6.9 per cent, as shown in the first chart. Consensus forecasts suggest this will drop further to 6 per cent next year.

Chart: Chart: Russian bond yields and inflation

In turn, this has created space for the central bank to start cutting interest rates, with one 50-basis point in June and another on Friday taking the one-week repo rate down to 10 per cent and lowering both bond yields and companies’ borrowing costs in the process.

Moreover, the stabilisation in the rouble appears to have brought to an end the capital flight witnessed in 2014 and 2015. Indeed, Morgan Stanley reports a “continued improvement in the capital account”, with net flows turning positive in August.

That said, Friday’s monetary policy statement from the central bank did put a fly in the ointment. Although the bank cut rates by 50bp to 10 per cent as expected, Elvira Nabiullina, the governor of the bank, said that rates should be maintained at this level “at least until the beginning of next year”.

Chart: Stock market performances

Ms Nabiullina argued that the most recent downward leg in inflation was driven by the unexpected strength of the rouble and a strong harvest, while non-food inflation and inflation expectations have declined more slowly. She also raised concerns that households’ inflation expectations remain far higher, at 16.5 per cent in August, than the CBR’s target inflation rate of 4 per cent.

This upended widespread expectations that interest rates would fall to 8 per cent, or lower, by the end of 2016, a move that would have been expected to extend the rally in local currency bonds.

Capital Economics said after the press conference that it now expected policy rates to fall to 8 per cent next year and 6 per cent by the end of 2018, the level it had previously pencilled in for December 2017.

Despite this, Yuri Tulinov, head of research at PJSC Rosbank, a division of Société Générale, who predicted the CBR would “strive to downplay the cut as much as they can by stating that it is not a continuation of the easing cycle and that multiple risks to inflation remain,” says he “would bet on [rouble bonds] preserving attractiveness”, given that rates across developed markets “are insignificantly different from zero”.

Mr Salter also sees the potential for further yield declines this year, noting that 10-year yields fell as low as 6.7 per cent in 2013, when inflation was higher than today at 7.1 per cent.

A key driver of the stock market rally has been the slide in the rouble in 2014-15, which increased the value of Russian companies’ foreign earnings in rouble terms, says William Jackson, senior emerging markets economist at Capital Economics.

Although this effect will be likely to fade as the newfound stability of the rouble starts to feed through, there would still appear to be scope for further equity gains.

In terms of consensus 12-month forward price-earnings ratios, Russian stocks are still far cheaper than in any other country in the MSCI Emerging Market index, at 6.4 times, as the last chart shows.

Chart: Price-equities ratios

Admittedly Russian stocks historically do command a lowly valuation — the discount to the EM average forward p/e, currently 48.1 per cent, is in line with the five-year average of 48.6 per cent, according to calculations by Mr Salter. But it is comfortably above the 10-year average of 36.5 per cent.

Russia also has the highest dividend yield of any major emerging market, at 4.5 per cent, with only the Czech Republic, which has a princely three stocks in the MSCI index, higher.

“As interest rates and bond yields come down, given Russia’s disinflation and rate-cutting story, as well as the global search for yield, Russia’s attractive dividend yields are likely to become more evident,” Mr Salter argues.

That said, risks remain. Oleg Kouzmin, chief Russia economist at Renaissance, says the shrinking current account surplus, likely to come in at 2-3 per cent of gross domestic product this year, against 4-5 per cent previously, “was a concern” for the rouble, although “it should not undermine the currency unless domestic capital flight picks up or Russia faces another external shock”.

Mr Osakovskiy says any further recovery in oil prices would slow this rate of deterioration, but warns that with the Russian economy forecast to return to growth next year, a pick-up in imports and remittances by foreign workers based in Russia could sap the surplus.

The other fear for bond investors is a “potentially abrupt increase” in the supply of government debt, says Mr Tulinov.

Mr Kouzmin echoes this, suggesting that in the absence of any meaningful pick-up in oil prices, the government could borrow Rbs300bn this year to fund a budget deficit of 3.4 per cent of GDP.

If so, this would mean the size of the rouble-denominated sovereign debt market will have risen 60 per cent in three years, potentially limiting any further decline in yields.

“Growing [supply] could tame future upside in bond prices even if disinflation and rate-cutting stories prove to work well,” he warns.

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