Russia. abc. *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations

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1 Vladimir Zhukov* Head of Equity Research () Dmytro Konovalov* Analyst, utilities Ildar Khaziev* Analyst, oil & gas Anisa Redman Analyst, oil & gas HSBC Securities (USA) Inc Gyorgy Olah* Analyst, banks HSBC Bank plc gyorgy.olah@hsbcib.com John Lomax * Strategist HSBC Bank plc john.lomax@hsbcib.com Wietse Nijenhuis* Strategist HSBC Bank plc wietse.nijenhuis@hsbcib.com *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 1

2 Introduction has a relatively young stock market. It was created in the early 199s as a result of the country s major transformation into a market economy, which entailed a mass privatisation of industrial companies. The n stock market is dominated by natural resource extraction industries, which account for almost 7 of the MSCI index. has been one of the top-performing emerging stock markets in the past 1 years owing to the rising prices of oil and other commodities. In the medium term, the government is planning to privatise its remaining interests in the oil & gas, utilities and commercial banking sectors, which should give a boost to the domestic stock market. The downside risk for the oil & gas sector, apart from global macro conditions, relates to the government s long-term goal of making the economy less dependent on natural resources, which entails the re-distribution of oil & gas revenues to fund growth in other industrial sectors and investments in the public economy. Market structure Dmytro Konovalov* Analyst Dmytro.konovalov@hsbc.com Vladimir Zhukov* Analyst vladimir.zhukov@hsbc.com *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations Historically, had two main stock exchanges: the MICEX (Moscow International Currency Exchange), which was set up in 1992 for currency and government bond trading, and the RTS (n Trading System), which was set up in 1995 to trade stocks. In 211, the two exchanges merged into the OJSC MICEX-RTS, which has become the prime n exchange for almost all traded instruments, including stocks, bonds, futures and forwards, commodities, currencies and money market instruments. Most of the n stocks are traded on the main market section of the MICEX-RTS, which accounts for over the 8 of stock turnover and almost 1 of bond turnover. MICEX-RTS is one of the Top 2 global exchanges by aggregate capitalisation value of all traded stocks. In 211, the combined traded volume exceeded USD1trn, with six-month average daily trading volumes of around USD2bn. The energy sector accounts for 58.2% of the MSCI with Gazprom representing approximately 25% and Lukoil another 14%. Second largest is the financial sector with a 15.4% weight, and Sberbank accounting for 11.6%. In other industries the companies with significant weights in the index are Uralkali (4.9%), MTS (4.3%), Norilsk Nickel (3.9%) and Magnit (3.5%). Equity index performance in MSCI price index (in Local currency) RTS price index (in Local currency, RHS) Source: MSCI, Thomson Reuters Datastream, HSBC Major stocks in MSCI index* Rank Stock name Weight (%) 1 Gazprom Oao Oil Company Lukoil Jsc Sberbank Of Spn Rosneft Oil Ojsc Uralkali Ojsc Novatek Oao Mobile Telesystems Ojsc Ojsc Mmc Norilsk Nickel Oao Tatneft Magnit Open Jsc Note: * data as at 22 May 212 Source: MSCI, Thomson Reuters Datastream, HSBC 2

3 Liquidity (6M ADTV) of equity indices in Sector composition of MSCI index* Sector Weight (%) Energy 58.2 Financials 15.4 Materials 11.1 Telecommunication Services 8. Utilities 3.9 Consumer Staples 3.5 Total 1. Note: * data as at 22 May 212 Source: MSCI, Thomson Reuters Datastream, HSBC MICEX Index 6M ADTV (USD m) Source: MICEX, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC Earnings and valuation stands out among emerging markets in terms of its valuation characteristics, as well as its liquidity. Valuation by itself is not enough in it provides little protection on the downside, but can create a lot of leverage on the upside. As the n stock market is heavily dominated by resource stocks, it functions primarily as a straight play on the global commodities cycle. Therefore, countryspecific factors may not play as much of a role as fluctuations in investors risk appetite. n stocks are normally high beta relative to their developed market peers. n stocks are sold off more heavily when the global macro situation deteriorates, as investors reduce their exposure to what they consider to be riskier assets, but they become a preferred investment choice in a strong macro environment, which triggers the return of risk appetite to emerging markets. Since 2, earnings in have followed a growth trend, with some fluctuations during major global economic downturns. Consensus recommendations for n stocks have been bullish most of the time since 28. However, has been increasingly de-rated relative to global EM, with the discount of the MSCI forward consensus PE to the MSCI EM increasing from zero in 26-7 to almost 5 by 212. As the MSCI index is heavily dominated by oil & gas stocks, we attribute the market discount to the weak earnings growth outlook for this sector. Growth will weaken due to a number of factors, including stagnation of oil output, increasing capex requirements and an increasing tax burden. As most of these factors will persist for some time, we therefore believe that, as a market, may continue to look relatively cheap. However, we also believe that offers the best exposure to any global economic turnaround, as it has the highest operating leverage to oil and other commodity prices. 3

4 Actual, trend and forecast earnings of MSCI index Annual growth in earnings: MSCI index 3. Log (EPS in USD) e 14 e 12M trail Trend I/B/E/S fcast e213e MSCI EPS growth Earnings momentum* versus returns: MSCI index IBES consensus recommendation score*: MSCI index MSCI earnings momentum MSCI y-o-y returns (RHS) Bearish Bullish Score Mean ± 2Stdev Note: *Earnings momentum is defined as the 6-month % change in 12 month forward EPS forecasts. Note: *represents the market cap weighted aggregate score of the IBES consensus recommendations for all the constituents. Scores should be interpreted as follows 1. to 1.49: Strong Buy; 1.5 to 2.49: Buy; 2.5 to 3.49: Hold; 3.5 to 4.49: Underperform; 4.5 to 5.: Sell Earnings growth* versus returns: MSCI index Earnings revisions* versus returns: MSCI index MSCI earnings growth MSCI y-o-y returns (RHS) MSCI earnings revision 12 MSCI y-o-y returns (RHS) 1-1 Note: *Forecast growth in 12m-forward earnings Note:- *Number of upward 12m-forward EPS estimate revisions over the last month as a % of the total number of revisions 4

5 MSCI index: 12M-forward PE scenarios* MSCI Price Index Note: *based on five scenarios of 12M-forward PE multiples (5x, 1x, 15x, 2x and 25x) 25x 2x 15x 1x 5x Earnings yield versus bond yield* in 4 35% 3 25% 2 15% 1 5% Y nominal par yield on Govt. securities 12M-forw ard earnings y ield of MSCI Note: * earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the MSCI index and the bond yield is the 1Y nominal par yield on Govt. Bonds. Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC 12M-forward PB versus RoE: MSCI index 12M-forward PE ratio of MSCI relative to MSCI EM MSCI 12M -forward price to book ratio MSCI 12M -forward RoE (RHS) 22% 2 18% 16% 14% 12% 1 15.x 1.x 5.x.x MSCI 12M-forward Price/Earnings ratio rel. to MSCI EM (RHS) 1.2x 1.x.8x.6x.4x.2x Fund flows In the last decade, has seen a substantial amount of foreign investment. However, since the end of 28, s relative weighting in GEM funds has fallen from 12% to approximately 7% (June 212). The fund outflow which took place in 211 was to a great extent driven by the rising global macro uncertainty, related to the crisis in the eurozone and concerns over the potential slowdown in Chinese economic growth. Although we believe that political uncertainty related to the 211 parliamentary and 212 presidential elections, and public protests which broke out towards the end of 211, contributed to the fund outflow, we believe the country-specific factors to be of less importance than the global macro conditions. Indeed, with both presidential and parliamentary elections behind us, we believe that any inflow of funds into EM and n equities is conditional on improvement in the global macro environment, especially a resolution of the situation in Europe, continuation of high economic growth rates in China and resumption of economic growth in the US. 5

6 Economic basics is the ninth-largest economy in the world, with GDP of USD1,85bn in 211, and the sixth-largest if measured by purchasing power parity, according to the IMF. On its income per capita basis falls into the UN s middle-income category, but it has the highest GDP per capita growth rates among the BRIC countries. is an open economy, with exports and imports exceeding 5 of GDP. Consumption (government plus households) made up two-thirds of s GDP in 211, with investment accounting for one quarter of GDP. The service and goods production sectors contribute almost equal proportions of GDP. The n economy is highly dependant on the global economic cycle, and on commodity markets, through the export revenues it derives from natural resources (primarily oil & gas) and the associated taxation. According to HSBC s economics team, an annual growth rate of above 3% is unsustainable in the medium term without support from external demand (ie a high oil price), even though economic growth currently has significant support from domestic consumption. is the 6th largest economy in the world (PPP basis) High sensitivity to oil (Urals) price Current international dollar (trln) US China India Japan Germany Brazil UK France Italy %, y-o-y Q 25 1Q 26 1Q 27 1Q 28 1Q 29 1Q 21 1Q 211 1Q %, y-o-y GDP (PPP, 211) GDP (LHS) Urals (RHS) Note: GDP based on purchasing power parity (PPP) Source: IMF, HSBC Source: Rosstat, HSBC Economic policy primer The Central Bank of (CBR) supervises exchange rate stability. The RUB exchange rate is floating within the corridor set by the CBR against the USD-EUR basket. The CBR uses FX intervention to keep the RUB within the corridor. s medium-term monetary policy is jointly developed by the CBR and the government for a threeyear period and published by the CBR. According to the latest policy, for the period, the CBR is planning to develop inflation targets based on a target growth range for the consumer price index. The current target is to keep headline inflation (Dec/Dec) between 6% and 7% in 212 and to reduce it to 4-5% in 214. The CBR also aims to maintain a flexible exchange rate, limiting its FX intervention to smoothing out RUB volatility, but also aiming to gradually reduce such intervention. The n budget and GDP growth rates are highly sensitive to the oil price. Assuming an oil price of around USD1/bbl, the government is expecting the country to maintain an annual GDP growth rate of around 3-4% during with the budget deficit not exceeding %. has over USD5bn 6

7 in currency and gold reserves, which it uses to mitigate fluctuations in the local currency as well as to fund any shortfalls in the government spending budget when government revenues fall on the back of lower commodity prices. A long-term economic strategy, Strategy 22, has been discussed by the government; if implemented, it would shift the focus of the economy from natural resources to more innovative industries and thus change the GDP structure and drivers. Political structure The n Federation is a federal presidential republic with the executive power split between the president and the prime minister. The n parliament has two houses: the State Duma (45 deputies), being the lower house, and the Federation Council (178 senators), being the upper house. The Duma deputies are elected at general public elections for a five-year term. The Duma elections are only open to political parties registered with the Ministry of Justice. The parties have to pass a threshold of 7% of total votes to get Duma seats. The Federation Council is comprised of representatives of all regions that are legal subjects of the n Federation. There are two representatives for each region, one appointed by its executive branch and the other by the legislative branch. Vladimir Putin was elected the President of on 4 March 212 for a six-year term. The previous president, Dmitry Medvedev was appointed prime minister. Elections to the State Duma were held on 4 December 211, with the pro-government United party taking the majority (53%) of seats in the new Duma; (the Chairman of United is currently the n Prime Minister, Mr Medvedev, who replaced Mr Putin in that capacity after the latter was elected as the n President). The other Duma parties are the Communists (2 of seats), Fair (14%) and the Liberal Democrats (12%). Following the liberalisation of the political legislation in 212, the requirements for registering political parties in have been dramatically loosened, which should open up the way for more opposition parties to take part in elections. Key regulatory bodies Central Bank of : responsible for monetary policy and supervising the banking system. Federal Service of Financial Markets: responsible for supervising non-banks and non-auditors, as well as capital markets, including brokers and stock exchanges. Federal Tariff Service: the federal agency responsible for setting the tariffs for natural monopolies, including utilities, gas and railroad transportation. MICEX-RTS Stock Exchange: the largest stock exchange in responsible for the introduction of listing requirements for domestic issuers. 7