By Avantika Chilkoti
Russian markets have soared this year as the threat of U.S. sanctions has waned and investors have turned their attention to signs of an improving economy.
Equities in Moscow are poised for their best annual performance in three years: The MOEX Russia Index, the main ruble-denominated stocks benchmark, has rallied over 27% so far, while the dollar-denominated RTS Index is up over 40%. The benchmarks have outstripped most other emerging markets and kept pace with the S&P 500.
Investors are getting back into Russian assets -- drawn by the rich dividends paid by state-run companies and the high yields generated by government bonds -- as fears of the impact of U.S. sanctions ebb.
"What we have in Russia is dividends growing, stable finances, and more and more investors starting to appreciate it is a relatively safe bet," said Marcin Lewczuk, a partner at investment firm Mobius Capital Partners.
The country is playing catch-up with other emerging markets, analysts said, following a five-year period in which its economy has been impaired by a sharp drop in the price of oil, the country's main export, and Western sanctions starting in 2014.
Since Russia annexed Crimea that year, Washington has barred transactions with many Russian people and businesses, and banned some exports to the country. The sanctions also restricted access to Western financial markets and services, though they imposed few limitations on buying Russian stocks and bonds on secondary markets.
The setbacks of 2014 pushed Russia's economy into a two-year recession and led to the currency losing about half its value against the dollar. The central bank boosted interest rates to 17% in December 2015. Food prices had soared after President Vladimir Putin banned Western agricultural imports, and inflation also climbed to double-digit percentage levels that year.
Russia has since been on a long road to recovery: Economic growth is expected to climb next year to 1.7%, a pace that will trail most other major emerging markets.
But the sanctions also forced the biggest Russian companies to pay off Western creditors, helping shrink foreign debt. Policy makers also channeled a portion of oil revenue into a special fund, boosting foreign-exchange reserves to about $436.1 billion at the end of November.
Meanwhile, inflation has dropped below 4%. That allowed the Bank of Russia earlier this month to ease interest rates for the fifth time this year, taking the benchmark to 6.25%, and signal it may reduce rates further.
Investors have cheered the signs of economic stability.
The ruble appreciated almost 11% against the U.S. dollar in 2019, even as most other emerging-market currencies weakened.
Washington's stance has also appeared to ease. In January, the U.S. Treasury Department lifted sanctions on United Co. Rusal PLC, helping send the aluminum giant's Hong Kong-listed shares up 43% year to date.
Fresh sanctions in August barred U.S. banks from lending foreign currencies to the Russian government or participating in the primary market for non-ruble-denominated sovereign bonds, but crucially spared ruble-denominated bonds and the secondary market.
"Can they ramp up sanctions a bit more? Yes," said Joseph Mouawad, emerging debt fund manager at the French investment firm Carmignac. "But is it a big game changer? No, because what the Russians have been doing is preparing."
The 6.35% yield generated by 10-year government bonds has also helped lure foreign investors at a time when Japan, Germany and Switzerland offer subzero yields.
Nonresidents held almost a third of ruble-denominated government bonds, known as OFZ, at the start of November, up from roughly 18% in early 2015.
Much of the stock market rally has also been fueled by international investors, according to Andrey Kuznetsov, a strategist at Sberbank CIB Investment Research, who estimates three-quarters of publicly traded Russian equities are owned by foreigners.
Generous dividends from Russia's state-owned firms are a big part of the draw. Energy giant Gazprom, which makes up 14.5% of the Russian benchmark index, has rallied almost 67% this year, while state-backed lender Sberbank, which constitutes 14% of the index, has advanced 31% on the back of promised payouts.
Despite the recent rally, the equities remain relatively cheap compared with emerging markets such as China, India and Brazil.
Still, many investors remain cautious about the risks facing Russia's economy and its markets.
Wealthy Russians increased their overseas cash holdings to about $118 billion in the first half of the year, underscoring their concerns about the economy. Oil prices have also remained stubbornly low, despite production cuts. And then there are the vagaries of U.S. politics.
"In 2020, we could get a different U.S. president that has a completely different agenda," said Mr. Mouawad.
Write to Avantika Chilkoti at Avantika.Chilkoti@wsj.com