State committed to spending and reform. The dominant theme in Russia in 2010 is expected to be Remont. Literally meaning “refurbishment”, it partly reflects the expected increase in state spending on infrastructure and in areas to promote growth in basic industries. It also reflects the hope that the greater level of commitment recently heard from President Dmitry Medvedev and senior government officials to push the reform agenda and to improve the business climate in the country will be followed with action. The country’s image with both portfolio and direct business investors could thus also be “refurbished”, and allow for a narrowing of the valuation gap with which Russian assets regularly trade to their peers in other developing markets.

RTS target raised. We have an RTS target of 1,950 (34% upside) and a MICEX target of 1,700 (28% upside) for 2010 based on a revision of some of the key market and economic drivers (see table in side column). Because of expected improvements in the economy, we expect both indices to reclaim their record highs in 2Q11, three years after they were set. While Russian equities are trading close to their emerging-market peers (when oil & gas stocks are excluded), stronger earnings growth in 2011E will again open the discount gap. Russia (excluding oil & gas) is trading at a 2011E P/E of 9.9, while the forecast GEM average is 12.8. This will help Russian stocks, especially the domestic themes, to outperform the emerging-market average in 2010.

Global backdrop still critical. The external environment – particularly the strength of the global economic recovery, oil and metals prices, dollar trends, and interest rates in developed economies – will continue to provide a critical backdrop for Russia’s recovery. Liquidity problems in the banking system in China and elsewhere may emerge as a significant problem in early 2010. Additional sentiment-shaking events, such as that in Dubai, cannot be ruled out. Amongst the key assumptions that we make are: global growth of 1.9% in 2010 and 2.5% in 2011; Urals to average $71.5/bbl in 2010 and $79.8/bbl in 2011; and the US Fed and European Central Bank to hold back from raising interest rates until 2H10.

Top picks. Our list of top stock picks reflects the preference for domestic themes. The regional telecoms and electricity sectors, supported by Svyazinvest restructuring and tariff reform, respectively, represent strong investment themes.

Infrastructure. Stocks with exposure to the expected increase in infrastructure spending, e.g. selected steel providers, should outperform in 2010.

Coking coal. Coking coal companies are forecast to benefit from both volume and price increases due to China and domestic factors.

Potash. Potash producers will perform better than other fertilizer producers over the full year, though the pricing of new China contracts may initially disappoint.

Telecoms. The mobile telecom stocks – including AFK Sistema, the owner of MTS – are, like the banks, amongst the best proxies for the expected economic improvement.

Oil & Gas. Gas companies and oil services are better placed to gain than the oil majors, as the latter’s financials are challenged by the tax regime.

Preferred plays. Several of the preferred-share stocks offer very good upside in addition to decent dividend yields, and we have included five in our top picks.