Monday, March 24, 2014

24/3/2014: Russian Roulette or a Wheel of (Risky) Fortune?


What to expect this week on the Russia v the Western World stage:

1) More theatrics or threatatrics: so far the sanctions delivered amount to not much more than a buzz of a mosquito in the June midnight - weakly threatening, largely painless. In fact, current state of sanctions-for-Ukraine play is causing no impact on the real economy of Russia, although financial markets are showing their usual propensity to panic. The problem, however is that the current sanctions pretty much exhaust the list of political sanctions possible: selective travel bans and individual restrictions on two banks and a handful of banks accounts can be expanded in size, but to shift sanctions to the next level of pain will require disrupting trade flows. Thus, the EU/US are now holding their mild trump card of more broadly-based sanctions and this is weighing on the Russian markets through heightened uncertainty channel.

Given the unaltered status quo in Ukraine-Russia relations, compounded by the fact that President Obama and G7 are about to start series of week-long deliberations in Europe, as well as physically in Kiev, we can expect more sabre rattling this week. I expect the threats of further sanctions, isolation and financial ostracising against Kremlin to  intensify in the next 3-4 days, but die out thereafter. The key to this timing is that the US and EU have already explicitly drew the line in the sand - status quo of weak sanctions will remain in place, assuming Russia stays out of Eastern Ukraine. The only two unknowns here are:

  • Will Russia stay out of Eastern Ukraine? My view here is that it will. We are more likely at the end of the game, than in the opening rounds.
  • Will Eastern Ukraine stay calm with no acceleration of currently rather subdued protests by pro-Russian groups? My view is that this is the key threat and that despite the West's firm belief to the contrary, the Kremlin has little control over the situation on the ground when it comes to the pro-Russian protesters. Thus, the real uncertainty here is whether or not Eastern Ukrainian opposition and Kiev Government will be able to refrain from forcing Moscow's hand.
2) Over the next few months, assuming no escalation in the conflict, we can expect gradual reduction in political risks and a swing in markets pricing of risks. Currently, markets price risks asymmetrically, to the upside. This means that any adverse newsflow will trigger a broad sell-off in Russian indices. If there are any signs of political normalisation, especially tied to bilateral risk declines on both Ukrainian and Russian sides, the markets will start pricing risk to the downside and indices can rally even on weaker news. The next two points discuss the catalysts for such switch in risk pricing.

3) Ukraine is about to start dealing with the problems of state and economic collapse. This will involve, first and foremost, the discussions with the IMF, EU and US on the financial bailout. Given the role Russia plays in this (Ukraine owes Russia significant amounts against Government borrowings and gas arrears, Ukraine is hugely dependent on Russian markets for supply of energy and major inputs into industrial production, and demand for its exports) this process is bound to start drawing Ukraine into more cooperative mood vis-a-vis Russia. Russia also holds a major trump card against Ukraine in the form of gas prices. Comes April 1, Ukraine will lose its gas discounts from Gasprom and will be facing a tariff of some USD480-500 per mcm of gas from current pricing around USD268 per mcm charged since January 1. Kiev has already warned that Ukraine's domestic retail prices for gas will have to rise some 40% in order to fulfil conditions for the IMF bailout. All of this means that any bailout talks will have to involve Kremlin. And this, in turn, means that bailout talks can act as a catalyst for enhanced cooperation and de-escalation of both the conflict and the sanctions rhetoric.

4) Second stage is longer duration - as it involves political normalisation in the Ukraine. The core catalysts here will be presidential (May 25th) which may drag out into the second round (less likely) and possible late 2014-early 2015 Parliamentary elections. Given the size of the political risks discount on Russian markets, May elections should be a catalyst for the upside, although volatility will remain through the summer as new Presidential administration in Kiev starts re-asserting its role over the current Government and as the discussion on the future of presidential powers will start building up.

All above considered, my view is that we are nearing the bottom-fishing grounds for Russian equities, subject to two caveats:

  • No further crisis escalation, and
  • Strong investor stomach to weather incoming volatility. 


Am I alone in this call? Not exactly. Current valuations multiples on Russian stocks are at the levels last seen at the height of the 2008 crisis. By CAPE (price to 10 year average of earnings ratio), Russian equities are currently second lowest valued, after Greece. Russian core indices currently trading at around 4.8 times earnings, just over 1/3 of Indian markets valuations and just over 1/2 the P/E ratios for Brazil’s Ibovespa.

Weaker ruble favours stronger current account surplus and higher domestic earnings for companies, meanwhile high oil prices alongside the said weaker ruble favours stronger fiscal performance, giving upside to the probability of the federal government stepping in with a stimulus. Of course, ruble is probably set to lose some more ground on the USD and Euro, but it is hard to see it moving much more down.

On the economy side: growth is slowing, with 2013 coming in at lowly 1.3% GDP expansion delivered by shocks to inventories and weak fixed investments. This year, pricing in the risks to-date and a good portion of potential risks forward, the economy should generate GDP growth of just 1.0%. A rapid rebound in H2 might push that to 1.5%. Both still shy of the late 2013 projections of 2.5-2.7% expansion. January 2014 fixed investment growth was negative 7% y/y against +0.3% in December 2013.

When you look at Russian ETFs, they too support the case for going long Russian equities. RSX, iShares MSCI Russia Capped ETF and SPDR S&P Russia ETF have been supported recently on foot of insiders buying oversold Russian equities.  Per reports in the media, Vagit Alekperov, CEO of OAO Lukoil has been buying Lukoil shares, and OAO Novatek purchased 2.5 million shares between March 11 and March 14. OAO Rosneft insiders have also been buying shares in the company. These three companies account for 18% of the RSX holdings and 21.3% of the iShares MSCI Russia Capped ETF

All you need for some of the above to start rising fast is: political risks abatement and dividends uplift. Political risks are talked-through above. So to dividends: in 2013, Russian equities were the fastest growing dividend generating market in the Emerging Markets and Putin has been actively pushing Russian listed companies to up their dividend payouts to 35% of their net income.

Buckle your seat belts (they should have been bucked already, folks)...

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