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)...

22/3/2014: Russian Capital Flight and Current Account: Crimea's Punch

While sanctions against Russia have been pretty much anodyne to-date in direct economic impact terms, there are indirect effects worth considering that are worrying from the economy's perspective. Some of these are boiling down to capital flight vs inflows of funds from external balance of trade.

Chart below sets the stage through Q4 2013:

While we do not have full Q1 2014 data in what we do know is that outflow of capital has accelerated on Ukraine/Crimea news. Here's one report putting full year 2014 estimates at USD130bn so far, double 2013 recorded official outflows: http://www.themoscowtimes.com/business/article/goldman-puts-2014-capital-flight-at-130bln/496228.html. And the Central Bank has so far promised not to impose controls on outflows: http://www.reuters.com/article/2014/03/18/us-ukraine-crisis-capital-idUSBREA2H0NH20140318.

On the current account side, so far, there should be little impact. Gas flows to Europe not only remained un-impacted by the Crimean crisis, but through March 10th, these actually averaged a rise month-on-month, from around 440 thousand cubic meters per day in 2013 to around 476-477 thousand cubic meters. But the problem is that much of shipments via Ukraine is currently accumulating in the arrears account, which is hard to close in the environment of a crisis. Should Ukraine default on payments to Russia or delay these significantly, the current account side of the above funds flows will be hammered. In 2013 alone, absent the standoff in Crimea, Ukraine's unpaid arrears to Gasprom stood at USD3.3 billion. This was partially covered by a payment of USD1.28 billion made on February 14th, with current arrears of USD1.99 billion still outstanding for the balance on 2013, plus January-February 2014.

The overall arrears on Naftogaz (Ukraine's state gas imports agency) are a problem and are likely to feature in the IMF funding deal to be struck before the end of this month. Whether or not the IMF forces Ukraine to default (partially or fully) on its gas imports-related arrears is unknown, but there is some possibility this might happen.

However, as is (above chart), since 2013, Russian current account surplus already no longer covers capital outflows, which explains much of the rouble weakness in 2013 and ongoing weakness in 2014.

So what is the possible impact of the risks to gas and oil trade from Russia on Russian economy? Here are some points:

1. Gas is far less important to Russian Government revenues than oil: Gas accounts for just around 20-22% of budget revenues. Russian Federal Budget is balanced at oil price of USD115/bbl, which is falling as rouble depreciates, and now probably set around USD110/bbl.
2. Balance of payments is under a greater threat from Ukraine crisis: gas accounts for 14% of Russian exports against 50% for oil and petroleum products.
3. Russia's oil exports are only about 8% exposed to Ukraine's transit (Druzhba pipeline) and shipments are declining (2013 transit of 15.6 million tonnes against 2014 planned transit of 15 million tonnes).

Mitigating factor to all of this is the South Stream pipeline which is scheduled to ship 63 bcm of gas cutting Russian exports transit dependence on Ukraine to roughly 50 bcm and is set to become operative around 2015.

Either way, the problem for Russia in the short term is capital flight. If Estimated losses of capital in Q1 2014 are to run at USD60-70 billion (note: Capital Economics forecasts the latter figure), given stagnant or declining current account surplus, monetary authorities have three tools at their disposal:

• Allow further devaluation of the rouble (chart below shows why that is unlikely to provide much of a cushion, given already massive devaluation to-date)
• Raise rates (current rates already biting hard into economy, with further uplifts risking to push economy into a recession)
• Capital controls (politically hard thing to swallow in the current investment environment: see second chart below) 

Which means that all three measures will be tried, with primary emphasis on devaluation. This in turn means that the investment case for Russia is still weak, despite a significant fall-off in equity valuations. Bottom fishing is some time off for investors.

7/10/2012: VTB and Sberbank relative position vis peers

Another interesting point from the Goldman note on euro area banks, relating to Russian banks - see chart below (you'll need to click to enlarge it):

Note that per my latest recent assessment of Russian equity markets, both VTB and Sberbank are relatively undervalued.

Original note is linked here.

15/9/2012: Russia to revamp SWF structure

According to the report in the Euromoney ( http://www.euromoney.com/Article/3087655/Category/4298/ChannelPage/0/Russias-new-SWF-seeks-bond-and-equity-exposure.html?copyrightInfo=true) Russia will launch a new state-owned investment agency in 2013 "to invest the country’s oil wealth in global financial markets, finance minister Anton Siluanov tells Euromoney in an exclusive interview."

The new Federal Financial Agency (FFA) will have investment mandate to cover "a more diverse range of domestic and international securities, including bonds and equities for the first time, under an investment strategy similar in part to that employed by the Norwegian sovereign wealth fund (SWF)". Anton Siluyanov, Russian finance minister said the FFA "will be managed by investment professionals and will be free from government intervention".

The fund will have under management assets of $150 billion-worth of investment funds in Russia’s existent Reserve Fund and the National Welfare Fund. These are currently managed from the Central Bank.

The net positive here is that the fund will be free to invest in domestic non-state owned enterprises - a significant opportunity for deepening Russian capital markets. It also can provide some new support for corporate debt issuance inside Russia. To-date Russian SWFs were primarily invested in foreign sovereign bonds. New allocation, according to Siluyanov, can be closer to 15%-20% equities.