Russia Outlook Solid but Sanctions Risk Looms

Russia was just upgraded by Moody’s to investment grade. While we have been negative on Russia, the upgrade shows just how resilient the economy has been. Yet the recent arrest of Michael Calvey has sent a chill through the investment community. Furthermore, the US Senate is also moving forward with another round of sanctions.

POLITICAL OUTLOOK

Moody’s recently upgraded Russia a notch to Baa3 with stable outlook. It now matches S&P and Fitch with their BBB- ratings. The agency cited the “positive impact of policies” seen in recent years that have strengthened its public finances and external accounts. We think the upgrade was long overdue, and our own ratings model suggests further upgrade potential.

Russia is subject to further sanctions by the West. Moody’s did warn that “a severe and unanticipated external shock, including the imposition of harder-than-expected sanctions that materially impair the government’s ability to service and refinance its debt or that undermine Russia’s finances or economy in some other way.”

A bipartisan group of US Senators are still negotiating the so-called “Sanctions Bill from Hell.” Loose details of the proposed bill had been released last fall, but details are now getting filled in. The bill includes possible bans on Russian sovereign debt and banking transactions. The US could ban trading of Russian debt in the secondary market, like Venezuela. It would also restrict US financing of Russian oil and gas projects.

The arrest of foreign private equity investor Michael Calvey on fraud charges was a shock to many. He has been active in Russia for decades and is somewhat of an insider. Calvey and two of his employees have been detained for at least two months. The dispute revolves around Calvey’s stake in a consumer lender that was under stress and merged with another. This will do nothing to attract foreign investment.

 

A BRIEF HISTORY LESSON

With Russia facing new sanctions, we thought it would be useful to summarize the major sanctions already in place. We note that while the situation is fluid, signs are clearly pointing to more sanctions that will continue to squeeze the economy.

  1. The sanctions process first started back in March 2014 in response to the Russian invasion of Ukraine. Then, the US imposed visa restrictions and asset freezes on Russian and Ukrainian officials. The US also banned exports of defense products or services to Russia. Ukraine-related sanctions have been widened and deepened since, including August 2018 sanctions that prohibited a range of exports to Russia that have a potential national security impact.
  2. In December 2018, the EU extended its sanctions on Russia by another six months to mid-2019. These were first imposed in 2014 along with the US and targeted senior Russian officials, lawmakers, and military officers with asset freezes and travel bans.
  3. In April 2018, the US sanctioned seven Russian oligarchs that are considered close to the Kremlin, as well as the twelve companies they own. Seventeen senior Russian government officials were also affected. The US said this was meant to punish Russian entities for profiting from “malign activities.” These include but are not limited to Russian actions in Ukraine as well as its ongoing efforts to subvert various Western democracies.
  4. In August 2018, the US State Department announced a new round of sanctions on Russia for its nerve gas attack in the UK on former Russian spy Sergei Skripal and his daughter Yulia. As required under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991, tougher measures were required after Russia failed to prove that it is no longer using or producing chemical weapons. The EU followed suit with its own set of sanctions.
  5. In January 2019, the US lifted sanctions on three companies owned by oligarch Oleg Deripaska. Despite objections from many Democratic lawmakers, the US Treasury removed sanctions after Deripaska complied with a Treasury Department request to relinquish his majority ownership. Deripaska himself remains on the April 2018 sanctions list.

 

ECONOMIC OUTLOOK

The economy remains sluggish. GDP growth is forecast by the IMF at 1.6% in 2019 and 1.7% in 2020 vs. an estimated 2.3% in 2018. GDP rose 1.5% y/y in Q3, while monthly data so far suggest a modest deceleration in Q4. As such, we see downside risks to these growth forecasts.

Price pressures are picking up, with CPI inflation at 5.0% y/y in January. This is the highest rate since January 2017 and moved further above the 4% target. A VAT hike was behind last month’s spike and poses further upside pressures as the impact spreads in Q1.

After hiking rates 25 bp in September and December to 7.75% currently, the Central Bank of Russia just paused this month. The guidance it gave was neutral, but we believe that the tightening cycle has only paused, not ended. Indeed, the bank has warned that the full VAT effects won’t be fully felt until at least April.

The fiscal outlook bears watching due to possible contingent liabilities stemming from the ongoing sanctions. We have seen a cyclical improvement in the budget numbers as the economy recovers with help from higher oil prices. The balance moved into a surplus last year equal to an estimated 2.6% of GDP from a deficit of nearly -2% of GDP in 2017 and -4% in 2016. The OECD sees the surplus narrowing to 1.8% in 2019 and 1.1% in 2020 but much will depend on oil prices.

The external accounts remain strong. The current account surplus was an estimated 7.1% of GDP in 2018, this highest since 2006. The IMF expects the surplus to narrow to 5.2% of GDP in 2019 and 3.4% in 2020. Due to higher oil prices, export growth has been far outstripping import growth. With the oil rally back on track in recent weeks, we think export growth will remain strong in the coming months and so there are upside risks to the external accounts.

Foreign reserves rose to a multi-year high of $470 bln in January. That’s the highest since July 2014, recouping much of the sanctions-related drop from over $500 bln at the end of 2013 to around $354 bln in April 2015. Reserves cover nearly 16 months of imports and are about 5 times the stock of short-term external debt. Russia’s Net International Investment Position (NIIP) is positive and about 20% of GDP, which is a strong position.

Russia central bank resumed its FX purchases. The bank started buying FX on February 1 after suspending them last year to stem ruble weakness. The purchases will be spread out evenly over three years, which suggests the daily amount will be around $43 mln. The bank added that the purchases could be suspended again “in the event of risks to financial stability.”

While external vulnerabilities would appear to be low, another round of sanctions that would cut off access to global capital markets would have significant impact on corporate Russia. If a state-owned company can no longer service its debt, the government will have to assume those liabilities, thereby draining precious foreign reserves.

 

INVESTMENT OUTLOOK

The ruble is outperforming after a poor 2018. In 2018, RUB was -17.5% vs. USD and was ahead of only the worst performers ARS (-50.5%) and TRY (-28%). So far this year, RUB is up 5.5% and is behind only the top EM performer COP (5.7% YTD). Our EM FX model shows the ruble to have VERY STRONG fundamentals, and so this outperformance is likely to continue.

USD/RUB has been largely rangebound after making a new cycle low near 65.1650 on January 31. The pair has been unable to break below the 200-day moving average and so we think it is likely to probe the upside. The major retracement objectives of the December-January drop come in near 66.9425 (38%), 67.4915 (50%) and 68.0405 (62%). Note that within EM, RUB has the second highest correlation with oil prices, behind only COP.

Russian equities continue to outperform. In 2018, MSCI Russia was -7% vs. -17.5% for MSCI EM. So far this year, MSCI Russia is up 11.5% YTD and compares to up 9% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Russia at a VERY OVERWEIGHT position.

Russian bonds have underperformed. The yield on 10-year local currency government bonds is -35 bp YTD and is behind only the best EM performers Argentina (-202 bp), Turkey (-126 bp), Chile (-44 bp), Mexico (-41 bp), and Brazil (-38 bp). With inflation likely to rise and the central bank likely forced to eventually resume rate hikes, we think Russian bonds will start to underperform. Sanctions risk should also weigh on Russian bonds.

Our sovereign rating model showed Russia’s implied rating rising a notch to BBB+/Baa1/BBB+. Higher oil prices are boosting Russia’s numbers and offsetting the negative impact of sanctions. Moody’s rating of Baa3 now matches the BBB- ratings from both S&P and Fitch, but all three are seeing stronger upgrade potential.