Russian assets are coming under greater pressure after various sanctions were announced by the US. The final tally of sanctions is not yet known, but uncertainty regarding their ultimate impact on the economy is likely to keep Russian assets under pressure.
The State Department announced new sanctions on Russia for its nerve gas attack on a former Russian spy and his daughter in the UK. It prohibits a range of exports to Russia that have a potential national security impact. This response was required under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991, which has only been invoked against North Korea and Syria. These sanctions must be enacted within 60 days, and tougher measures are required after three months if Russia fails to prove that it is no longer using or producing chemical weapons.
This is a separate action from what the bipartisan group of US senators proposed last week. Details of the proposed bill were released this week, which includes proposals to sanction new sovereign debt and banking transactions. No action will be taken on the draft until Congress is back from summer recess in September, however. Russia has threatened retaliatory measures, but whatever the response, we see continued pressure on the ruble.
Recall that in April, the ruble plunged as the US announced sanctions on 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 that round 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.
All these sanctions follow those enacted by then-President Obama after Russia’s invasion and annexation of Crimea. While Russia likely hoped that President Trump would reverse those sanctions, its continued misbehavior has only led to more pain. Given Putin’s intransigence, we suspect even more sanctions by the US will be forthcoming.
A BRIEF HISTORY LESSON
The Crimean Peninsula has been the center of many past conflicts, repeatedly colonized and occupied over the centuries. The Russian Empire annexed Crimea in 1783, after numerous wars with the Ottoman Empire. The Crimean War of 1853-56 (which some historians regard as the first truly world war) saw France, Britain, and the Ottomans pitted against Russia. While most of the fighting was on the peninsula, the Crimean War was an attempt to push back against perceived Russian hegemony in Europe. Crimea was devastated, but remained part of Russia.
After the 1917 Russian revolution, Crimea became part of the Russian Soviet Federative Socialist Republic, the largest in the USSR. In 1944, Stalin deported the entire Crimean Tatar population to Siberia and Central Asia as punishment for alleged collaboration with the Nazis. In 1954, a controversial move by Soviet leader Nikita Khrushchev (himself an ethnic Ukrainian) transferred Crimea from the Russian Soviet Federative Socialist Republic to the Ukrainian Soviet Socialist Republic, carving it out of the larger Russian territory.
Ukraine has had a long and prosperous history of its own. Kiev was at one time (in the Middle Ages) the largest city-state in Europe, situated on several important trade routes. Much of what is now Ukraine came under the control of Poland and Lithuania, but then became part of the Russian empire after the partition of Poland in 1793. Ukraine declared independence in 1918 after the Russian revolution. In 1921, however, the Ukrainian Soviet Socialist Republic was established after the nation was conquered by the Russian Red Army. Ukraine was subject to many reprisals and hardships under Stalin.
When the USSR crumbled, Ukraine became a sovereign nation in 1991. There was much debate then about the fate of Crimea. When all was said and done, Crimea was granted special status as a so-called Autonomous Republic within Ukraine. This gave it a larger say over local issues, but it remained governed by Ukraine. Today, ethnic Russians make up nearly 60% of the Crimean population, with ethnic Ukrainians (25%) and Tatars (12%) the other major groups. The exiled Tatars began returning to Crimea after the fall of the USSR.
The Ukrainian revolution of 2014 saw the ouster of pro-Russian President Yanukovich. He came under fire for seeking closer ties with Russia instead of the EU. As protests spread in February, Yanukovich fled the capital (eventually reaching Russia) even as Ukraine’s parliament voted 328-0 in favor of impeaching him.
As Yanukovich was pushed out, masked Russian forces invaded Crimea in late February. Strategic sites were captured by these troops. After a pro-Russian government was installed, Crimea declared independence from Ukraine on March 11, 2014. A referendum was held on March 16 upholding this declaration. The international response was unanimously against Russian aggression. Russia was suspended from the G8 and sanctions were quickly put into place. The UN General Assembly rejected the annexation and the referendum.
The economy remains sluggish. GDP growth is forecast by the IMF at 1.7% in 2018 and 1.5% in 2019 vs. 1.5% in 2017. GDP rose only 1.3% y/y in Q1, while monthly data so far suggest a modest acceleration in Q2. With widening sanctions likely to hit the economy hard, we see downside risks to the growth forecasts.
Price pressures are low but picking up, with CPI inflation at 2.5% y/y in July. This is up slightly from the 2.2% trough in January and February but remains below the 4% target. We believe that the easing cycle has ended, especially as ruble weakness continues. Inflation spiked up to 17% in 2015 as Ukraine-related sanctions hit and the ruble plunged. The bank was forced into an aggressive tightening cycle during the 2014 Ukraine crisis, hiking rates from 5.5% to 17% in less than a year. We believe a similar dynamic will be seen in the coming months.
After hiking rates to 17% over the course of 2014, the Central Bank of Russia started the easing cycle in February 2015. There were several pauses but the policy rate was last cut to 7.25% in March. The bank had hinted that this was merely a pause. However, with pressures building on the ruble again, we think the easing cycle is over and a tightening one may begin soon. We do not think markets are positioned yet for this risk.
The fiscal outlook bears watching due to possible contingent liabilities stemming from the sanctions. We have seen a cyclical improvement in the budget numbers as the economy recovers with help from higher oil prices. The nominal deficit was equal to -nearly -2% of GDP in 2017, and the OECD sees the gap narrowing to -1.4% in 2018 and –1.0% in 2019. We see upside risks to these forecasts.
The external accounts remain solid. The current account surplus was 2.2% of GDP in 2017, and the IMF expects the surplus to widen to 4.5% of GDP in 2018. Due to higher oil prices, export growth has been far outstripping import growth. With the oil rally running out of steam in recent weeks, we think export growth will slow in the coming months.
Foreign reserves rose to a multi-year high of $460.4 bln in April. That’s the highest since August 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 4 times the stock of short-term external debt.
While external vulnerabilities would appear to be low, sanction that would cut off access to global capital markets will 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.
The ruble continues to underperform. In 2017, RUB rose 5% vs. USD and was ahead of only the worst performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), PHP (-0.5%), COP (+0.5%), and PEN (+4%). So far in 2018, RUB is -13.5% and is ahead of only the worst performers ARS (-34%) and TRY (-31.5%). Our EM FX model shows the ruble to have STRONG fundamentals. However, the sanctions are a game changer and so the ruble seems likely to continue underperforming.
USD/RUB tested the November 2016 high near 66.8715 today. After that, nearby targets include the August 2016 high near 67.45 and then the June 2016 high near 67.70. With numerous sanctions in the pipeline, we think the market should start thinking about this pair eventually revisiting the January 20016 high near 85.9575. Major retracement objectives of the big 2016-2018 drop in USD/RUB come in near 67.169 (38%), 70.756 (50%), and 74.344 (62%).
Russian equities are outperforming this year after underperforming last year. In 2017, MSCI Russia was flat vs. 34% for MSCI EM. So far this year, MSCI Russia is -3.5% YTD and compares to -6.5% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Russia at an OVERWEIGHT position. However, the sanctions pose great risk in the coming months.
Russian bonds have underperformed. The yield on 10-year local currency government bonds is +62 bp YTD and is ahead of only the worst EM performers Turkey (+750 bp), Argentina (+353 bp), Hungary (+145 bp), Indonesia (+131 bp), the Philippines (+125 bp), and Brazil (+109 bp). With inflation likely to rise due to RUB weakness and the central bank likely forced to eventually hike rates, we think Russian bonds will continue to underperform. This is especially true in light of the sanctions impact. Data show that the foreign share of Russian domestic debt fell to 27.5% in July from 34.5% in March. This will only get smaller in light of the sanctions threat.
Our own sovereign ratings model shows Russia’s implied rating steady at BBB/Baa2/BBB after rising a notch last quarter. Higher oil prices are boosting Russia’s macro numbers. Moody’s rating of Ba1 is lagging, but even the BBB- ratings from both S&P and Fitch are seeing some upgrade potential. However, we suspect the agencies will turn more negative on the sovereign in light of these latest sanctions. There are far too many contingent and perhaps even direct liabilities to the sovereign that might stem from the sanctions.