Trump Threatens Nord Stream Sanctions Ahead of Russian Central Bank Meeting

President Trump has threatened sanctions over the Nord Stream 2 project. Further details are awaited ahead of the Russian central bank decision tomorrow, where it is expected to start the easing cycle.

 POLITICAL OUTLOOK

Trump has threatened sanctions over the Nord Stream 2 project. This is a natural gas pipeline from Russia to Germany (see A Brief History Lesson below). Trump has been very critical of Germany. He has complained about the “devalued” euro and foreign auto imports. He has also threatened to move US troops out of Germany and relocate them to Poland. More details are needed but the knee-jerk reaction has been to sell the euro.

Germany produces very little energy. It imports 98% of its oil needs and 92% of its gas needs. As such, Germany has stepped up efforts to secure a reliable supply of gas from Russia. This is especially important for Germany’s manufacturing sector. As Germany weans itself from coal and nuclear power generation, natural gas must take up the slack.

By concentrating its gas imports from Russia, Germany has raised eyebrows. It risks becoming too dependent on what many consider to be an adversarial source. This makes Germany more vulnerable to threats of cutting off that supply.

Nord Stream is also controversial because Russia seems to be bypassing Ukraine for geopolitical reasons. Both Nord Stream projects are offshore via the Baltic Sea and bypass Ukraine altogether. Currently, about 40% of Europe’s natural gas supply from Russia flows through Ukraine.

US concerns may not be so altruistic. Reports suggest US natural gas producers are eyeing Europe as a major export market. Indeed, Poland just signed a contract to purchase an additional $8 bln of liquified natural gas from US producers during this current official visit by President Duda.

 

A BRIEF HISTORY LESSON

The development of the Soviet natural gas industry began during WWII. In 1965, the government centralized the exploration, development, and distribution of natural gas under the Ministry of Gas Industry. During the 1970s and 1980s, the Ministry discovered large gas reserves in Siberia and other regions, transforming the Soviet Union into a global player.

Gazprom was founded in 1989. It was created when the Ministry of Gas Industry was converted to the first Soviet state-run corporation. Gazprom is majority-owned by the Russian government, with the minority held by shareholders and employees. Its production fields are located mainly in Western Siberia.

The original Nord Stream project was first studied in 1997 as a joint venture between Gazprom and Finland’s Neste. Eventually, a group consisting of Gazprom and Germany’s BASF and E.ON signed a basic agreement in 2005 to build a pipeline and formed the European Gas Pipeline Company. In December 2005, Gazprom started construction and in 2006, the pipeline and company were renamed Nord Stream AG.

In August 2011, the first Nord Stream pipeline was connected with the existing OPAL pipeline. Gas first flowed through this first line in September 2011. The second line was completed in August 2012.

That same year, Nord Stream AG started studying a possible expansion. An agreement to build two additional lines was signed in 2015 by Gazprom, Royal Dutch Shell, E.ON, OMV, and Engie. Nord Stream 2 is scheduled to become operational in early 2020.

 

ECONOMIC OUTLOOK

The Russian 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 only 0.5% y/y in Q1, while monthly data so far suggest further deceleration in Q2. With oil prices likely to remain under pressure, we see downside risks to these growth forecasts.

Price pressures are starting to ebb, with CPI inflation easing to 5.1% y/y in May. This was the second straight month of deceleration, though it remains above the 4% target.

After hiking rates 25 bp last September and December to 7.75% currently, the Central Bank of Russia ended its tightening cycle. The bank meets tomorrow and is widely expected to cut rates 25 bp to 7.5%. Governor Nabiullina said as much in recent comments. We think this would likely be the start of a slow but steady easing cycle that Bloomberg consensus sees taking rates down to 7.0% by mid-2020.

We have seen a cyclical improvement in the budget numbers as the economy recovered 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 7.0% of GDP in 2018, this highest since 2006. The IMF expects the surplus to narrow to 5.7% of GDP in 2019 and 5.1% in 2020. Due to higher oil prices, export growth far outstripped import growth last year. With oil selling off this year, exports are now contracting y/y and so we see downside risks to the external accounts.

Foreign reserves rose to a multi-year high of $495.2 bln in May. That’s the highest since January 2014, recouping virtually the entire sanctions-related drop from over $500 bln at the end of 2013 to around $354 bln in April 2015. Reserves cover more than 16 months of imports and are nearly 6 times the stock of short-term external debt. Russia’s Net International Investment Position (NIIP) is positive and about 23% of GDP, which is a strong position.

 

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 8% and is the top EM performer by far. Next best is THB at +4.2% YTD. Our EM FX model shows the ruble to have VERY STRONG fundamentals, and so this outperformance is likely to continue.

Oil prices rebounded today after two tankers were apparently attacked. Before that, supply concerns were going the other way as both API and DOE reported huge builds (4.85 mln barrels, respectively) in crude stockpiles. Brent futures price tested the 62% retracement objective of this year’s rally near 59.75, and a break below would set up a test of the December low near 49.95. RUB and COP are the most highly correlated EM currencies with respect to oil prices.

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 27.1% YTD and compares to only 7.4% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Russia at an OVERWEIGHT position.

Russian bonds have outperformed. The yield on 10-year local currency government bonds is -100 bp YTD and is behind only the best EM performers the Philippines (-181 bp) and Brazil (-124 bp). With inflation likely to ease and the central bank poised to cut ratees, we think Russian bonds will continue to outperform.

Our sovereign rating model showed Russia’s implied rating fell a notch to BBB/Baa2/BBB, reversing last quarter’s rise. Higher oil prices are boosting Russia’s numbers and offsetting some of the impact of sanctions. As such, there is still upgrade potential for actual ratings of BBB-/Baa3/BBB-.