Tougher Than Expected Sanctions to Weigh on Russia

russiaThe US announced a new round of sanctions on Russia, this time targeting the oligarchs that are considered close to the Kremlin.  US entities are now barred from doing any business with the people and firms on the list, and is a much stronger than expected measure that is already creating havoc in Russian assets.

POLITICAL OUTLOOK

On Friday, the US announced sanctions that targeted 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.  This comes after several tit-for-tat expulsions of diplomats on all sides after the London poisoning of ex-Russian spy Sergei Skripal and his daughter in the UK.

The US is punishing these Russian entities for profiting from “malign activities.”  These include but are not limited to Russian activity in Ukraine, supporting Syrian President Assad, and efforts to subvert various Western democracies.  Back in January, the US identified over 200 oligarchs and senior officials that could be targeted by sanctions, and so markets are rightfully braced for more measures ahead.

The scope of the sanctions was much larger than expected, impacting many of Russia’s largest most widely held companies.  The US Treasury Department blacklisted two companies owned by Oleg Deripaska (Rusal and EN+).  It also targeted Alexie Miller, head of state-owned Gazprom, as well as Andrey Kostin, head of state-owned VTB Bank.

Any assets in US jurisdictions are now frozen, while US entities are barred from doing any business with the people and firms on the list.  This basically cuts off all foreign funding for these companies.  Indeed, Rusal has already warned that technical defaults are possible for certain obligations.  The government may eventually take over some (but not necessarily all) of these debt obligations but there are limitations.  Note that the sovereign Eurobond issue last month of $4 bln was handled by VTB, one of the sanctioned companies.

The Russian government has pledged to support those firms that are affected.  Prime Minister Medvedev asked his Cabinet to draw up measures to support sanctioned companies, but short of taking on their debt obligations, measures are likely to fall short.  Russia has also threatened to retaliate but it’s not clear what it can really do on such a widespread economic scale.

Elsewhere, Syria remains tense after weekend reports of chemical weapons attacks on rebel positions by the Assad government.  The UN Security Council is expected to hold an emergency session in response.  To make matters worse, Syria and Russia accused Israel of airstrikes today on a Syrian military base.  After the last reports of chemical weapons use back in April 2017, the US conducted missile strikes on government positions.  We suspect US plans to withdraw from Syria are premature.

President Putin handily won the elections last month with 77% of the vote.  However, it is clear that his fourth term will be anything but smooth sailing.  Observers are already looking ahead to the transition process.  The problem is that there are no obvious successors to Putin.  When his term ends in 2024, Putin will be 72 years old.  If Prime Minister Medvedev acts like a placeholder again, Putin would be 78 when the 2030 election rolls around, making it unlikely that he would run again in 2030.

Russia ranks surprisingly well in the World Bank’s Ease of Doing Business rankings (35 out of 190).  The best categories are protecting registering property and getting electricity, while the worst are trading across borders and dealing with construction permits.  Russia does much worse in Transparency International’s Corruption Perceptions Index (135 out of 180 and tied with Dominican Republic, Honduras, Kyrgyzstan, Laos, Mexico, Papua New Guinea, and Paraguay).

ECONOMIC OUTLOOK

The economy is recovering but 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 0.9% y/y in Q4, the second straight quarter of slowing.  With this latest round of sanctions likely to hit hard, we see downside risks to the growth forecasts.

Price pressures remain low, with CPI inflation at 2.4% y/y in March.  This is up slightly from the 2.2% trough in January and February and remains below the 4% target.  We believe that the easing cycle is near an end, especially if ruble weakness continues.  Inflation spiked up to 17% in 2015 as Ukraine-related sanctions hit and the ruble plunged.  We believe a similar dynamic will be seen this year.

With the exception of July 2017, the Central Bank of Russia has cut rates at every meeting since it resumed easing in March 2017.  The bank undertook an aggressive tightening cycle during the 2014-2015 Ukraine crisis, hiking rates from 5.5% to 17% in less than a year.  It is still in the process of unwinding those hikes.  It next meets April 27 and is expected to cut rates 25 bp cut to 7.0%.  However, with pressures building on the ruble again, the central bank may have to hold rates steady until conditions improve.

The fiscal outlook bears watching due to possible contingent liabilities stemming from the sanctions.  We are seeing a cyclical improvement in the budget numbers as the economy recovers from higher oil prices, but this may be running out of steam.  The nominal deficit was equal to -nearly -2% of GDP in 2017.  We see upside risks to the 2018 and 2019 numbers.

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 3.2% of GDP in 2018.  With the oil rally running out of steam in recent weeks, we think export growth will be limited in the coming months.

Foreign reserves rose to a multi-year high of $458 bln in March.  That’s the highest since August 2014 and has recouped much of the sanctions-related drop from over $500 bln in 2013.  Reserves cover nearly 19 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 have 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.  

INVESTMENT OUTLOOK

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%), BRK (-2%), IDR (-1%), PHP (-0.5%), COP (+0.5%), and PEN (+4%).  So far in 2018, RUB is -4% and is ahead of only the worst performers ARS (-8%), TRY (-6%), and PHP (-4%).  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 high near 60.61 today.  It held for now but a break seems likely, which would then target the July high near 61.00.  After that, the next major target is the November 2016 high near 66.87, as there simply aren’t a lot of chart points in between.

Russian equities continue to underperform.  In 2017, MSCI Russia was flat vs. 34% for MSCI EM.  So far this year, MSCI Russia is -3% YTD and compares to up 1% YTD for MSCI EM.  All those losses came today, as the sanctions wiped out a modest YTD gain.  This underperformance should continue, as our EM Equity model has Russia at an UNDERWEIGHT position.

Russian bonds have outperformed.  The yield on 10-year local currency government bonds is -21 bp YTD and is behind only the best EM performers Brazil (-40 bp), Mexico (-39 bp), Peru (-28 bp), and Poland (-26 bp).  With inflation likely to spike due to RUB weakness and the central bank no longer able to ease further, we think Russian bonds will start to underperform.  This is especially true in light of the sanctions impact.

Our own sovereign ratings model shows Russia’s implied rating steady at BBB-/Baa3/BBB-.  Moody’s Ba1 rating appears to have some upgrade potential.  Fitch’s never cut Russia to sub-investment grade and so its BBB- rating now seems to be correct.  S&P upgraded Russia to BBB- back in February, matching Fitch.  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 stemming from the sanctions.