Taming the Bear: Russia in the wake of the Ukraine crisis

Since then we’ve had the Maidan protests that led to what Russia branded a ‘coup’, the annexation by Russia of Crimea that prompted international consternation and economic sanctions, and the landslide election of billionaire businessman Petro Poroshenko as president.

Violence in the eastern region of Ukraine continues to erupt frequently, however, in spite of a crackdown by the new leader. Western leaders continue to appeal to Russian President Vladimir Putin to pull out of the country amid accusation it is stoking tensions. The crisis is far from over.

At a time when economic stability appears to have returned to the eurozone the ongoing conflict between Russia and Ukraine has reminded investors of the fragility of markets, with some sounding a note of caution over Russian investments.

Squeezed by sanctions

Meanwhile, Russia’s presence and role in the conflict has taken an economic toll, with Russian GDP growth at 0.9 per cent in the first quarter of 2014, down significantly from the 2 per cent recorded in the last quarter of 2013, as sanctions bite. It is expected to grow only 0.5 per cent for 2014 as a whole.

Towards the end of April this year, ratings agency Standard & Poor’s (S&P) announced it was downgrading Russia. The agency lowered its foreign currency ratings to BBB- from BBB, while the country’s local currency long-term rating faced a downgrade from BBB+ to BBB.

The ratings agency attributed the lower ratings to “a continuation of the large financial outflows observed in the first quarter of 2014, during which the size of Russia’s financial account deficit was almost twice that of the current account surplus”.

It also warned that the “tense geopolitical situation” between Russia and Ukraine could prompt additional outflows of foreign and domestic capital from the Russian economy.

For Craig Botham, emerging markets economist at Schroders, the latest GDP figures suggest the slowdown has been driven by lower investment spending and that PMI data reveals continuing contraction in manufacturing and services.

He warns: “The slowdown will worsen policymaker headaches – presumably already throbbing from sanctions and political pressure – as inflation remains high. Rates have already been hiked in response to this and currency weakness, but there will be increasing conflict if the political situation does not improve.

“Further sanctions are being discussed and the economic damage from extant sanctions and general uncertainty will build over time.”

Mr Botham observes that if there is no resolution in Ukraine then Russia’s GDP numbers will worsen this year. “As it stands the second quarter already looks likely to disappoint, and will probably put Russia into recession,” he cautions.

The situation in Russia and Ukraine is likely to be up for discussion among Western leaders at the G7 Summit in Brussels this week on Wednesday 4 and Thursday 5 June. The meeting was originally scheduled to take place in Sochi in Russia and between the leaders of the G8 countries.

Then on Thursday, Vladimir Putin and Barrack Obama are separately scheduled to be having dinner with French president Francois Hollande, a day before both are in attendance, along with Mr Poroshenko at a lunch to commemorate the 70th anniversary of the D-Day Normandy landings.

One way or another, this week could prove crucial, especially at a time when there is reason to be optimistic following suggestions of a slow tropp withdrawal by Russia at the Ukraine border.

Russia and the wider world

While investors and markets have remained wary of the unfolding crisis in the two countries, the tensions have yet to simmer over into Europe or even neighbouring emerging markets as many feared it would earlier in the year.

Abi Oladimeji, head of investment strategy at Thomas Miller Investment, acknowledges that beyond Russia the response from the financial market has been “relatively muted”, although he notes that investors should not get complacent, particularly as any escalation is likely to be felt most acutely in Europe.

“With global growth slowing in recent months, the last thing financial markets need is a significant negative shock coming from a trade war or military stand-off between the West and Russia,” he says.

“While such an outcome will have far reaching consequences in the developed economies, the bulk of the damage will be felt in Europe which receives some 40 per cent of its natural gas supply from Russia. The region’s nascent recovery could be nipped in the bud by a significant energy price shock.”

Mr Oladimeji cites the coming summer months as a period when financial markets will be vulnerable to “any negative shocks” because volatility will be “amplified”.

Elsewhere away from talk of the Ukraine, a much heralded deal with China brought more positive headlines for Mr Putin in May. After 10 years of negotiation an energy trade deal between the two countries was agreed.

According to Heartwood Investment Management, the agreement represents a $400bn deal to supply 38 billion cubic metres of natural gas annually to China through a new pipeline over 30 years, with supplies due to start in four to six years.

Heartwood Investment Management explains: “The deal makes absolute sense for both countries. Gazprom has been searching for a diversifier away from Europe for both macro and political reasons.

“For China, the issue has been a rising dependence on gas imports and therefore a deal with Russia would not only help fill any supply gaps, but also dilute its dependence on any one gas supplier. It also helps in the aim of decreasing reliance on environmentally ‘unfriendly’ coal.”

Investing in Russia

So where do the investment opportunities lie in Russia, if indeed there are any?

Renat Nadyukov, portfolio manager of emerging markets equities at ING Investment Management, believes Russia remains one of the few unleveraged economies with its relatively low dependence on foreign capital inflows.

He advises: “In terms of investment opportunities, privately-owned Russian energy and materials companies offer an attractive entry point given depressed valuations, superior resource base, increasingly stable taxation framework and attractive free cash flow and dividend yields.

“Together with mining companies, Russian oil majors are the main beneficiaries of currency weakness as their costs are mostly in Rubles and revenues are mostly in US dollars.”

He adds: “In general, we avoid exposure to leveraged Russian companies due to rising costs of capital and effectively closed financial markets.”

Mr Nadyukov claims that lack of reforms and confidence in Russia’s ability to “maintain coherent macroeconomic policy” explains the perceived lack of opportunities better than geopolitical risk.

“Russia has always been a very volatile market so investors are used to elevated risks when investing into Russian equities,” he concludes.