Threat of tightening sanctions makes Russia too risky

This article is part of
Emerging Markets - November 2014

Amid a swirling international debate over the fighting in eastern Ukraine and the imposition of economic sanctions, Russian stocks have weathered some significant ups and downs.

When fighting broke out in the region in February, Russia’s stockmarket slumped to its lowest level since 2009.

Since then, however, Russian stocks have rebounded somewhat, as the fighting appears to be mostly contained and is not likely to be the precursor to a much larger military conflict.

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For investors, Russia’s support for rebel fighters in eastern Ukraine presents something of a dilemma: sell before international economic sanctions hit Russia’s economy, or use the ultra-cheap valuations as an attractive entry point into one of the Bric (Brazil, Russia, India, China) economies.

The best course of action is probably to do neither.

Yes, Russian stocks are cheap. The benchmark Micex index currently sells at roughly 5.9 times earnings, making Russia one of the few countries with a single-digit price-to-earnings ratio, according to data from Thomson Reuters.

China and Bulgaria are the only others. For those who already own Russian stocks, they are probably too cheap to sell at present.

At the same time, the shifting political landscape and the threat of tightening economic sanctions makes Russia too much of a risk for new investment.

The country’s economy has been losing steam lately, with growth slowing to 1.3 per cent last year from 3.4 per cent in 2012 as a lack of economic reforms weigh down both business and consumer confidence.

The rouble has fallen by roughly 10 per cent this year against the US dollar, eroding returns on Russian assets for US investors.

In addition, Russia’s heavy reliance on oil for growth has become something of a liability as oil prices have stagnated.

Since the outcome of the conflict in eastern Ukraine is impossible to predict, the World Bank has developed two scenarios for the 2014-15 period.

If the conflict is short-lived and contained, growth will probably slow to 1.1 per cent this year and pick up slightly in 2015 to 1.3 per cent.

If the conflict escalates, Russia’s economy will probably contract by 1.8 per cent in 2014.

In either case, the country will have to implement economic reforms if it is to raise consumer and investor confidence, according to the World Bank.

These reforms include moves to attract private investment and to improve the quality of regulatory and market institutions.

However, the government’s need to manage the conflict with Ukraine makes it less likely new reforms will be enacted soon.

Overall, the situation in Russia is not conducive to taking a strong position at present.

Those who think the Russian stockmarket’s low valuation is attractive may find the market trading at an even lower valuation in the months ahead.

And those who want to get out won’t find anywhere cheaper to get back in.

Alex Muromcew is managing director at TIAA-CREF