Tag Archives: russia

Russia – “The Colder War”

“Wise men say only fools “Russia” in, but I can’t help falling in love with you.” On the last episode of “The Colder War”…

 shutterstock_230184931

How time flies when the world is experiencing serious global geopolitical tensions! For those just tuning in – a quick summary…

2014 March

  • Russian forces help separatists seize power in Crimea, which Russia then annexes, prompting the biggest East-West showdown since the Cold War.
  • The US and its European allies impose asset freezes and visa bans on individuals involved in the Crimean breakaway.
  • Crimea votes to join Russia – 97% favour Russia in Final Referendum Results. Putin recognises Crimea as a Sovereign State.

2014 April

  • NATO announces it is suspending "all practical civilian and military co-operation" with Russia.
  • Pro-Russian separatists in the eastern city of Donetsk declare an ''independent republic''.
  • Obama announces additional sanctions on Russia. EU and Russia introduce new sanctions.
  • The IMF approves $17bn aid package for the beleaguered Ukrainian economy.
  • Government launches ''anti-terrorist'' operation in the east.

2014 May

  • UN reports human rights violations in Eastern Ukraine.
  • Voters call for independence in the provinces of Donetsk and Luhansk in a poll rejected as illegitimate by Kiev.

2014 June

  • Obama and Cameron threaten to impose further sanctions if Putin does not stop Russia's actions in Ukraine.
  • Petro Poroshenko wins presidential election.
  • Biden announces $48m in US assistance to Ukraine.
  • Poroshenko signs a delayed association accord with the EU, pulling the country decisively out of Moscow's sphere.
  • Russian separatists shoot down a Ukrainian military transport plane over Luhansk killing all on board.
  • Russia halts gas deliveries to Ukraine - Gazpromannounces Ukraine will only receive gas it pays for in advance.
  • Poroshenko announces a week-long ceasefire. Putin supports Poroshenko's plans for a ceasefire.
  • Poroshenko signs an EU association agreement.237989_mkan548_hi

2014 July

  • Poroshenko ends a tentative ceasefire and launches military operations against pro-Russia rebels.
  • US and EU tighten sanctions on Moscow over its alleged involvement in the uprising in Ukraine.
  • A Malaysian airliner comes down in rebel-held territory, killing all 298 people on board. It is believed to have been shot down by a BUK-M1 surface-to-air missile shot from territory controlled by pro-Russia rebels. The UN Security Council calls for a full inquiry.
  • Red Cross says it considers Ukraine to be in a state of civil war.
  • EU leaders threaten to impose further sanctions on Russia if more access to MH17 crash site is not granted.
  • Pro-Russian groups hand over MH17's black boxes.
  • First bodies of the victims arrive in Kharkiv, Ukraine, to begin the journey home.

2014 August

  • Investigators from Holland and Australia begin a detailed inspection of the MH17 crash site.
  • Russia sends unauthorised aid convoy to besieged rebel-held cities, prompting Ukraine to say it has been invaded.
  • NATO says Russian forces are engaged in direct military operations inside Ukraine.

2014 September

  • Kiev government signs ceasefire with pro-Russian leaders in eastern Ukraine. Under the terms of the Minsk peace plan, the Donetsk and Luhansk regions are given special status. The two separatist regions agree to hold local elections under Ukrainian law in December.

2014 September – November

  • There are repeated violations of the ceasefire on both sides.
  • Putin orders troop pull-back from Ukraine border.

2014 November

  • Ukraine and Russia strike gas deal.
  • Obama and Putin meet to talk sanctions.
  • The self-proclaimed "people's republics" of Donetsk and Luhansk hold early elections, in which two pro-Russian leaders are declared the winners. President Poroshenko describes the rebel-held vote as an "election farce" which he says violates the Minsk truce deal and jeopardises "the entire peace process".
  • The Kiev government, the US and the EU refuse to recognise the results of the Donetsk and Luhansk elections, but Russia says that they reflect "the will of the people of the south-east".

A double helping of slippery slope

After reading the above, it isn’t difficult to see why Russia over the last while has not exactly been the poster child for investor friendly economies. The graph below tells the story of recent Russian woes.

US Dollar to Russian Ruble Exchange Rate

US dollar to russian ruble exchange rate

Since the crisis started in March 2014, the Ruble has weakened approximately 31.5% against the US Dollar. Initially the CBR (Central Bank of Russia) attempted (halfhearted) currency intervention, but last month decided (rightly so) to let the currency float and only intervene “in extreme circumstances”. This move was wise and in our opinion will aid in reducing the extreme volatility we have seen.

However, it is our opinion that fairly benign neglect towards Ruble weakening together with the abovementioned announcement by the CBR regarding the curtailment in FX (Foreign Exchange) intervention signal that Ruble weakening may well be desired in order to promote import substitution. This should cushion domestic manufacturing and services, employment and the housing market, as consumers shift consumption away from imports toward domestic goods and services. It also mitigates the impact of lower commodity prices (see below).

It is clear that the geo-political events in Russia are enough to cause serious shock waves and one might be forgiven for thinking that Putin playing real life “Risk” is the sole reason for recent volatility in Russian markets, but, they would be wrong. While the geo-political and military drama has been unfolding as set out above, another well-known role player in previous games of global domination decided that it was tired of sitting on the side lines.

Oil…. glorious oil

Brent Crude Oil Price

Brent Crude Oil Price

The rout in the Crude oil price has been significant with the price of Brent Oil dropping approximately 34% since March. Russia is an energy-exporting nation (>50% of exports) and its economic well-being will always (for now) be at the mercy of the energy markets.

237989_rmgn52_hiOne would expect a spike in the price of a commodity when one of its main producers (that is, Russia) is in turmoil but in this instance oil has done the opposite. Since the beginning of the year, the oil price has dropped significantly and one can blame this on massive supply emanating from the US’s shale gas production, Saudi unwillingness to cut production to bolster price and, importantly, reduced demand especially from developed countries in the wake of emissions reduction agreements.

Indeed even the US and China, the two biggest consumers of oil worldwide, have pledged to deeply reduce Greenhouse Gas emissions.

However we believe that the upturn in oil prices are inevitable – many oil producing countries cannot sustain such low prices and indeed US shale is costlier to produce than Saudi oil, which should prices continue at current levels, will apply downward pressure on supply worldwide. What is clear is that OPEC has declared war on US producers by refusing to cut back production – something has to give and perhaps sooner rather than later.

What does the equity market think?

shutterstock_95201779We all know that equity markets are in theory supposed to discount all future events to derive at their current values.

On the surface Lady Russia has so much baggage at the moment that to most people it is not worthy of any love or affection: capital flight, collapsing currency, bleak economic outlook, sanctions, falling oil prices, geo-political tension, inflation – need one say more!

It is a hard sell, but beauty is not skin deep. Even so, superficial investors have dumped Russia in their droves since July this year.

Russian Index Performance in USD terms

russian index performance in usd terms

A bit of perspective: Russia is the world’s 8th biggest economy and as can be seen from the graph above, the equity market has dropped around 11 percent since the crisis began in March and around 22% since June. An interesting (but useless!) fact - as at the date of this article, Apple’s market capitalization is bigger than Russia's entire stock market (the 20th largest market in the world). What's more, as Bloomberg notes, there would be enough money left over after selling Apple and buying Russia to purchase over 190 million contract-free 64 GB iPhone 6 pluses (enough for every Russian).

But wait ... there’s more

There is a famous saying that goes: “the time to buy is when there is blood in the street.” (Lord Rothschild). We are firm believers in this mantra and for this reason alone Russia is worth a further look. However, besides a pure contrarian mindset the following should be noted.

Lower oil prices have been effectively offset by the weaker currency and for all intents and purposes, from a Russian perspective, the price of oil in Ruble terms equates to the oil price effectively staying the same as it was pre-crisis. This means that the Russian revenues from oil sales will remain unscathed in the face of the carnage. Sanctions will, however, lead to some import substitution and companies and banks will have to work far harder to raise offshore capital (to, amongst other things, settle its offshore debt). In addition, Mr Putin’s tit-for-tat strategy of banning food imports into Russia will contribute to inflationary pressure, however it will also develop the domestic market for food.

Further, oil prices, in our view, are set for a modest rebound as certain members of OPEC are unable to sustain the low price of oil indefinitely and US producers struggle due to shale gas’s relatively higher cost.

237989_kscn260_hiRussia has an extremely low debt to GDP ratio of approximately 13%. This is crazy small when compared with 101% and 76% for the US and Germany respectively. As such, even as interest rates go up and the currency continues to weaken, Russia is still very much able to meet its demands. Further, it is our view that unless oil prices stay consistently below 75USD per barrel, Russia will still maintain a current account surplus.

Currently it has USD370bn in reserves, a sizable amount to weather any economic storm it may need to face over the next few years.

We believe that based on our fundamental view, the Russian share market as a whole is significantly undervalued with the biggest value hidden in the energy, telecoms and banking sector. Based on current conditions and the use of a variety of relative metrics, we believe there is approximately 40 percent upside potential to be realised after the problems are resolved, sanctions are lifted and the situation calms down.

Where we will be “Putin” our money

Below are a few of the counters that we are flirting with – only time will tell whether we were naïve in falling for these Russian beauties or whether we have true love.

From Russia with love pic

  • SBERBank -The largest bank in Russia has seen growth in earnings as well as corporate and retail loans despite the tough economic and credit conditions they face in the country. The gain in market share for loans means that it is perfectly poised for the eventual upswing. The Russian government is also a majority shareholder, which we think lowers the risk considerably. Think “too big to fail”.
  • Magnit – A discount retail chain in Russia, Magnit has already posted good growth results in spite of conditions. This can be chalked up to a resilience of consumer spending on staple foods; while other retailers focus on selling discretionary items, Magnit’s stores have 90% of inventory in food.
  • LUKOIL - The second largest oil producer in Russia; we believe LUKOIL is well positioned to take advantage of the pending upturn in oil prices. In spite of the poor currency performance, LUKOIL has 90% of its reserves in Russia, which means their costs are in Rubles but their revenues are in US dollars.
  • Yandex – The largest search engine in Russia with 60% market share. This company continues to grow and we believe that the current market presents a good opportunity to own shares in a solid company that is unfairly affected by investor fear.

Contact us to learn more

Cold War v2.0

“November of this year will be 25 years since the fall of the Berlin Wall and arguably the symbolic end of the Cold War. History never repeats itself, but it rhymes – are we seeing version 2.0 of the Cold War in 2014?”

A lesson in history

The Cold War is named as such as there was no direct large-scale armed conflict between the key players – the Western Bloc (the United States and NATO allies) and the Eastern Bloc (USSR and allies of the Warsaw Pact[1]). Instead there were regional wars, the simmering threat of nuclear war and a dedicated fight for psychological supremacy and power that was waged through propaganda, espionage and the Space Race.

Cold War Alliances

map

US Propaganda

Soviet Propaganda

usprop russian-prop

After World War II, Stalin imposed Soviet-style communism on its eastern neighbours, just as Chinese communism was establishing itself. The Soviet Union actively promoted its communist ideals in Latin America (Cuba), the Middle East (Afghanistan) and Asia (Vietnam, North Korea) while the US through programmes like Operation Cyclone[2] provided direct financial aid and weaponry as well as covert support to anti-Soviet groups; and all out military force in Vietnam. 

Successive American presidents and Soviet leaders used differing strategies to try and maintain political dominance both domestically and internationally often through rhetoric and posturing. Due to the very real threat and awareness that escalations to a “hot war” would ultimately mean nuclear weapons deployment and MAD – mutually assured destruction – a delicate balance-of-power needed to be maintained by both super-powers.

Defence budget figures for the ex-Soviet Union are not readily available, but the chart below details US Military spending post-World War II. Within the Cold War era, the Vietnam War – in many ways a proxy for the Cold War – consumed a large portion of the US budget – over 10% of US GDP during the 1960’s. Although beyond the scope of this article, it is interesting to see the post 9/11 response in defence budget allocation; now around 5% of US GDP.

US Defence Budget History (Billions of 2005 Dollars)

graph1

Take two . . .

There is much literature detailing the previous Cold War era – the question is whether we are once again forming East-West power Blocs. The Cold War was largely about ideology, what appeared to be a credible alternative to capitalism and democracy – people across the world were prepared to fight and die in the name of Communism. However, there was no direct conflict between the US and the USSR – no troops were sent “behind the Iron Curtain” – neither side wanted to risk all out conflict, particularly after the Cuban Missile Crisis[3].

The US right-wing media and politicians are currently having a field day accusing the current US government as being “weak” in its response to Putin’s manoeuvring in Ukraine. They of course have their own political agenda at play and are enjoying the opportunity to use Cold War scare-mongering. There is certainly no Western military force assembling to combat the increasingly hostile Russian-orchestrated breakup of Ukraine and a military response is unlikely.

Instead, we have a situation where the current degree of economic interweaving between the east and west makes economic sanctions imposed on Russia by the west a bit of a blunt tool. Those sanctions may hurt Europe almost as much as Russia (oligarch London playboys aside). The threat of nuclear conflict has also diminished, New START (Strategic Arms Reduction Treaty), a follow-on from the START I treaty signed between Presidents Bush and Gorbachev in 1991 was signed by Presidents Obama and Medvedev in 2010 with both nations committing to further reductions in nuclear weapons.

Nuclear Weapons Stockpiles

russia-usSource: Norris, Robert; Hans M. Kristensen (July 1, 2010). "Global nuclear weapons inventories, 1945−2010". Bulletin of the Atomic Scientists

Version 2.0?

We are certainly in a situation where on the surface, Cold War analogies abound. There is rhetoric and political posturing, displays of Russian nationalism (Sochi) and incitement of conflict in Ukraine – but the ideological underpinning of the Cold War is absent. No one is going to take up the Communist cause for Putin’s rich circle of ex-KGB officials.

The west will continue to make noises about respect for sovereign borders and freedom and democracy which served as the back track (but with little real effect) for version 1.0 of the Cold War. Rather than Cold War v2.0, the current situation could be better described as “Cold War Lite”.

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[1] The Warsaw Pact: a pact for the mutual defence of Albania, Bulgaria, Czechoslovakia, East Germany, Hungary, Poland, Romania and the Soviet Union.

[2] Operation Cyclone was the CIA code name for the operation to arm and finance the Afghan mujahideen who opposed the Soviet intervention. Critics of this operation claim the US was responsible for arming and financing the very groups that would coalesce to form the Taliban.

[3] The Cuban Missile Crisis was a 13 day confrontation in 1962 between the Soviet Union and Cuba against the United States. The Soviets intended to place nuclear missiles in Cuba; the US would not permit the delivery of such weapons and equipment and a naval blockade was set up. Several Soviet ships attempted to run the blockade and the Cold War came unnervingly close to a nuclear conflict.