Weathering adversity (Archived)
Russia defied expectations in 2015 with its response to the twin challenge of western sanctions and plunging oil prices. Here Standish’s1 Urban Larson and Insight’s Robert Simpson ask what’s in store for the country in the year ahead.
At first glance Russia has had a tough 12 months, with multiple shocks: a depressed oil price, a volatile currency, sanctions, recession and conflict in Ukraine.
However, initial fears the country’s recent difficulties would be far worse than it experienced during 2008-09 proved wide of the mark as its economy has been much more resilient than was first assumed.
The Russian Central Bank skilfully managed the perilous tasks of allowing the rouble to fall before staunching its decline, hiking and then cutting interest rates and capping inflation, which hit almost 17% in year-on-year terms in 2015. The central bank is targeting inflation of 7% in 2016.2
Urban Larson, Standish’s emerging markets debt specialist, says: “The Russian authorities followed the textbook, coping with the imposition of sanctions and falling oil prices by allowing the rouble to weaken. They entered the crisis with very low levels of foreign debt and high levels of FX reserves. The bottom line is that the Russian economy coped surprisingly well with the varied environment of 2015.”
Not that it has been painless, as Russia’s economic fortunes are inextricably linked to the oil price. Around 70% of Russia’s exports are energy related, mostly oil, and nearly 50% of the government’s revenues are also from crude.3
Robert Simpson, emerging markets debt portfolio manager at Insight Investment, says Russia’s economy has become more narrowly focused in recent years. “It has increasingly become an oil price story. Investment in the economy tends to be state-led and limited to the oil and gas sector.”
The dependence on oil, compounded by geopolitical tensions, sanctions and a fall in investment, drove the economy into recession in 2015. However, the outlook has since brightened. Simpson explains: “The economy has probably bottomed out. It doesn’t mean it’s going to return to strength but we think it will continue to bump along at 0% to 1% growth.
“Our expectation - assuming a stable exchange rate – is that inflation will continue to trend downwards towards a target of 5% to 6% in 2017.”
The IMF also predicts a recovery supported by increasing external demand and the normalisation of domestic financial conditions. However, this will not be a return to the high growth of the past. With investment and consumption expected to remain sluggish it forecasts weak GDP growth of around 1.5% in the medium term.4
Recovery is expected to be helped by the rouble’s competitive exchange rate. A few years ago the Russian currency was standing around Rb40 to the US dollar but when oil prices collapsed in late 2014 it plunged, bottoming out at a price lower than Rb70 to the dollar in December 2014.5 Since then it has recovered some ground but Larson says: “We are not going back to Rb40 to the dollar anytime soon. We don’t think the oil price is going to rebound in the near term and that is probably the biggest driver of the rouble.”
Russia’s stable political climate is also seen as supportive of recovery. Through the worst of the crisis of the past year, says Larson, most ordinary Russians appear not to have lost faith in the government to proficiently manage the challenges. That was even the case when sanctions were imposed and when the counter sanctions Russia initiated on food imports led to shortages in some stores.
Legislative elections to the State Duma are scheduled for September but these are not expected to pose any risk to the recovery, says Simpson. “There will be noise and demonstrations at the time of the elections but President Putin and his advisers have such a strong grip on power that the elections will be largely irrelevant.
“Most of Russia supports the president in what he is doing on the international stage. It’ll be business as usual.”
Lack of investment
Foreign investors tentatively started returning towards the end of 2015, ending the effective blockade sparked by the US and EU sanctions that restricted access to international capital markets. Although the sanctions do not explicitly bar Russian companies from international markets, the restrictions curbed investor appetite for Russian debt, driving up the cost of borrowing and making it an unattractive way to raise capital.
At the height of Russian volatility, the country’s sovereign bond credit rating was also cut to non-investment grade or ‘junk’ status by S&P and Moody’s, so narrowing the universe of buyers for Russian debt.
For most of the past year, there was practically no debt issuance on external markets but in October 2015 commodities giants Gazprom and Norilsk Nickel placed two large eurobond issues.6
In general, a more stable outlook for the economy and falling interest rates could result in lower yields, thus encouraging more Russian companies to issue debt. Towards the end of 2015, these yields remained between 5-10%.7
In the meantime, “with the appropriate degree of caution” investors could have an opportunity to pick up debt that looks good value, says Larson.
He explains: “The yields on all types of Russian bonds are higher than would be normally warranted by the financials. If you look at nothing but the credit rating they might look warranted but Russia lost its investment grade rating due to more qualitative factors: that the economy is on a slower growth trajectory; that there is a high degree of political interference in the economy and that its government is not very popular in the world. Look at the balance sheets alone and these yields are too high.”
Where to find value
The key thing when buying Russian debt is to look at the relationship of the issuer with the Russian government Larson believes. “Given the degree of political management of the economy, investors are better off being closer to the government, so it could be better to buy a company that is government owned or has close government relations.”
In the corporate space that could mean the bonds of companies that are strategically important to the Russian government or are state controlled.
What to watch
- Interest rate cuts would signal confidence that inflation is under control
- Falling yields expected to encourage more debt issuance
- Legislative elections in September are not expected to be particularly relevant
1. BNY Mellon Investment Management EMEA Limited is the distributor of the capabilities of its investment managers in Europe, Middle East, Africa and Latin America. Investment managers are appointed by BNY Mellon Investment Management EMEA Limited or affiliated fund operating companies to undertake portfolio management services in respect of the products and services provided by BNY Mellon Investment Management EMEA Limited or the fund operating companies. These products and services are governed by bilateral contracts entered into by BNY Mellon Investment Management EMEA Limited and its clients or by the Prospectus and associated documents related to the funds.
2. The Economist Intelligence Unit
3. International Monetary Fund:‘Russia Feeling The Pinch of Cheaper Oil, Sanctions’, 6 August 2015
4. International Monetary Fund:‘Cheaper Oil And Sanctions Weigh On Russia’s Growth Outlook’, 3 August 2015
5. The Economist Intelligence Unit
6. Bloomberg: ‘Gazprom Follows Norilsk Nickel With Russia's Second Eurobond’, 8 October 2015
7. The Wall Street Journal: ‘From Russia With Debt: What Investors Won’t Do For Yield’, 7 October 2015 (Norilsk Nickel’s issue yields 6.625%) Bloomberg: Russia's Growing Rate-Cut Bets Drive Best Bond Rally Since 2010, 16 October, 2015 (Five-year local-currency debt yields 10.23%)