US monetary policy may have been a well-established determinant of investor sentiment across emerging markets, but this year geopolitical tensions have weighed far more heavily on them. For Russia, intensifying US sanctions have exacerbated already jittery foreign investors – spooked by contagion risk from turmoil in emerging economies elsewhere – causing a sharp devaluation in the rouble against the US dollar and a sell-off in Russian federal loan bonds (OFZs).
Currency weakness, coupled with a rise in domestic fuel and food prices, drove a faster-than-expected rise in inflation in August to 3.1 per cent, from 2.5 per cent in the previous month. That prompted the central bank to raise its lending rate last week for the first time since December 2014, when the rouble collapsed amid a deterioration in oil prices and Western sanctions following Russian action in Ukraine. The 0.25 percentage point rise in the central rate to 7.5 per cent was greeted by a 0.8 per cent uplift in the rouble, admittedly still near a two-year low.
Unsurprisingly, Russian asset prices have also tumbled, with the Moex trading at a two-and-a-half-year low, or 10 times forward earnings – the cheapest valuation in almost three years and shy of a 10-year average of 11 times. Likewise, the yield on 10-year OFZs had climbed to 9.05 per cent just prior to the rate rise, although still below the levels reached in 2014. However, the question is whether the fact that assets have moved into value territory is enough to outweigh the uncertainty around more intense Western sanctions being introduced.
Threat from the west
Russia is not the only emerging market to be the subject of US hostility, but the deterioration in relations is not just due to the effects of protectionist trade policies. International sanctions were imposed on Russia and Crimea following Russian military intervention in Ukraine in 2014, and restrictions on businesses and individuals have intensified during the past month. Following the poisoning of ex-Russian spy Sergei Skripal and his daughter Yulia with Russian nerve agent Novichok in Salisbury in March, the US imposed sanctions preventing Russia obtaining a wide range of its security-sensitive technologies – including in oil and gas production. As an EU member, the UK cannot unilaterally impose sanctions, with EU-wide restrictions requiring unanimous support.
Despite President Trump’s efforts to pursue better relations with Russia, his government is seeking to extend sanctions over the Skripal attack and alleged meddling in the 2016 presidential election. Last month US senators introduced a bipartisan bill that included proposals to ban US investors from buying new issuances of Russian sovereign debt and bar them from Russian energy projects globally.
The threat of the US Congress continuing to step up sanctions is the main risk behind a further sell-off in Russian federal bonds, according to Jan Dehn, head of research at Ashmore, given that the move could cause international banks to reduce market-making in OFZs. The resulting illiquidity may keep some investors on the sidelines, even as bonds and FX move into clear value territory, he suggests. However, US sanctions have prompted a sell-off in OFZs among foreign investors, according to central bank governor Elvira Nabiullina. Foreign investors held a record 34.5 per cent of rouble-denominated bonds in March said Ms Nabiullina upon raising the lending rate, but since April they have sold Rbs480bn in OFZs, reducing their share to 26.6 per cent.
However, some say Russia’s fiscal prudence may defend it against any funding crisis should further US sanctions be enacted, even if there is some short-term pain. That fiscal prudence means Russia’s external funding needs are not large, says Oxford Economic’s global macro strategist Nafez Zouk. “So this isn’t the case of a country like Turkey that faced an immediate need to secure billions of dollars of short-term financing when faced with sudden stops of capital flows,” says Mr Zouk. “On the contrary, Russia runs a large current account surplus, has limited FX debt and enjoys high oil price revenues.”
Indeed, unlike countries such as Turkey and Argentina that have also suffered rising inflation and a rapidly depreciating currency this year, Russia’s current account deficit is relatively low. The general government deficit improved to 1.5 per cent of GDP in 2017, according to data from the International Monetary Fund, from 3.6 per cent in 2016. In May, the Russian Finance Ministry said it expected the budget to run a surplus of 440.6bn roubles – equivalent to 0.45 per cent of gross domestic product – this year, the first since 2011.
Rising oil revenue is a major driver behind those improved expectations – a key differentiator from the last time the central bank raised interest rates. In fact, the rising price of Brent Crude – it touched $80 a barrel earlier this month – combined with a weaker rouble has boosted sales income for Russian companies this year. State-controlled oil and gas producer Gazprom – the largest global gas producer – said that during the second quarter it sold 57bn cubic metres of gas to Europe and other non-CIS (Commonwealth of Independent States) countries at an average $238.4 per million cubic metres (mcm), up from 53.5 mcm at $192.4 per mcm. While that was partially offset by a $2bn foreign exchange loss, profits were Rbs259.2bn, up from Rbs47.9bn in the prior year. Mr Zouk reckons that, judging by the impact a crash in the oil price had on the currency four years ago, the rise in the prices set against the threat of further sanctions will result in a “net positive”.
The country’s status as the world’s top oil and gas producer – and rising prices – has also boosted its international currency reserves, which can be tapped to shore up a weak rouble. Those reserves stood at $460.6bn at the end of August, back to similar levels as those just before the 2014 currency crisis.
Meanwhile, the central bank’s decision to raise rates seems to have been welcomed by the market in the days immediately following, judging by the appreciation in the rouble. There should be no doubt about the Russian central bank’s credibility, says Mr Dehn. “Mr Nabiullina is one of the most orthodox central bankers in the world. Investors should therefore not fear major macroeconomic risks under her stewardship,” he says.
However, the longer-term risk centres on the threat of further US and EU sanctions being imposed. “The decision definitely helps bolster sentiment, showcasing the fact that they stand ready to be proactive, although the prevailing risk from sanctions obviously isn’t gone,” says Oxford Economics’ senior economist, Maya Senussi.
Russian equities trade on a cyclically adjusted price/earnings (PE) ratio of 6.4, according to Star Capital, compared with an emerging markets average of 16.2 and a global average of 24.7. However, given the geopolitical risks, investing in Russia is one for those with a high risk appetite and is best accessed via managed funds – unless you are prepared to accept the volatility that accompanies the numerous Russian companies whose shares trade on UK markets.
