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What's happening in Russia

At the end of the first week after Easter, the Trump administration unveiled new sanctions on Russia. GAM Investments' Paul McNamara analyses the implications for investors in Emerging Market debt.

Monday, April 16, 2018

A dish best served cold

These new sanctions differ from those that preceded them in that they seek to penalise not just the companies, but the individuals who own them and government officials – a retaliatory response in respect of Russian meddling in the 2016 elections. Though initiallyignored for the most part, their importance was magnified over the weekend, following an alleged chemical attack by the Syrian government – which relies on Russian military support – that was strongly condemned by President Trump. The sanctions differed from those imposed in 2014, when Russia invaded Crimea: then, US investors were forbidden from buying new securities, whereas now they are banned from holding any outstanding debt or equity in the sanctioned entities, which include one of the world’s largest aluminium companies. In other words, investors have been forced to sell their existing positions. The result is a sharp decline in Russian asset prices: the equity market tumbled 8%, government bond yields widened 50bps and the ruble sank 10%.

Further forced selling?

The size of the moves reflects investors’ uncertainty that such sanctions could be applied more broadly, triggering further forced selling. They also reflect heavy positioning in local assets: Russia has been a popular overweight in emerging market equity and bond portfolios – which themselves have attracted significant inflows - reflecting the country’s improving economic fundamentals. Growth has recovered (albeit less than we would have expected looking at credit metrics), while higher oil prices have boosted trade and fiscal balances, and foreign currency reserves have grown steadily to US$458bn from a $350bn trough in early 2015. Unlike Turkey, Russia’s public balance sheet and balance of payments are rock solid.

A tricky conundrum

This is the conundrum facing investors today: a broadening of sanctions would undoubtedly have a further negative impact on Russian asset prices; but without it, the macroeconomic impact would likely be minimal, making valuations look exceedingly cheap. An unpredictable White House makes it even harder than usual for investors to gauge the situation and position accordingly.

It is worth clarifying that sovereign debt is not directly impacted by the sanctions. Estimates suggest that foreigners own one-third of the local bond market, equivalent to US$40bn, and anecdotal evidence suggests they have been buying US dollars against the rouble to neutralise the FX exposure from their bond positions, rather than attempt to sell bonds in testy market conditions. This helps explains why the rouble has suffered so much more than local bonds.

Implications for portfolio positioning

We reduced our exposure to Russia in February, feeling that local assets had already performed strongly and that we’d need markedly higher oil prices to drive further gains. This left us with a neutral position on local bonds, albeit with slightly long duration as we expected the central bank to cut rates further given low inflation levels. We have no exposure to Russian corporate debt. We kept a small overweight position in the rouble, however: this reflected our positive view on emerging markets overall, and helped to offset our long-standing, significant underweight in Turkey (which, incidentally, has fallen 5.5% so far this month, the second worst performer by far). The combined long duration and FX overweight position of the portfolio has led to a marginal relative detraction over a time span of just a few days, although the strategy continues to outperform its benchmark over longer time frames, including year to date.

For now, we are monitoring the situation closely. Russian authorities have responded by suspending routine US dollar purchases and pledging liquidity to local players; the central bank may well curtail its rate-cutting cycle, too. However, we would not expect FX market intervention unless the ruble was to weaken significantly from current levels. Given the political nature of the crisis, it is difficult to say whether we will be more likely to buy or sell Russian assets from here, with technical risks offsetting a potential valuation gap. Our close-to benchmark position seems a reasonable place to shelter until further clarity emerges.

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April 2018