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Assessing the Opportunity : What is the current situation?

What is the Outlook of the Russian Markets? Is There Opportunity in Russia?

Assessing the Opportunity : What is the current situation? Though still a developing situation, today’s Russian equity market may present a unique opportunity. The build-up of Russian military forces on Ukraine’s border has led to a significant sell-off in Russian assets translating into valuation multiples falling to levels similar to the 2014/2015 Crimea Crisis. Russian officials deny any intention to invade Ukraine and defend the county’s activity as an act of self-defense. The US and the North Atlantic Treaty Organization (NATO) have exchanged letters and held calls with Russia, and all parties have delivered press conferences discussing the ongoing actions and security in Ukraine. NATO has now deployed additional military support along Ukraine’s Eastern border, furthering concerns. 

The US and Europe have discussed implementing new sanctions on Russia to deter further military action.

However, it’s important to note that Russia is the largest supplier of oil and gas to the European Union (EU) and a leading producer of several other key minerals, including nickel, copper, diamonds, gold, palladium, aluminum, and titanium. Russia is also the third-largest importer of European goods. This economic interdependence between Russia and the EU may make it difficult for the bloc to hit Russia with sanctions without hurting itself. 

Why Now? 

Ukraine shares borders with both the EU and Russia. Russia sees Ukraine, a former Soviet republic, as a buffer from the West. Like many neighboring countries, Ukraine historically maintained an amicable relationship with Russia via Russian-friendly leadership. When Ukrainians moved in a different political direction in 2014, Russia annexed the Crimean peninsula and backed pro-Russian local forces. Russia now says it has no desire for military escalation. However, the country wants assurance that Ukraine will not join NATO and that their border will remain protected from Western forces. Essentially, Russia wants NATO to return to its pre-1997 borders, an end to any eastward expansion, and overall implementation of the Minsk agreement. 

For Russia, given the current environment, it seems like a good time to ask. With a healthy economy, conservative balance sheets, a Europe dependent on Russian supplied energy, and both the UK Prime Minister and US president with low approval ratings, Russia holds more negotiating power now than in the past. Russia might see the current environment as an opportunity to improve security and increase its power in the region. 

Upside/downside from Russia’s Standpoint 

The current tensions between Ukraine and Russia escalating to war is not our base case. While the timing could be advantageous for Russia to push for its goals, it also appears that any military escalation would bring more negative consequences than positive outcomes for the country. 

Russia risks higher on-the-ground casualties, bad for internal approval ratings. Today, the Ukrainians seem to be better armed and organized than when Russia invaded Crimea in 2014. This is especially true given recent NATO support. 

Strengthen NATO relationship with EU and foothold in Eastern Europe 

⮚ NATO has repeatedly said that it has no plans to add Ukraine to the alliance. That said, if Russia were to invade Ukraine, it likely would lead to an increased presence from NATO in the region – exactly what Russia does not want. It may also strengthen the case for other regional countries to join the alliance. Military escalation might even unite the EU and NATO against Russia more than before. 

Hasten Europe’s transition to alternative energy 

⮚ If Russia attempts to leverage energy as a weapon, Europe could speed up its transition to alternative energy sources. 

The first three concentrated solar power (CSP) units of Spain’s Solnova Solar Power Station in the foreground. With the PS10 and PS20 solar power towers in the background

Put in Perspective 

Russian tension with the West has escalated and waned over centuries, and the current situation appears more moderate than in the past. Looking back at the modern-day Russian stock market. We have seen other extreme points of pressure including a default of the national debt in 1998, two wars in Chechnya, the 1993 constitutional crisis, hyperinflation, a war with Georgia, political protests, volatile oil prices, the Crimea crisis, and sanctions. The Russian economy looks stronger today than it has historically. If the situation with Ukraine deteriorates, the economy should prove relatively resilient, and if it improves, the market could bounce. 

Russia’s fiscal break-even price, or the price of oil that is necessary to balance the budget of an oil exporting country, stands at roughly US$50 a barrel today.

This compares to US$110 a barrel in 2014.

The Government Debt-to-Gross Domestic Product (GDP) level in Russia is one of the lowest in Emerging Markets (EM). Russia was the only G20 country to run a budget surplus in 2021. Due to the adoption of the “Fiscal Rule” in 2017, designed to shield Russia from swings in oil prices, the Russian Ruble’s dependence on oil has dwindled significantly. The Central Bank has balanced growth with single-digit inflation, and mid-single-digit unemployment. Overall, Russia’s economy is a notable standout among EM countries. 

Conservative Corporate Governance 

As investors, we are encouraged to see Russian companies prioritize shareholder returns over asset growth. The increased volatility and geopolitical premiums actualized in 2014 have translated into more conservative balance sheets, a focus on profitability, and overall improving capital stewardship. Average net debt-to-equity levels stand below 20, state companies now pay a minimum 50% of net income in dividends, and the share of EBITDA spent on capital expenditure (capex) stands at 40% versus 71% in 2013. Strong corporate governance and steady balance sheets should help Russian companies fare better in today’s market versus during past periods of turbulence. 

Companies are not only focused on dividends, but management teams have actively taken advantage of market weakness. Firms, implemented share buybacks to drive earnings-per-share (EPS) growth. Eight Russian companies have announced buybacks amid the recent sell-off. In historical comparison, there were four companies that executed buybacks at the start of the pandemic and seven companies in 2018. 

Market Outlook 

Russia boasts, arguably, the best fundamentals in EM. High oil prices have allowed the country to maintain its substantial fiscal and current account surplus. While the Finance Ministry’s “Budget Rule” provides a stable currency regardless of external factors. Russia’s Central Bank was also one of the first to begin hiking interest rates this cycle. As a result, putting Russia ahead of the curve in monetary policy tightening. 

Despite headwinds from geopolitical concerns, the Russian corporates are healthy and the domestic economy remains steady. A de-escalation of tension could allow the transition from a savings model to consumption-led growth to continue. In the long-term, we continue to like domestic stories with structural growth drivers in Russia and anticipate a better-than-expected asset quality cycle in the financial sector, supporting banks with higher liquidity. 

Assessing the Opportunity : What is the current situation? by Malcolm Dorson

Written by Malcolm Dorson
Emerging Markets with Malcolm Dorson

Assessing the Opportunity : What is the current situation?