Despite the relentless headlines about what Russia may or may not have been up to during the US presidential elections, or Brexit and other EU elections for that matter, and the country’s involvement in Syria, etc, the newsflow from within Russia has been relatively quiet or, at least undramatic, for most of 2017. With the exception of the US sanctions legislation, signed into law on August 2nd and the Opec deal renewal, there have been no major market moving events this year. At least not compared to those over the previous three years.
This year’s relative calm has been reflected in the mood amongst investors; there is a long list of issues for them to worry about but nothing happened to move markets significantly in either direction. Since the start of the year (to mid-December) MICEX is off 5% while the RDX Index of Russian DRS is up 1.4%. Of course that flat-lining performance translates into a big under-performance within emerging market portfolios when compared to the 31% gain in the MSCI EM Index.
But what has been a disappointing, albeit relatively calm, year is about to give way to a much more energetic and news-filled six-month period, starting in early February until late July. There will be no ignoring Russia in that period and we can expect to see much greater market volatility than was seen in all of this year. How the events expected in this six-month period unfold, and are reacted to, will determine not only what returns investors will get from the equity and debt markets in 2018 but will also put in place the conditions for the trend in the economy, FDI and risk perception for the following two or three years.
First up will be the two US Treasury Department reports mandated by the US Congress and which must be submitted in late January. One of these is the so-called Section 241 list and the other is the report assessing the implications of extending the current sanctions applied to state banks to sovereign issues.
The former will be a public list of individuals and entities that may be the subject of future sanctions. There is no stated intention to apply sanctions automatically but it will form something of a Sword of Damocles over those named and will affect their ability to trade with US counter-parties, at least for some time. That could, at minimum, disrupt trade and investment flows into Russia and activity in the economy.
The second report has clearly dangerous implications. If the credit restrictions were applied, then US funds would have to sell their OFZs and Eurobonds. EU funds would be under pressure to do the same because of the also newly introduced threat of secondary sanctions. Foreign investors hold between 35% and 50% of Russia sovereign debt. We have heard from the central bank and the finance ministry that there is a contingency plan in place to soak up those forced to exit but that would substantially drain liquidity from the banking system and, in turn, reduce future lending and badly impact economic growth. There should not be a crisis but the threat of extended stagnation is clear enough.
It is not assumed that the US executive branch, which is responsible for enforcing sanctions, will act on these reports quickly and it may even try to ignore them on the basis that taking action would make any even modest political engagement with Moscow more difficult. The real test is expected in April when US Congress will get a report on Russia’s alleged violation of the 30-year old Intermediary Nuclear Forces (INF) Treaty. Both Congress and the White House have said that if the violations are proven then they will impose additional economic sanctions. April could be quite a volatile month.
Against this backdrop, President Vladimir Putin is expected to deliver the delayed Federal Assembly Address in February. He may address the escalating sanctions enforcement threat (if the two reports have been published as scheduled) and we may hear if counter-measures are being considered. Up to now the message from the Kremlin has been that “bad politics” should not be allowed damage “good business”. That may again be the message until we get to April and the almost inevitable escalation over the INF report.
The March 18th election result is a foregone conclusion. Russia does not do Trump or Brexit-style surprises. What is more important is the voter turnout. It needs to be at least 60% while closer to 70% is ideal. Such a high turnout would strengthen Putin’s position both at home and internationally. The former because it would allow him to push through his preferred policy programme, while the latter would ensure his status on the international stage.
Sometime between the election and inauguration day in early May, we should hear whether there will be a new prime minister or whether Dmitri Medvedev will stay. If asked that question in May this year, a majority would have answered that a change was inevitable. But today, and with Medvedev now acting with such public confidence, the answer is much less clear.
Once the new or existing premier is confirmed, the question will then be whether there will be changes amongst the ministers or other senior officials. That is important because whatever new policy programme is finally settled on will only get credibility when we see who is put in place to manage it. A strong line-up will give much greater confidence of progress and effective enforcement than a weak line-up would.
The expectation of a broad-brush change amongst officials has been building for some time. The precedent is based on the extensive changes amongst regional governors and in their administrations. Kremlin officials have been consistent in the message that change not only requires new published plans, but also in the people tasked with making those plans work. Next up should be government and ministry officials and, soon afterwards, senior management shake-ups in the state-owned enterprises. At least that is the message from the administration.
But, as Lenin once said, “everything is connected to everything else”. Which means we may not hear about personnel changes or the final version of the policy plan for the next presidential term until the threat of US sanctions enforcement is known and can be assessed. The likely timeline of events suggests that may be closer to the inauguration than election day.
What happens with regard to East Ukraine and the Minsk talks will also be important. The engagement between Moscow and the Normandy Group has been also relatively light this year as the EU dealt with Brexit and various key elections. Kyiv has also been calmer in 2017 than in the previous three years. But that also is starting to change. The IMF and EU are starting to increase pressure for reform progress and public frustration is again evident on the capital’s streets.
2019 is election year in Ukraine for both the presidency (spring) and the Rada (autumn). The current political and reform stalemate is unsustainable for too far into 2018. The key question for investors in Russia is whether the next moves will improve the likelihood of EU sanctions easing in 2019 or 2020 or push the EU towards tougher actions against Russia?
All of this comes ahead of the World Cup, which kicks off on June 14th. The almost entirely unfavourable Russia scrutiny has, as expected, already started and it is a reasonable bet that the stories and analysis will get worse and more amplified up to the event. Almost the best case scenario is that which played out around the Sochi Winter Olympics, in that while the coverage was borderline hysterical ahead of the event it quietly disappeared during and afterwards. There is little national economic impact from the World Cup and the risks are now almost entirely stacked on the downside in terms of PR and risk perception.
For investors what all this adds up to is a likely return of much greater market volatility in the period from early February to the World Cup. The cheap asset valuations should prevent much of a sustained downside, i.e. buy the dips, but the big question is whether conditions for a sustained asset valuation rally in the second half and into 2019 can be put in place by the World Cup final whistle on July 15th. There are only so many times one can blame the referee.
Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer.