Sanctions shield protects Russia from Brexit fallout

Sanctions shield protects Russia from Brexit fallout
Russia has been a winner from the Brexit crisis
By Vadim Dumesh and Ben Aris June 27, 2016

Sanctions on Russia may well prove to be a blessing in disguise. As global markets were rocked by Britain's unexpected decision to leave the European Union (EU) on June 23, Russia has been largely unaffected thanks to the attempted isolation imposed by the West that was supposed to punish it. Indeed, some analysts have called Russia a safe haven and recommended buying the ruble and Russian bonds.

Global markets have been stunned into inaction after some $2 trillion of value was destroyed in a day – more than in the aftermath of the Lehman Brothers collapse in November 2008. S&P Global Ratings lowered the UK to AA from AAA, while Fitch cut its rating to AA from AA+, both with a negative outlook. With interest rates already at near zero and German bonds paying negative returns, investors are desperately looking round the world for somewhere to park their money until some sort of clarity returns. Gold has been one winner and that earned Russia a cool $2.4bn windfall in 24 hours, but Russian assets in general now look more attractive than ever.

"At a time when the European integration is breaking apart, a relatively isolated Russia looks like a safe haven for investors," Yury Tulinov, head of research at Societe Generale SA's Russian unit Rosbank PJSC, said in a comment to Bloomberg. "It's best to stay away from European assets due to the uncertainty and it's worth looking at developing markets, where Russia and the ruble look quite attractive."

Ruble to the rescue

The ruble rebounded on June 27 as Russia's sanctions-enforced isolation from the West showed signs of shielding it from the shock waves of Britain's vote to quit the EU four days earlier.

In its initial comments on Brexit, the Finance Ministry in Moscow named the oil price, weaker ruble, and higher financial market volatility as the main direct effects for Russia. "None of those are nice, however, this volatility is notably smaller that the one we had recently passed," minister Anton Siluanov said, seeing a limited effect of a Brexit on internal Russian economic dynamics.

The ruble gained the most among emerging currencies and can likely withstand the current volatility if commodity and oil prices avoid a steep plunge in the aftermath of the referendum, in which 52% of the UK's population voted to leave the 28-country bloc.

According to Bloomberg, the ruble gained 13% so far this year, constituting the second-largest advance in 24 emerging market currencies tracked by the agency.

However, the effect could be temporary for the ruble as June 27 and 28 are the last days of large tax payments. The ruble rate is supported by large corporate exporters selling currency to pay extraction taxes, VAT, excise duties and income taxes. Sberbank CIB estimated on June 27 that out of total of RUB870bn ($13.3bn) to be paid, RUB700bn were to be cashed out on June 27.

There is a risk that without the support of the corporate tax liquidity the ruble will slip to RUB66.5-RUB67.5 already in the coming days, unnamed currency traders told Reuters.

OFZs rock in the storm

But it's not only the ruble that quickly rebounded after its initial slip on June 24 amid the global shock. Russian OFZ government bonds are also looking strong. "In the Russian fixed income universe, the reaction in OFZs to the Brexit vote was only temporary," Gazprombank also notes, noting that with yields quickly now having returned to pre-Brexit levels.

Russia's economy may be in the doldrums, but the country's macro fundamentals are very strong. The state's external debt is in the low teens. Federal hard currency reserves are around $390bn, or some 15 months of import cover. Inflation has been stuck at 7.3% for the last three months, but the trend is clearly downward and the Central Bank of Russia (CBR) target of 4% by 2017 looks entirely achievable. And industry and banking sector woes seemed to have at least reached bottom.

All of this has made Russian federal bonds, that are still paying above average yields, increasingly attractive to international investors. The expectations of future key interest rate cuts by the central bank that has recently resumed the monetary easing cycle will continue to be supportive for OFZs, Gazprombank believes.

Compared with other emerging market peers, Russia is well-positioned to deflect volatility brought about by the Brexit vote, due to "improved fundamental position and resilience to external shocks", Gazprombank analysts argued on June 24.

"With a current account surplus (+$11.7bn in 1Q16), Russia compares particularly well versus EM peers," the bank said in a note, forecasting that after the initial wave of selling subsides, Chinese growth and global monetary policy will remain the key factors governing Russia risk perception.

In the Russian Eurobonds segment too, "after widening by 10-30bp, the spreads stabilized on Monday with some compression apparent," Gazprombank notes, adding that, "overall, loose monetary policy on the part of global central banks will be supportive for Russian Eurobond issues".

Still early for equities

Russian equities were doing well until the Brexit vote, with the dollar denominated RTS returning 24.3% ytd and the ruble denominated MICEX returning 9% as of June 24 before the storm broke.

However, the global fears predictably hit equity markets which are still in as delicate a state as Russia's economic recovery, widely expected to resume in the second half of this year, has still not established itself. The RTS index fell from 941 on June 24 to 912 as of June 27 and the MICEX index took a milder hit, dropping from 1,919 to 1,884 over the same period.

Local banks in Moscow were upbeat on equities saying, "the free-floating ruble could act as a shock absorber and mitigate losses in local share prices, followed by a rebound," according to Gazprombank, seeing Sberbank, MTS and Moscow Exchange as particularly well-positioned to benefit in this scenario.  

And Deputy Chairman of Russia’s VEB development bank Andrey Klepach believes that the crisis in Europe will rekindle investors' interest in emerging markets. "In the long-term I think the turmoil on the European financial market may revive the interest to emerging markets’ securities and to Russia particularly," he said, reports TASS.

Crisis: been there, done that

Russia has suffered less from the fall out from Brexit as it has already been in crisis for almost two years and there is not much room left to fall. The country has already had its crisis while the rest of the world is only having its crisis now.

Russia's economic growth had already fallen to under 1% in 2013 at a time when oil prices were still over $100 a barrel and the ruble/dollar exchange rate in the thirties. The economy was already sick when the oil prices crashed in December 2014, but the central bank's decision to free the exchange rate has gone a long way to allowing the economy to respond to the constant stream of external shocks Russia has had to bear since.

Following the economic sanctions slapped on Russia by the EU and US in 2014 for its annexation of Crimea, the country has undergone a sharp but well-managed deleveraging of foreign liabilities, slashed imports, cushioned the hydrocarbon revenues with ruble devaluation, and is coping with corporate investment and fiscal needs largely without relying on Western capital markets.

On the geopolitical side, President Vladimir Putin has been actively seeking new regional partnerships and cooperation frameworks. As the Brexit vote came through, he was on his way to Beijing where he signed off on investment and energy deals worth a reported $50bn. While, Russia's initial declared "pivot to the East" was not as sweeping as the Kremlin wanted, Putin's visit to the Uzbek capital of Tashkent on the way to China saw the possible inclusion of Iran and India in the Shanghai Cooperation Organization next year, which will significantly increase the weight of that body. (The SCO was founded in June 2001 by China, Kazakhstan, Kyrgyz Republic, Russia, Tajikistan, and Uzbekistan).

Russia, of course, remains highly susceptible to external shocks and if the country is to escape stagnation it's newly launched grand economic reform programme, headed by former finance minister and co-head of the president's economic council Alexei Kudrin, needs to succeed. With its high reliance on commodity exports and chronic inability to carry out structurally reform, the jury is still out on that one. But there are growing signs the economic slump caused by collapsing oil prices and sanctions has now bottomed out and the economy will return to slight growth by the end of 2016.

Should the rebound forecasts indeed materialise, Gazprombank sees ruble equities as being a good target, after a relatively short period of selling based on fundamental position of the companies relative to emerging market peers.

"As a short term speculative trade, we would focus on stocks with favourable exposure to RUB weakness, particularly fertilizers and metals & mining names offering high dividend yields," the bank suggests, naming PhosAgro, Norilsk Nickel and Severstal as three top picks.

More conservative and longer-term players on the equity market are likely to remain on the sidelines and wait out the Brexit volatility, which comes on top of seasonally thin and unfavourable summer market period.