MACRO ADVISER: Sentiment reversals on Russia are far from over

MACRO ADVISER: Sentiment reversals on Russia are far from over
A meeting between Vladimir Putin and US President Donald Trump on the sidelines of the G20 summit in July 2017.
By Chris Weafer of Macro-Advisory July 16, 2018

Russia is a country where one can start the day in a mood of optimism and end it feeling pessimistic… and the next day do the opposite. This regular alteration between optimism and pessimism, or risk perception, is as much a driver of market volatility as more fundamental considerations such as earnings, oil and macro trends. Over the past six months we have seen a perfect example of this sentiment reversal and, the process is far from over.

From late January, when the US Treasury Department published the section 241 and 242 reports, as required under the Countering America’s Adversaries Though Sanctions Act (CAATSA), Russia has endured a near perfect storm of negativity. The Skripal poisoning and the April 6 sanctions escalation when Rusal, Gaz, EN+ and other important companies were added to the US Specially Designated Nationals (SDN) List, all contributed to raising the risk perception and lowering stock valuations. 

Over the past few weeks, thanks in no small part to the very successful hosting of the World Cup tournament plus the higher oil price, sentiment has started to turn more positive, even if grudgingly. The summit between Presidents Donald Trump and Vladimir Putin on July 16 in Helsinki, the first between US and Russian leaders since before 2014, offers the possibility of extending the sense of optimism and further reducing the risk premium in Russian asset valuations. But, the event is not without significant risk and could very well result in an own goal for the Russian side. For this reason investors are more likely not to react to the expected well-choreographed summit but to prudently wait to see what substantive follow-up emerges from it over the second half of the year.  

The fact that the summit is taking place at all is of course a positive. It follows several both official and unofficial summits with Europe’s two most important leaders, French President Emmanuel Macron and German Chancellor Angela Merkel. But the summit does not represent a return to business as usual in the pre-2014 sense. That is a very long way off. It does however, when aggregated with the meetings with the European leaders, suggest the creation of a new form of engagement. One based on pragmatism where issues of mutual interest may be discussed and resolved and the herd of elephants in the room conveniently ignored.

There has been little formal clarity about what will be discussed but some issues are clear enough. President Trump will publicly scold Russia for election interference — he has been warned by Congress to do so — and caution Moscow against any further similar actions. Putin may again deny any involvement or simply look disinterested. Either way it is well-rehearsed theatre. 

The two leaders are expected to discuss Syria and, in particular, start the process of formally delineating areas of interest and identifying the proverbial political lines in the sand. It is also expected that the topic of nuclear arms control will be discussed and be the main issue in the post summit communique. The INF Treaty, which bans intermediary range nuclear missiles, is now over 30 years old and clearly needs updating. The START Treaty, which sets limits on long range missiles, is due to expire in 2021. Agreeing to start formal talks on replacement treaties will suit both leaders and send a clear message that a) Russia still has a seat at the top table of global politics, and b) that both leaders are acting in a very responsible way. Having their names enshrined in such important treaties for the next 30 or so years will also suit their respective egos. Move over Reagan – Gorbachev. 

Below the surface it is also expected that there will be a certain amount of trade-offs discussed. This is now a well-established part of Trump’s negotiating style and Putin will have seen this play out with regard to the North Korea talks and in Trump’s domestic agenda over the past eighteen months. Included on that list will almost certainly be Russia’s wish that the White House drop objections to the construction of the Nord Stream 2 gas pipe to Germany. The fact that this was almost the first topic Trump mentioned upon arriving in Brussels is a clear indicator that he expects to use this for some form of barter. One possible trade-off may be the new supply route into Afghanistan via the Caspian and Central Asia, which the US is hoping to build to replace the previous routes via Pakistan and the Gulf States. It will want to make sure Russia does not try to block this. 

Then there is the thorny question of Iran. Moscow is one of the few countries with access to Tehran and is well placed to act, or to continue to act, as a go-between the US, Saudi Arabia, Turkey, Israel and Iran. That is a critical role which Moscow should be able to leverage off when it comes to Trump’s real-estate negotiation style. 

These are all positive factors that support the flip-over from the pre-World Cup pessimism to a more optimistic outlook. But, as mentioned, there is a clear risk in this process and that is linked to the US Congress’s unrelenting efforts to add more sanctions against Russia and to have existing sanctions more aggressively enforced. The bottom line is that the more positive the summit looks and especially if it looks like Trump and Putin are striking up a personal relationship, the hawks in US Congress are more likely to be even more infuriated and more aggressively push for new sanctions.

The CAATSA legislation, signed into law in early August last year, was a game-changer for US-Russia sanctions. That legislation took away the US president’s ability to remove or ease any sanctions against Russia. To do so now he would need to make the case to Congress and get approval. There is no realistic possibility of that happening for years. One has only to look at how long it took to have the Jackson-Vanik legislation, amending the Trade Act of 1974, revoked to understand that. 

An improved personal relationship between Putin and Trump cannot therefore lead to any reduction of existing sanctions, albeit it is hoped that Rusal, Gaz and EN+ will be removed from the SDN List before the October deadline, possibly during the quiet month of August. But an improved relationship can reduce the risk of further sanctions escalation. The executive branch, i.e. the White House and the Treasury Department, does have power to interpret sanctions legislation and how to enforce it, even though they cannot actually amend the legislation. 

Over the past six months US senators have introduced a number of draft bills, and are promising more, aimed at containing or punishing Russia. Amongst the bills in the former category is the Cyber Deterrence and Response Act where the authors specifically highlight Russia, China, Iran and North Korea as the main threats and propose draconian and automatic retaliation in the event of any egregious actions against the US. In the latter category is the Protect European Energy Security Act which would impose severe secondary sanctions on any company or individual working on the Nord Stream 2 pipeline.

The most dangerous bill floating around Capitol Hill is that introduced by Senators Rubio and Van Hollen in January. It is the Defending Elections from Threats by Establishing Redlines Act, otherwise known as the DETER ACT. If passed into law, this act would mandate automatic triggering of severe sanctions against any individual, entity or country deemed to have interfered or attempted to interfere in a US election. The process would be automatic and the White House would not be able to block or amend the actions. 

The fear that this bill may get enough support to be legislated ahead of the November mid-term elections has already caused many strategic investors to delay investment plans in Russia until next year. The big concern now is that photos of Trump and Putin establishing a positive personal relationship in Helsinki may lead to more undecideds in Congress supporting this dangerous bill. If it were to be passed then the personal relationship would be largely irrelevant. Congress would call the shots to an event greater extent than it does today.

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.