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Russia: more illusion than opportunity

Russia has always gripped the western public’s imagination. Take investors’ dreams of fabulous riches or moviegoers’ anticipation of another Russian villain’s demise at the hands of James Bond. Ironically, the current situation in the Kremlin seems to be taken straight out of an Ian Fleming book with a former secret-service agent running the show, posing a threat to the West. Nevertheless, markets are impartial and constantly looking for opportunities – even in “Moscow”. However, we believe the environment for investors will remain very difficult apart from occasional bargain trades.

For the West in general and investors in par-ticular, Russia is fascinating and mysterious at the same time. It is alternatively seen as a country with huge resources and outsized po-tential as well as a source of political risk, poor governance and eternal disappointment. To quote Winston Churchill in 1948: “Russia … is a riddle wrapped in a mystery inside an enig-ma, but perhaps there is a key. That key is Rus-sian national interest.” And indeed 10 years ago at the Munich Security Conference, Rus-sian President Vladimir Putin declared that the post-Cold War order was a sham. He accused the US of disregarding international law and expanding the North Atlantic Treaty Organiza-tion eastward. He clearly meant business. Rus-sia has since invaded Georgia, annexed Crimea, destabilised eastern Ukraine and played a deci-sive role in the Syrian conflict. From a side-lined medium-sized power, Russia has again turned into a serious player in global geopoli-tics.

“Soft power” the Russian way
Moreover, Russia has with some success fos-tered an alternative to the liberal global or-der championed by the US since the Second World War. This comes at a time when western democracies are under pressure. On the one hand, populist leaders, who see the European Union or the euro zone as the root of all evil, are only too eager to embrace Moscow’s help. Moreover, they stand ready to protect their countries and “the People” from the perils of global trade. On the other hand, many voters have come to despise their political elites. Combine these two factors and you get Brexit, the election of Donald Trump as the 45th US president, the surge in the polls of the Front National in France or the Alternative für Deutschland in Germany.

Russia’s own brand of soft power encompasses hacking into sensitive computer systems and disseminating “alternative facts” through me-dia ventures in the West. To all appearances, the Kremlin has meddled in the US presidential campaign and might yet try to influence the upcoming French and German elections. Donald Trump’s triumph may have well looked like a sweet victory for Russia, possibly clearing the path towards a grand bargain between “strong men”. This may take different shapes such as US recognition of Russia’s sphere of influence, a cooperation to fight Islamist terrorism or a lifting of western economic sanctions against Moscow.

But given the new US administration’s unpre-dictability, things may look quite different. With Donald Trump facing a first Russia-linked scandal over the sacking of his National Secu-rity Advisor Michael Flynn, any quick deal with Vladimir Putin may now be off the cards.

Chart 1: The current Russian recession is less severe than during the crises in 1998 and 2009

vontobel russia more illusion than opportunity2

The country has expanded, the economy less so
While the biggest country on earth has grown even bigger with the annexation of Crimea, its economy is struggling along. Russia has suf-fered a recession for two years in a row under the twin impact from the collapse of the oil price and western economic sanctions follow-ing its land grab.

However, the macroeconomic shock has been far less severe than during previous crises such as 1998 or 2009 (see chart 1). This was largely thanks to a western-style central bank policy under the leadership of independent-minded Elvira Nabiullina. She let the rouble devaluate (see chart 2) as the oil price was falling but raised interest rates to control inflation. Moreover, the country’s financial reserves, fed by oil sales, have provided a use-ful source of cash for the state budget to mit-igate the downturn. The banking system weath-ered the recession reasonably well while the current-account balance remained positive.

All in all, the economy has stabilised, but the recovery is likely to be muted. Russia remains overly dependent on fossil energy (70 percent of exports, 50 percent of state revenues). Without a strengthening of the rule of law and property rights – and assuming western sanctions remain in place – it is difficult to conceive a future economic growth rate of more than 1 to 1.5 percent.

Where is Russia in political terms? Despite subdued popular ratings on the country’s eco-nomic policy, Russian voters overwhelmingly support Vladimir Putin for his assertive for-eign policy. Another term for the master of the Kremlin can be expected after the election in March 2018, prolonging his uninterrupted hold on power since 1999. This would bestow tsar-like qualities on Putin, a century after Nicholas II had to abdicate. While the longing for strong rulers in Russia seems to be an his-toric constant, everything else is uncertain.

No need for Russian equities to gain oil expo-sure
Finally, let’s turn to financial markets. Even though global equities have just hit a record high, investors should not fool themselves. Populist agendas, if successful, will over time undermine global economic growth and threat-en operating margins of global multinationals.

Given Russia’s political prospects, any hope for sustainable improvement in corporate govern-ance and shareholders rights seem misplaced at this juncture. The local market remains a leveraged oil play with an optically cheap val-uation. But we believe that investors who ex-pect oil prices to move higher in the medium term could make better use of their money out-side the Moscow stock market.

Chart 2: The Russian ruble and oil prices generally move in unison

vontobel russia more illusion than opportunity1

Christophe Bernard - Chief Strategist - Vontobel

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Asia might not be too worried about US protectionism

Trump’s decision to remove the US from the Trans Pacific Partnership (TPP) was a formality given that Congress was unlikely to ratify the deal during Obama’s final months. Additionally, his disapproval for the TPP was evident throughout the campaign, suggesting that withdrawal was not only well advertised but also fully priced into the market.

The situation becomes sadly ironic as the pact he was so anxious to reject would actually have solved several problems his election campaign had promised to fix, including expanding the tradeable market for US goods and promoting international business standards. Trump’s administration is now scrambling to promote copious proposals which do little to spur exports but instead damage US consumers by reducing real incomes through efficiency losses. The proposed border tax and border adjustment aim to reduce the trade deficit by either imposing a tariff on countries deemed currency manipulators or removing import deductibles to subsidize exports. Proponents argue these policies would lower the national trade deficit and improve export competiveness, while a stronger dollar offsets the tariff placed on overseas imports.

For Asian exporters, these circumstances could provide dual near-term tailwinds at the expense of US manufacturers. On the value side, most trade contracts are negotiated in USD terms, which would negate any exchange rate savings from a stronger US dollar. For Asian exporters that report in local currency (non-USD) denomination, the appreciation of the USD translates to better sales. The downside for foreign exporters comes if supply quantities drop significantly. While this would lower the trade deficit for the US, weaker import growth would also suggest a waning US economy which Trump seeks to avoid. If the volume remains unchanged, the tariff is either absorbed by the manufacturer or passed on to the end consumer.

On the volume side, US import substitutions are not immediately available to fill the gap. According to the US Census Bureau, Asia accounts for roughly 50% of the US trade deficit. Using OECD’s estimates that US exports contain on average 20% of foreign content, US manufacturers would need to expand product capabilities that would equate to the 10% value loss. While subsidies and tax breaks offset the financial costs, most industries lack the raw materials in enough quantity and scale to meet the target of the new administration to generate the immediate growth.

The US withdrawal from the TPP could also provide a near-term catalyst for most of Asia. Though only five Asian countries were original signatories of the TPP (Japan, Singapore, Brunei, Malaysia and Vietnam), several others had pledged an interest to join (South Korea, Taiwan, Thailand, Indonesia and the Philippines). However, many demonstrated reluctance given that the pact would open competition between domestic small and medium enterprises against foreign companies. Given the possibility that the US or even China could join later, the delay provides the opportunity for capital expenditure and infrastructure spending to improve production efficiency. Even if China decides to follow through with its own trade pact, the Regional Comprehensive Economic Partnership (RECEP), this would indirectly reduce the role of state-owned enterprises to improve returns, which had been one of the objectives of TPP.

Christopher Chu - Fund Manager, Asian equities - Union Bancaire Privée (UBP)

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