Moscow’s insistence on fomenting separatism in Ukraine and violating the air space of its Baltic neighbors, on top of its annexation of Crimea, reinforce the belief of Global Markets Intelligence (GMI) that Russian equities merit nothing more than a wholly understated exposure in investment portfolios. The geopolitical machinations of the regime of President Vladimir Putin in Eastern and Central Europe have earned it widespread condemnation as well as progressively exacting economic and financial sanctions aimed at choking off foreign investment destined for Russia and rendering inaccessible vital financial outlets abroad for wealthy allies and supporters of Putin. Needless to say, the political destabilization engineered by Moscow, in cahoots with pro-Russian separatists, via subversive schemes in order to disaffiliate territory of a key sovereign state bordering the world’s largest country in terms of land mass makes Russia a manifestly unattractive avenue for overseas investors.
Insurrectionary intrigue aside, an ailing economy and ill-conceived policymaking merit Russia an inauspicious destination for foreign direct investment for the foreseeable future. Having abated to a 0.8 percent annual rate, the momentum of the macro-economy is not expected to regain strength anytime soon. In fact, domestic economic activity is likely to stagnate this year and undergo little improvement in 2015. Economic and financial restrictions on trade and capital flows imposed by Western governments in response to the seizure of the Crimean peninsula as well as other attempts by Moscow to undermine stability in Eastern Ukrainian provinces will continue to take their toll on the domestic business climate, eroding investor confidence and much-needed fixed capital formation for infrastructure and industrial development.
Worse still, as one of the world’s leading commodity exporters, Russia has fallen prey to adverse supply and demand patterns globally. Indeed, oil revenues have retreated 28 percent in just the last five months. The discovery of shale petroleum in the US has brought on stream an additional source that is engendering a worldwide glut in the supply of oil. Moreover, slowly expanding growth in both the emerging and industrialized economies is weakening the demand for many commodities, especially fuel. Consequently, enfeebled industrial demand combined with surplus petroleum production – in dampening the upside for oil and natural gas prices – should further diminish the nation’s export receipts and put the visible trade surplus in steady descent in the period ahead.
Crisis management, meanwhile, will probably remain a dominant influence of the policy atmosphere in Moscow for as long as Western economic and financial sanctions stay in effect. Despite a still sizable reserve of foreign exchange at the disposal of the country’s monetary authorities, a ruble crisis could be afoot in light of persistent gyrations in the trading configuration of the Russian currency. The rapid descent of the ruble both bilaterally and multilaterally in relation to the US dollar and in real effective trade-weighted terms, respectively, leaves the central bank no choice but to defend the unit aggressively in order to halt hemorrhaging capital outflows by establishing a floor for the ruble.
In already draining $83 billion of its foreign currency reserves and reducing its sum to a five-year low of $428.6 billion, the Bank of Russia appears determined to undertake the requisite intervention measures to stabilize the unit. Last week’s tightening of credit through a 150 basis point hike in the policy rate by the Bank of Russia signaled its commitment to stem the outward tide of capital flows. Yet, in doing so, it may have set in motion an economic recession that would only accelerate capital flight and depreciate the ruble further.
Fiscal policy can do little to counteract the ill-effects of a more restrained credit policy on the economy. Reliant on petroleum and natural gas sales overseas for half of its budget revenues, Moscow has practically no leeway to pump-prime the economy through fiscal expansion. If anything, owing to commodity revenue shortfalls, the government needs to contract rather than increase spending, making it impossible for the Putin administration to counterbalance the negative impact of a restrictive monetary policy posture.
From an absolute valuation perspective, the MICEX stock exchange’s positive-adjusted, one-year forward price-earnings multiple (p/e) of 4.6x in US dollar terms seems the least expensive compared with that of any other equity market in Eastern Europe. Furthermore, it is cheaper than the 5.8x multiple of its MSCI Eastern Europe benchmark. Moreover, it understates its record high of (72.3x), is hovering above its all-time low of zero and underwhelms its historical average (7.3x). Also, compared with its aforementioned bellwether, the MICEX is 0.23 point undervalued on a relative basis, all of which normally would argue in favor of an upgrade were it not for its saber-rattling, disheartening economic outlook and crisis-torn policy atmosphere in Moscow.
Sporting the poorest performing currency vis-à-vis the US dollar (-29.8 percent) and fourth worst equity return (-29.2 percent) globally in the year to date, Russia is clinging to life support both financially and economically. Either Moscow retreats from its current course of threatening its neighbors or it is doomed to repeat what other emerging markets have undergone in the past – a run on its currency and, in the worst case scenario, a balance of payments crisis once its reserves have dwindled below the country’s import coverage ratio. In view of the foregoing, we reaffirm our recommendation for solidly underweighting Russian shares until clear-cut evidence emerges of a reversal in Moscow’s confrontational foreign policy toward its neighbors when it might get some relief from the crippling economic effects of the stringent penalties imposed by the West.