In Russia, Caution Still Required
May 12, 2015
Ordinarily one of Europe’s most vibrant cities, Moscow on a recent visit looked like a town in a defensive crouch. And while Russian economic conditions have stabilized somewhat, we think they will remain difficult for some time.
On a recent visit to the country, we saw the effect that international sanctions and lower oil prices were having on the Russian economy. Restaurants and shopping malls were less crowded than usual. A number of billboards around Moscow were empty. Even the legendary traffic jams that usually clog the capital’s massive boulevards and concourses had thinned.
Conditions have improved a bit since then, with oil recouping some of its recent losses. But the oil price remains well below the levels that had prevailed over the last few years. Meanwhile, sanctions against Russia for its role in the Ukraine crisis and a banking crunch are making it harder for banks and domestically-oriented companies to secure financing.
On top of that, the high level of political risk rose even further with the assassination of opposition politician Boris Nemtsov. And nobody knows how durable the Ukraine ceasefire really is. All of this makes it hard to see things in a positive light.
Banking System Remains Fragile
Some investors may not fully appreciate just how fragile the banking system is and how close the country came to a major bank run. In December, one of Russia’s largest banks saw more deposits pulled than at any time in its history.
Unfortunately, the vulnerabilities of the banking system are taking the shine off some of the economy’s bright spots. For instance, Russian exporters are doing very well and are fast becoming the lowest-cost producers globally.
Russia’s foreign-exchange reserves are still ample. For now, that gives the government the ability to cover payments on the maturing foreign loans of Russian banks and companies. Indeed, the willingness to pay is high: Rosneft has paid off several billion in debt over the past few months.
If this situation persists for too long, though, the costs to the government will add up. Bank executives we spoke to made it clear that higher rates would lead to an increase in corporate defaults and a surge in non-performing loans. Against this backdrop, it’s not surprising that Moody’s and S&P cut Russia’s sovereign debt rating to junk status for the first time in a decade.
Some of the foreign bondholders we spoke to in Russia were cautiously optimistic. Some told us that local ownership of much Russian corporate debt might make defaults less likely. We also heard that local companies were wary of default for fear it would jeopardize future access to Western markets.
But Russian investors and company executives also told us that things will have to change soon. While President Vladimir Putin’s popularity levels remain at an all-time high, we heard plenty of concerns from local contacts about the sustainability of his policies.
For now, the Ukraine ceasefire is holding—but it remains fragile. Russian assets have bounced back from depressed levels and outperformed of late. But geopolitical uncertainties, the risk of a renewed oil price decline and the vulnerability of the banking sector remain serious concerns.
EM Corporates Still Attractive
Of course, the challenges Russia faces are by no means a reason to shy away from emerging-market (EM) corporate bonds altogether. EM corporates with dollar-linked revenues, for instance, may be in a position to benefit from the stable global growth outlook and currency depreciation. Fundamentals in the sector are generally strong and the balance of risk and return is attractive compared to other sectors.
But, in our view, investors must be careful about security selection and conduct thorough research in order to focus on individual issuers with solid credit fundamentals.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.