Dispatches from Moscow

Dispatches from Moscow:
In wintry Russia, signs of a thaw
Pictet Asset Management I For professional investors only
Q&A
How do you describe the economic climate in Moscow?
HB. Even as the temperature plunged below -20c in
Moscow, the city was functioning reasonably well, as far as
I could see. True, the economy is expected to contract by as
much as 5 per cent and inflation is likely to hit 18 per cent
this year as the value of the RUB halved since last year. Even
President Vladimir Putin himself admitted that Russia's
economy will suffer two "most unfavourable" years.
March 2015
However, there is little sign of stress in the labour market,
and the dozen or so corporate executives we met had no
plans for massive layoffs. We can find many domestic
companies that have sound fundamentals to deal with an
economic slowdown. What is more, the country’s overall
savings rate stands at a comfortable 29 per cent of GDP,1
higher than in the previous crises.
Hugo Bain, Senior Investment
Manager, Russian equities
Alain Defise, Head of Emerging
Corporate Bonds
Moscow and Kiev agreed
a ceasefire deal that may
help end fighting in eastern
Ukraine which killed nearly
6,000 and took a heavy
economic toll on Russia.
Pictet Asset Management’s
Hugo Bain and Alain
Defise discuss the business
outlook for Russia and
share insight from their
recent trip to the capital.
AD. Russia has experienced economic hardships
before, notably in 1998 and 2008. It seems to me that the
government and companies already have a template to deal
with a crisis. Sanctions may be hitting some parts of the
economy and the food imports ban means oligarchs may not
be able to find their mozzarella cheese. But there is a spirit
of pragmatism and perseverance pervading the country.
Indeed, the companies we invest in are sufficiently
capitalised to withstand the odd liquidity shortage. Some
of them have cash holdings equivalent to four or five times
their short-term debt.
How has the decline in the RUB affected Russian
companies?
AD. The sharp decline in the RUB is a boon for many
Russian corporations, especially exporters whose revenues
are in the USD but whose cost base is in local currency. One
metal company in our emerging corporate debt portfolio
had so much cash on its balance sheet that it offered to
repay its short-term debt ahead of schedule in a tender;
we did not participate because we believe we are better
rewarded in holding the debt for the time being. We’re likely
to see more evidence of companies using their cash pile to
reduce leverage.
HB. The energy sector is another beneficiary of the decline
in the RUB. For example, an official from a state-owned
energy giant told us that some 70 per cent of its capex base
1
Gross national savings, National Statistical Office, 2013
is in RUB. Despite a sharp decline in energy prices,
RUB-denominated oil prices have stayed largely steady
over the past year except for a period of volatility in
December. Some Russian companies, such as those in
energy and mining sectors, have free cash flow – operating
cash flow minus capital spending – of 30 per cent, which is
the highest level we have seen in the country.2
In our view it seems unlikely that the RUB, which is closely
correlated with oil prices, would decline much further.
According to our economists, the RUB is now trading nearly
60 per cent below its long-term fair value against the USD
(Fig 1).
FIG. 1 – RUB HAS FALLEN SHARPLY BELOW ITS FAIR VALUE
%
80 —
What is the government doing to tackle the financial
crisis?
AD. The government has launched a USD35 billion anticrisis plan, like the ones it implemented in 2008 and 2012.
It promises state support for 199 strategic companies which
make up 70 per cent of the country's gross national income
and employ more than a fifth of all Russians at work (Fig.
2). This would help support key sectors such as energy,
steel and mining. However, the financing environment
is expected to remain tough for small and medium-sized
enterprises, which make up around a quarter of Russia's
economy.3
FIG. 2 – RUSSIA’S ANTI-CRISIS PLAN
RUB overvalued
Deviation from equilibrium
+/- 1 standard deviation
Russian banks with at least RUB 25 billion
in capital and willing to increase
lending to key sectors of the economy
will be able to participate in a
RUB1 trillion recapitalisation plan
60 —
40 —
The central bank has
relaxed regulation of banks
and is considering further steps
to ease on burden on banks
20 —
0—
The Economy Ministry has listed
199 strategic companies
which will be eligible for state support
-20 —
-40 —
-60 —
Source: Reuters
RUB undervalued
20
15
20
13
20
11
09
20
07
20
05
20
03
20
01
20
9
19
9
19
97
5
19
9
19
9
3
-80 —
Source: Thomson Reuters Datastream
What is the impact of higher interest rates and
inflation on corporate Russia, and what is your outlook for
monetary policy?
AD. We did see some signs of stress building up in
the banking sector, which is natural when your central
bank raises interest rates by 12 percentage points. Every
corporate executive we met complained that the high
interest rates imposed on them were a significant challenge.
One agricultural company told us that its clients were
having difficulty securing financing to buy its products.
HB. The central bank did cut its main lending rate to 15 per
cent from 17 per cent in January, in a move which we think
implies a shift in the bank’s priorities away from reigning
in inflation to supporting growth. From what we have
heard, the central bank has now become more pragmatic
in dealing with economic challenges such as slow growth
after a recent personnel change in the team under Governor
Elvira Nabiullina. From officials we’ve spoken to, I got
an impression that emergency monetary tightening in
December, when the central bank raised rates by 6.5
percentage points, is likely to be removed in the short to
medium term. Inflation – which has risen as a result of the
RUB decline and Moscow’s self-imposed ban on Western
food imports – should come down this year because slower
growth has a disinflationary impact, helping the central
bank focus on supporting growth.
2
Bloomberg
The government plans to distribute
up to RUB1 trillion of OFZ
treasury bonds issued late last year
to state-owned banks including VTB,
Gazprombank and Rosselkhozbank,
all under Western sanctions
HB. Companies we met, especially in the cyclical sector,
are re-drafting their business plans, changing assumptions
based on new and more realistic economic forecasts.
What is your investment outlook for Russia this year
and what are downside risks?
HB. I expect portfolio flows to gradually return to Russia,
whose equity markets are now among the most attractively
valued in the world. The central bank expects a net capital
outflow of USD118 billion this year, but much of that
reflects corporate foreign debt repayments.
The Russian equity market is attractively valued and
under-owned by international investors. In the PictetGlobal Emerging Market equity fund, we have taken the
opportunity to increase what was a small overweight
position, adding holdings of export companies that should
benefit from a weak RUB and others which are significantly
undervalued. We are underweight consumer-focused
companies that purely generate revenues from domestic
markets.
However, investors should keep an eye on political risks,
even though the ceasefire seems to be slowly coming into
force in eastern Ukraine. The West is still threatening Russia
with additional economic sanctions, which could weigh on
the economy.
AD. The RUB is expected to remain under pressure and
the central bank can only help slow its slide, given that it
has lost nearly a quarter of its FX reserves last year. Since
3
European Investment Bank
energy provides 70 per cent of Russian export earnings and
half the government revenues, the central bank coffers are
unlikely to be replenished quickly.
In the Pictet-Emerging Corporate Bond fund, we have
also recently added positions in Russian energy producers
and gold exporters, and as a result we are overweight
the country. Those investors who have not sold Russia
by December are unlikely to leave now. Given extreme
valuations, this gives us a great opportunity to invest in the
inherent strength of Russian corporates and the potential
for a long-term economic recovery. There are many
examples of undervalued corporate bonds. For example, we
have invested in this corporate bond issued by a Russian
oil company which we think is unjustifiably tainted by the
country's economic troubles. Its credit rating of BBB- is
better than that of government bonds after both Standard
& Poor's and Moody's cut Russia's sovereign ratings below
investment grade. With the bond's yield spread at an
attractive 540 basis points and the yield to worst of over 7
per cent, we are amply compensated for taking the risk and
volatility especially as the company has solid fundamentals.
I think Russia offers a great opportunity for investors.
As they say in the Russian proverb: stormy weather cannot
stay all the time, the red sun will come out, too.
RETAIL ACTIVITY PICKING UP?
Azerbaijan’s PNN Group plans to
open two stores selling Superdry
clothing label in Moscow shopping malls
with floor space of 850 and
900 square metres at end-April,
before adding more than 10 stores
in Russia before 2020.
Russia’s top food retailer Magnit
attracted strong demand from foreign
investors, raising RUB9.8 billion
by selling down its stake to fund
a separate investment. It also plans
to open as many stores in 2015 as never
before in one year, confident it can
win crisis-hit customers without giving up
much profitability.
Hugo Bain, Senior Investment Manager, Russian equities
Hugo Bain joined Pictet Asset Management in 2009
as a Senior Investment Manager in the Emerging Markets
Equities team, specialising in EMEA. Before joining Pictet,
he spent five years with Fleming Family & Partners Capital
Management LLP (FCM) and was a founding partner and
co-manager of the FCM European Frontier Fund. He began
his career in 1997 at ING, where he remained until 2002
as Head of Russian, Emerging Europe, Africa and Latin
America Sales. In 2002 he joined Merrill Lynch as Specialist
in EMEA sales.
Hugo has an MA in Modern History from the University
of St Andrews.
Alain Nsiona Defise, Head of Emerging Corporate Bonds
Alain Nsiona Defise joined Pictet Asset Management in 2012
as head of the emerging corporate bond team. Previously,
Alain was at JP Morgan in London where he managed the
emerging corporate business, worth over USD 2 billion. Prior
to that, he worked for nine years at Fortis Investments where
he started as a senior credit analyst focusing on the high
yield market and later worked as a senior emerging fixed
income portfolio manager building the emerging corporate
business.
Alain holds a Master's degree in Business Engineering from
Solvay Business School, Brussels and a Diploma in Financial
Analysis from the European Federation of Financial Analysts
Societies.
US carmaker Ford plans to roll out six new models in Russia this year.
Source: Reuters
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