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Business person holds roubles and red arrow and shows thumb down. Devaluation of the Russian rouble. Toned picture

 

The Forward Observer is a series written by Kevin Virgil, CEO/Co-Founder of Frontera. Every two weeks he writes about trends that are re-shaping our world, and events taking place at the cutting edge of foreign affairs, business and finance.

Mayhem!  Carnage!  ??????????!

These are the messages that blared forth from my TV screen and broker notes this morning.  Yesterday – hereafter branded as “Red Monday” – was a day of reckoning for the Russian economy.  The schadenfreude on display in Western media is nearly as relentless as the ruble’s selloff:

“It couldn’t happen to a nicer guy” — WSJ on Putin

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“Russian sanctions could be lifted ‘within days’ if Vladimir Putin makes different choices, John Kerry says” — Daily Telegraph

Let’s disregard the fact that Secretary Kerry may be a bit premature with the sanctimony after two years of diplomatic outmaneuvering and general ????????? (beatings) at Putin’s hands in Syria, Libya, and Ukraine.  It might be easy to get caught up in the media hype around yet another Russian currency crisis, but time can be better spent in considering what Putin’s next moves might be, and the ramifications for the global economy.  Few will disagree that Vladimir Putin is easily the most effective head of state on today’s world stage.  Americans may not like him, but Russians love and adore him.  Trust me on this one, Mr Putin is not going anywhere and the only effective outcome of Kerry’s sanctions has been to unite the Russian people in defense of their president.

Let’s quickly recap the facts as we know them now:

Crude prices are at a five-year low; WTI traded below $57, and Brent just passed through $60 for the first time since 2009.

Yesterday (Mon 16 Dec) the ruble (RUB) dropped nearly 10% against the US Dollar (USD) in a single day of trading.

Last night – literally in the middle of the night (1 AM) – the Russian Central Bank (CBR) raised rates from 10.5% to 17% – a 62% increase in the overnight lending rate.  This stopped the RUB’s downward slide – for less than two hours – before continuing down past the 75 handle.

The RTS, Russia’s benchmark equity index, is -12% today as I write this and nearly -40% in the month of December.

redmonday2
Source: Financial Times

All of this information is readily available – but what does this mean for the global markets?  How can we predict the ‘second bounce of the ball’…or the unintended consequences of the Russian implosion?

I lived and worked in Moscow for a couple of years, and during my tenure the RUB never breached the 32 handle.  This morning a friend told me via email that middle-class Muscovites are piling into Ikea, 7th Continent and other large retailers to buy every consumer good on the shelves before the inevitable mark-ups are applied.  I only wish that I were there to load up on deeply-discounted bottles of Kalashnikov vodka – a much better souvenir than the NFL-themed matryoshka dolls from the tourist traps at Ismailovskiy Park.

Russia’s first post-Soviet currency crisis, in 1998, pre-dates my arrival there but I often heard about how market traders would price their goods in ‘conditional units’ instead of rubles – a thinly-veiled attempt to price their goods in USD (which is illegal; Russian businesses can only price their goods in RUB).

It is virtually indisputable that Russia will experience a painful recession next year; their economy’s most significant shortcoming is its near-total reliance on resource exports.  Russia’s break-even production cost of crude oil is just over $100, so the country’s famed $400bn ‘stabilization fund’ will soon begin to draw down.  Russia has its problems, to be sure, but their fiscal policy has actually been quite solid since they launched this fund in 2004 to mitigate volatility in the crude oil market.

Let’s tick off some other, lesser-known (but no less true) facts:

Remember the European mega-banks that were imperiled in the Greek sovereign debt crisis of 2012? Disaster was only averted when ECB President Mario Draghi pledged to do ‘whatever it takes’ to save the Euro?  Let’s take a look at current exposure for some of the largest Russian banks (courtesy of Bloomberg). How much of this exposure was denominated in US Dollars?  I suspect that we’ll soon find out.  This week’s events will surely serve as a wake-up call for the sovereign debt markets — remember that, less than three months ago, Spain and Italy were pricing bond issuances at a lower yield than US Treasuries!

BankLoan Exposure (Greek Crisis 2011-12)Loan Exposure (Russia 2014)Russian Exposure (as % of tangible book value)
Societe Generale€2.9B€25B62%
UniCredit€0.6B€18B40%
Raiffeisen€0.1B€15B?200%

Russia’s gold reserves are at a 20-year high now, with over 1,150 tons (worth over US$ 1.5B) on record. Theirs is the fifth-highest stockpile, having just passed China and Switzerland. Does the US hold more in Fort Knox?  Good question!  The Fed refuses any attempt to independently audit its reserves.  Even if you’re not a ‘gold bug’, you have to appreciate the (image of) stability that these holdings can convey to the world in a full-on currency crisis.

Russia has made no secret of its interest in dethroning the US Dollar as the global reserve currency. Recent moves such as the establishment of the New Development Bank (also known as the ‘BRICS Bank’), and joint efforts with China to begin direct currency conversion with their respective trading partners (and each other) are beginning to chip away at global dollar hegemony.

Make no mistake, this sell-off is a big problem — not just for Russia, or for the other over-levered emerging market currencies (TRY, INR, ZAR) that stand to be traumatized by a rising US dollar, but ultimately even for the US itself.  As US capacity utilization returns to pre-2001 levels, and inflation gains momentum, dollar-pegged currencies around the world are about to come under increasing strain.  I expect that Putin’s plans to chip away at the global reserve currency – the US Dollar – are about to shift into high gear.

I’ll be watching this situation closely.  In the meantime, some food for thought…it might be time for investors to give some serious thought to the major Russian names out there.  Here is what I saw in the GDRs this morning…

Current prices, P/Es and div yields for Russian majors:

CompanyPerformance Last 12MP/EDividend Yield
Sberbank (SBER)-39%3.3x6.2%
Gazprom (OGZD)-53%2.7x10.9%
Lukoil (LKOD)-45%3.2x8.5%
Rosneft (ROSN)-58%4.4x13.1%

Of course one must remember that these companies’ ability to pay such attractive yields may be imperiled by crude prices that are currently 40% below Russia’s production break-even.  Nonetheless, it’s indisputable that there are going to be some real bargains in this market.  (Disclosure: I own all of the stocks on this list in my personal account.  This is not a recommendation; make your own decisions please!)

I’ll write more about this in a few days.  I’m increasingly of the opinion that 2015 is going to be a year that investors will someday tell their grandchildren about.

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