Russia – Will the Bear come in from the cold?

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Macro Letter – No 67 – 9-12-2016

Russia – Will the Bear come in from the cold?

  • In 2015/16 the Russian economy suffered in the sharpest recession since 2008/09
  • The RTSI Stock Index, anticipating a recovery, is up 78% from its January lows
  • Russian government bonds traded at 8% in August down from 16% in December 2014
  • The Ruble has stabilised after the devaluation of 2014/2015 and inflation is still falling

Since January many emerging equity and bond markets have staged a spectacular recovery. Russia has been among the winners, buoyed by hopes of an end to international sanctions and a, relative, rapprochement with the new US administration. A near-virtuous circle is achieved when combined with the country’s strengthening trade relationship with China and the rising oil price, stemming from the first OPEC production agreement in eight years.

Looking at the RTSI Index, a lot of this favourable news is already in the price:-

rtsi_2016_-_moscow_exchange

Source: Moscow Exchange

Since January the RTSI has rallied by 78% and, at 1082 is close to the highs of May 2015 (1092) from whence it broke down to the lows of January (607). Is it too late to join the party? A longer-term chart lends perspective:-

rtsi-1995-2016

Source: Tradingview

By a number of other metrics Russian stocks still look inexpensive. The chart below compares stock market capitalisation to GDP:-

russia-mktcap-to-gdp-guru-focus

Source: Guru Focus

The current ratio is 20%, the average over the period since 2000 is 65% – return to mean would imply a 19.25% annual return for Russian stocks over the next eight years. That would equate to a compound return of 409%.

The table below shows the P/E Ratios of four Russian ETFs as of 8th December:-

Symbol Name P/E Ratio
RSXJ VanEck Vectors Russia Small-Cap ETF 6.07
ERUS iShares MSCI Russia Capped ETF 7.33
RBL SPDR S&P Russia ETF 7.72
RSX VanEck Vectors Russia ETF 8.73

Source: EFTdb.com

For comparison, the iShares MSCI BRIC ETF (BKF) currently trades on a PE of 10 times.

Bonds, Inflation and the Ruble

Russian inflation has been declining rapidly this year as the sharp devaluation of 2014/2015 feeds through. The two charts below shows the USDRUB (black – RHS) and Russian CPI (blue – LHS) and Russian 10 year Government bonds (blue – LHS) versus CPI (black – RHS):-

russia-inflation-cpi-and-usdrub-1-1-14-to-8-12-16

Source: Trading Economics

russia-government-bond-yield-and-cpi-1-1-14-to-8-12-16

Source: Trading Economics

Whilst the Ruble has stabilised at a structurally higher level than prior to the annexation of the Crimea, the inflation rate has been brought back under control by the hawkish endeavours of the Central Bank of Russia. The benchmark one-week repo rate remains at 10%, down from 17% in December 2014 but still well above the rate of inflation – which the Central Bank of Russia forecast to fall to 4% by the end of next year. The yield curve remains inverted but that has not always been a structural feature of the Russian market. The chart below compares the one week repo rate (black – RHS) versus 10yr Government bonds (blue – LHS):-

russia-government-bond-yield-vs-interest-rate-2003-2016

Source: Trading Economics

Economics and Politics

The IMF WEO – October 2016 revised its GDP forecast for Russia in 2017 to +1.1% (versus +0.1% in July) although they revised their 2016 estimate to -0.8% from +0.4%. Focus Economics poll of analysts, forecast 1.2%, whilst Fathom Consulting’s Global Economic Strategic asset Allocation Model (GESAM) is predicting +0.8. Between 1996 and 2016 the average rate of GDP growth was 3.08%. As the chart below shows, the growth rate has been volatile and, like many countries globally, the post 2008/2009 period has been more subdued:-

russia-gdp-growth-annual

Source: Trading Economics, Federal Statistics Service

Oil and Gas

Russia’s largest export markets are Netherlands 11.9%, China 8.3% and Germany 7.4%. Their main exports are oil and gas. The chart below shows the price of Russian gas at the German border over the last 15 years:-

russian_gas_15_year-indexmundi

Source: Indexmundi

Whilst this may be good news for European consumers it has led to considerable political tension. Russia is developing a new gas pipeline – Nord Stream 2 – which will double Russia’s gas export capacity and avoid the geographic obstacle of the Ukraine. It is scheduled to be operational in 2019.

However the EU is developing another gas pipeline – the Southern Gas Corridor, avoiding Russian territory, which is scheduled to be operational in 2020 – to diversify their sources of supply. The Carnegie Moscow Centre – Gazprom’s EU Strategy Is a Dead End – December 6th 2016 takes up the story:-

The EU points out that Ukraine has never violated its gas transit obligations, while Russia shut off the tap during some of the coldest days in 2006 and 2009, and then sharply cut the volume of exports to Europe in late 2014, each time for political reasons. Brussels believes that the real threat to European energy security is not Ukraine but rather the unpredictability of Russian authorities.

US LNG exports are slowly increasing but producers are expected to focus on meeting demand from Japan and other parts of Asia, where prices are higher, first. The Colombia SIPA Center on Global Energy Policy – American Gas to the Rescue – September 2014 – made the following observations which still hold true:-

Although US LNG exports increase Europe’s bargaining position, they will not free Europe from Russian gas. Russia will remain Europe’s dominant gas supplier for the foreseeable future, due both to its ability to remain cost-competitive in the region and the fact that US LNG will displace other high-cost sources of natural gas supply. In our modeling we find that 9 billion cubic feet per day (93 billion cubic meters per year) of gross US LNG exports results in only a 1.5 bcf/d (15 bcm) net addition in global natural gas production. 

By forcing state-run Gazprom to reduce prices to remain competitive in the European market, US LNG exports could have a meaningful impact on total Russian gas export revenue. While painful for Russian gas companies, the total economic impact on state coffers is unlikely to be significant enough to prompt a change in Moscow’s foreign policy, particularly in the next few years.

Oil is a more global market and the 29th November OPEC production agreement, the first that OPEC members have signed in eight years, should help to stabilise global prices – that is assuming that OPEC members do not cheat. Russia, although not a member of OPEC, agreed to reduce production by 300,000 bpd. Russia had just achieved record post-soviet production of 11.1mln bpd in September, they have room to moderate their output:-

rusian-oil-production-2005-2016-bloomberg-energy-ministry

Source: Bloomberg, Russian Energy Ministry

Prospects for 2017

In 2015 tax from oil and gas amounted to 52% of Russian receipts – a stabilisation of the oil price will be a significant fiscal boost next year. Russia has been far from profligate since 2008, it runs a trade and current account surplus and, although the government is in deficit to the tune of 2.6% of GDP this year, the government debt to GDP ratio is a very manageable 17.17%.

Looking ahead to 2017 Brookings – The Russian economy inches forward – highlights a number of features which support optimism for the future:-

…the country seems to have turned the corner and growth is expected to be positive in 2017-2018. One key reason is that over the last two years, the government’s policy response package of a flexible exchange rate policy, expenditure cuts in real terms, and bank recapitalization—along with tapping the Reserve Fund—has helped buffer the economy against multiple shocks.

…The banking sector has also now largely stabilized. The consolidated budget of regional governments even registered a surplus in the first eight months of 2016. Indeed, on the back of projected rising oil prices, we expect the economy to enter positive territory in 2017 and 2018, reaching 1.5-1.7 percent.

With a growing federal fiscal deficit (3.7 percent of GDP by end 2016), one proactive step the government has taken is to reintroduce a three-year, medium-term fiscal framework, which proposes to cut the deficit by about 1 percent each year ultimately leading to a balanced budget by 2020. The budget is conservatively costed at a $40 per barrel oil price, and cuts are driven mostly by a reduction in expenditures in mostly defense/military and social policy. If adhered to, this medium-term framework will be an important step toward reducing overall policy uncertainty. 

China (and India)

In the longer term a major focus of Russian economic policy has, and continues to be, the development of trade with China. The first Russo-Chinese partnership agreements were signed in 1994 and 1996, followed by the Treaty of Friendship and Cooperation in 2001 and the Strategic Partnership in 2012 which was superseded by a further agreement in 2014 – signed by President Xi. Ratified shortly after the annexation of the Crimea and imposition of sanctions by the US and EU, the latest agreement has substance. Here are some of the more prominent deals which have emerged from the closer cooperation:-

  • Gazprom and China National Petroleum Corporation (CNPC) announced a 40 year gas supply deal, including plans to build the “Power of Siberia” gas pipeline.
  • Rosneft agreed to supply CNPC with $500bln of oil, potentially making Russia, China’s largest supplier of oil, surpassing Saudi Arabia. The Eastern Siberia-Pacific Ocean oil pipeline will be connected to Northeast China next year and a pipeline linking Siberia’s Chayandinskoye oil and gas field to China comes online in 2018.
  • The Central Bank of Russia signed a RUB 815bln swap agreement with the PBoC to boost bilateral trade. They had previously contracted business in US$.

The Diplomat – Behind China and Russia’s ‘Special Relationship’ – investigates the impact this new cooperation is beginning to have:-

…Russia has become one of the five largest recipients of Chinese outbound direct investment in relation to the Chinese government’s Belt and Road Initiative (BRI) connecting Asia with Europe. Meanwhile, China was Russia’s largest bilateral trade partner, in 2015; in spite of declining overall bilateral trade in U.S. dollar terms (mainly due to sharp declines in the ruble as well as the yuan), relative to 2014, trade flows continued to expand in terms of volume.

In this context, it was significant that Russia’s exports of mechanical and technical products to China rose by about 45 percent over the course of 2015 possibly signifying an important trend in the diversification and competitiveness of Russia’s non-energy sector in terms of bilateral trade prospects with China.

The Diplomat goes on to highlight the improved and increasing importance of Russian trade with India:-

The Russia-India-China (RIC) trilateral grouping is considered by its participants as an important arrangement in securing political stability, both globally and in the region. India and Russia’s relations have remained strong for several decades, with Russia being India’s largest defense and nuclear energy partner. However, while China’s and Russia’s relations have clearly improved in the last few years, the China-India relationship has somewhat lagged the development of the other two legs of the triangle. Consequently, Russia has played a role in bringing both sides closer together through its interactions in the RIC grouping.

The Trump Card?

US pre-election rhetoric from the Trump campaign suggested a less combative approach to Russia. Trump said he would “look into” recognising Crimea and removing sanctions, however, Republican hawks in Congress will want to have their say. Syria may be the key to a real improvement in relations – don’t hold your breath.

Conclusion and Investment Opportunities

The Ruble has stabilised and whilst Russia has some external debt the amount is not excessive. The effect of the devaluation of 2014/2015 has run its course and inflation is forecast to decline further next year. It may weaken against the US$ in line with other countries but is likely to be range-bound, with a potential upward bias, against its major trading partners.

The Central Bank of Russia has maintained tight grip short term interest rates, leaving it room to reduce rates, perhaps, as soon as Q1 2017. Russian government bond yields halved since their highs of 16% in late 2014, but have risen by around 60bp since August following the trend in other global bond markets. With short term interest rates set to decline, the inversion of the yield curve is likely to unwind, but this favours shorter dated, lower duration bonds – there is also a risk of forced liquidation by international investors, if US and other bond markets should decline in tandem.

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord. The VanEck Vectors Russia Small-Cap ETF (RSXJ) has very little exposure to oil and gas and therefore reflects a less commodity-centric aspect of the Russian economy. The chart below covers the five years since 2011. It has risen further than the major indices since January yet still trades at a lower PE ratio:-

rsxj-index-yahoo

Source: Yahoo Finance

Like the RTSI Index the small-cap ETF looks over-bought, however, the economic recovery in Russia appears to be broad-based, Chinese growth, in response to further fiscal stimulus, has increased and the oil price has (at least for the present) stabilised around $50/bbl. If you do not have exposure to Russia, you should consider an allocation. There may be better opportunities to buy, but waiting for trends to retrace can leave you feeling like Tantalus. The last two bull-markets – January 2009 to March 2011, and July 2004 to May 2008 – saw the RTSI Index rally 315% and 382% respectively. In the aftermath of the Russian crisis of 1998 the index rose from 61 to 755 in less than six years (1,138%). Don’t be shy but also keep some power dry.

Broken BRICs – Can Brazil and Russia rebound?

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Macro Letter – No 35 – 08-05-2015

Broken BRICs – Can Brazil and Russia rebound?

  • The economies of Brazil and Russia will contract in 2015
  • Their divergence with China and India is structural
  • Economic reform is needed to stimulate long term growth
  • Stocks and bonds will continue to benefit from currency depreciation

When Jim O’Neill, then CIO of GSAM, coined the BRIC collective in 2001, to describe the largest of the emerging market economies, each country was growing strongly, however, O’Neill was the first to acknowledge the significant differences between these disparate countries in terms of their character. Since the Great Recession the economic fortunes of each country has been mixed, but, whilst the relative strength of China and India has continued, Brazil and Russia might be accused of imitating Icarus.

Economic Backdrop

In order to evaluate the prospects for Brazil and Russia it is worth reviewing the unique aspects of, and differences between, each economy.

According to the IMF April 2015 WEO, Brazil is ranked eighth largest by GDP and seventh largest by GDP adjusted for purchasing power parity. Russia was ranked tenth and sixth respectively. Between 2000 and 2012 Brazilian economic growth averaged 5%, yet this year, according to the IMF, the economy is forecast to contract by 1%. The forecast for Latin America combined is +0.6%. For Russia the commodity boom helped GDP rise 7% per annum between 2000 and 2008, but with international sanctions continuing to bite, this year’s GDP is expected to be 3.8% lower.

Brazil’s service sector is the largest component of GDP at 67%, followed by the industry,27% and agriculture, 5.5%. The labour force is around 101mln, of which 10% is engaged in agriculture, 19% in industry and 71% in services. Russia by contrast is more reliant on energy and other natural resources. In 2012[update] oil and gas accounted for 16% of GDP, 52% of federal budget revenues and more than 70% of total exports. As of 2012 agriculture accounted for 4.4% of GDP, industry 37.6% and services 58%. The labour force is somewhat smaller at 76mln (2015).

The Harvard Atlas of Economic Complexity 2012 ranks Brazil 56th and Russia 47th. The table below shows the divergence in IMF forecasts since January. During the period October 2014 and February 2015 the Rouble (RUB) declined by 30% whilst the Brazilian Real (BRL) fell only 9%:-

Country GDP GDP Forecast Forecast Jan-14 Jan-14
2013 2014 2015 2016 2015 2016
Brazil 2.7 0.1 -1 1 -1.3 -0.5
Russia 1.3 0.6 -3.8 -1.1 -0.8 -0.1

Source: IMF WEO April 2015

On March 14th the Bank of Russia published its three year economic forecast: it was decidedly rosy. This was how the Peterson Institute – The Incredibly Rosy Forecast of Russia’s Central Bank described it:-

…the Bank of Russia argues that the huge devaluation of the ruble that took place between October 2014 and February 2015 has a minor effect on economic growth. This claim neglects much empirical evidence that sharp devaluations retard investment activity, for two reasons. First, investment technology from abroad becomes more expensive—nearly 80 percent more expensive in the case of Russia. Second, devaluations increase uncertainty in business planning and hence slow down investment in domestic technology as well. Both effects work to depress economic activity in the short term.

…2017 is presented as the year of a strong rebound, as a result of cyclical macroeconomic forces. In particular, says the Bank of Russia, growth will reach 5.5 to 6.3 percent that year. It is true that the economy was already slowing down in 2012, before last year’s sanctions and devaluation. It is also true that the average business cycle globally has historically lasted about six years. But this is no ordinary cycle—sanctions are likely to play a bigger role than the Bank of Russia cares to admit. The main reason is their effect on the banking sector, where credit activity is already substantially curtailed, and may be curtailed even further once corporate eurobonds start coming due later this year. The devaluation has exacerbated the credit crunch as interest rates spiked in early 2015 to over 20 to 25 percent for business loans. These effects point in one direction: a prolonged recession.

Finally, the Russian government is reducing public investment in infrastructure in this year’s budget to try and cut overall expenditure by about 10 percent. This cutback is going to dampen growth because the multiplier on infrastructure investment is highest among all public expenditures. The Bank of Russia seems to have forgotten to account for this elementary fact of life.

Overall, the economic picture may end up being quite different from what the Bank of Russia forecasts. Instead of economic growth of –3.5 to –4 percent in 2015, –1 to –1.6 percent in 2016, and 5.5 to 6.3 percent in 2017, it may be closer to –6 to –7 percent in 2015, –3 to –4 percent in 2016, and zero growth in 2017. This scenario is worth contemplating, as it would mean that the reserve fund that the government uses to finance its deficit may be fully depleted in this period. What then?

The table below compares a range of other indicators for the two economies:-

Indicator Brazil     Russia    
  Last Reference Previous Last Reference Previous
Interest Rate 13.25% Apr-15 12.75 12.50% Apr-15 14
Government Bond 10Y 12.90% May-15 10.71% May-15
Stock Market YTD* 14.70% May-15 23.20% May-15
GDP per capita $5,823 Dec-13 5730 $6,923 Dec-13 6849
Unemployment Rate 6.20% Mar-15 5.9 5.90% Mar-15 5.8
Inflation Rate – Annual 8.13% Mar-15 7.7 16.90% Mar-15 16.7
PPI – Annual 2.27% Jan-15 2.15 13% Mar-15 9.5
Balance of Trade $491mln Apr-15 458 $13,600mln Mar-15 13597
Current Account -$5,736mln Mar-15 -6879 $23,542mln Feb-15 15389
Current Account/GDP -4.17% Dec-14 -3.66 1.56% Dec-13 3.6
External Debt $348bln Nov-14 338 $559bln Feb-15 597
FDI $4,263mln Mar-15 2769 -$1,144mln Aug-14 12131
Capital Flows $7,570mln Feb-15 10826 -$43,071mln Nov-14 -10260
Gold Reserves 67.2t Nov-14 67.2 1,208t Nov-14 1150
Crude Oil Output ,000’s 2,497bpd Dec-14 2358 10,197bpd Dec-14 10173
Government Debt/GDP 58.91% Dec-14 56.8 13.41% Dec-13 12.74
Industrial Production -9.10% Feb-15 -5.2 -0.60% Mar-15 -1.6
Capacity Utilization 79.70% Feb-15 80.9 59.85% Mar-15 62.04
Consumer Confidence** 99 Apr-15 100 -32 Feb-15 -18
Retail Sales YoY -3.10% Feb-15 0.5 -8.70% Mar-15 -7.7
Gasoline Prices $1.04/litre Mar-15 1.16 $0.68/litre Apr-15 0.61
Corporate Tax Rate 34% Jan-14 34 20% Jan-15 20
Income Tax Rate 27.50% Jan-14 27.5 13% Jan-15 13
Sales Tax Rate 19% Jan-14 19 18% Jan-15 18
*Bovespa = Brazil
*Micex = Russia
** Consumer confidence in Brazil – 100 = neutral, Consumer confidence in Russia – 0 = neutral

Source: Trading Economics and Investing.com

From this table it is worth highlighting a number of factors; firstly interest rates. Rates continue to rise in Brazil despite the relatively benign inflation rate. The rise in the Russian, Micex stock index has been much stronger than that of the Brazilian, Bovespa, partly this is due to the larger fall in the value of the RUB and partly due to the recent recovery in the oil price. PPI inflation in Brazil remains broadly benign, especially in comparison with 2014, whilst in Russia it is stubbornly high – making last week’s rate cut all the more surprising.

Brazilian industrial production continues to decline, a trend it has been struggling to reverse, yet capacity utilisation remains relatively high. Russian industrial production never rebounded as swiftly from the 2008 crisis but has remained in positive territory for the last few years despite the geo-political situation. Remembering that one of Russia’s largest industries is arms manufacture – the country ranks third by military expenditure globally behind China and US – this may not be entirely surprising.

Of more concern for Brazil, is the structural nature of its current account deficit, since the advent of the Great Recession. This combination of deficit and inflation prompted Morgan Stanley, back in 2013, to label Brazil one of the “Fragile Five” alone side India, Indonesia, South Africa and Turkey. Russia, by contrast, has run a surplus for almost the entire period since the Asian crisis of 1998.

The Government debt to GDP ratio in Russia has risen slightly but the experience of the Asian crisis appears to have been taken on board. Added to which, the sanctions regime means Russia is cut off from international capital markets. In Brazil the ratio is not high in comparison with many developed nations but the ratio has been rising since 2011 and looks set to match the 2010 high of 60.9 next year if spending is not curtailed.

A final observation concerns gold reserves. Brazil has relatively little, although they did increase in January 2013 after a prolonged period at very low levels. Russia has taken a different approach, since 2008 its reserves have tripled from less than 400t to more than 1,200t today. There have been suggestions that this is a prelude to Russia adopting a “hard currency” standard in the face of continuous debasement of fiat currencies by developed nation central banks, but that is beyond the remit of this essay.

Are the BRICs broken?

In an article published in July 2014 by Bruegal – Is the BRIC rise over? Jim O’Neill discusses the future with reference to the establishment of a joint development bank:-

Some observers believed that the whole notion of a grouping of Brazil, Russia, India and China never made any sound sense because beyond having a lot of people, they didn’t share anything else in common. In particular, two are democracies, and two are not, obviously, China and Russia.  Similarly, two are major commodity producers, Brazil and Russia, the other two, not. And their levels of wealth are quite different, with Brazil and Russia well above $10,000, China around $ 7-8 k, and India less than $ 2k per head.  And the sceptic would follow all of this by saying, the only reason why Brazil and Russia grew so well in the past decade was simply due to a persistent boom in commodity prices, and once that finished, as appears to be the case now, then their economies would lose their shine, as indeed appears to be the case.  Throw in that China would inevitably be caught by its own significant challenges at some point, which the doubters would say, is now, then all is left is India, and if it weren’t for the election of Modi recently, there has not been a lot to justify structural optimism about that country recently.

…I do believe each of Brazil and Russia have got some challenges to face, that they are not yet confronting, which at the core is to reduce their dependency to the commodity cycle, and while there are many differences between them, they do both need to become more competitive and entrepreneurial outside of commodities and to boost private sector investment.

The development has caused much political jawboning but I suspect its impact will be small in the near-term.

Looking again at the figures for capital flows, Brazil appeared to be in better shape, but Russian FDI has been positive in every quarter since 2008 until the most recent outflow in Q3 2014.

Consumer confidence in Brazil has remained more robust, possibly this is due to innate Latin optimism but it may be partly in expectation of the forthcoming Olympics. The games will take place in Rio, reminding us of the high urbanisation rates in Brazil, 85.4%. This is not dissimilar to Russia at 73.9% but substantially higher than China 54.4% and India 32.4%. Interestingly US urbanisation is 81.4% – but US GDP per capita is significantly higher.

Russia

The Peterson Institute – Russia’s Economic Situation Is Worse than It May Appear from early December 2014 painted a gloomy picture of the prospects:-

The Russian economy suffers from three severe blows: ever worsening structural policies, financial sanctions from the West, and a falling oil price. 

…Russia is experiencing large capital outflows, expected to reach $120 billion. Because of Western financial sanctions, they are set to continue. The large outflows erupted in March as investors anticipated financial sanctions, which hit in July and in effect have closed financial markets to Russia. No significant international financial institution dares to take the legal risk of lending Russia money today. 

Not wishing to be left out of the rhetoric on Russia’s demise, in late December the ECFR – What will be the consequences of the Russian currency crisis?:-

The watershed moment was the imposition of the third round of Western sanctions, which cut Russian companies off from the world’s financial markets. Along with falling oil prices (a key market factor), this caused market players to reassess the risks. Before the introduction of sanctions, the ratio of external debt to foreign exchange reserves (at 1.4) was not particularly worrying. But the fact that companies could no longer refinance their debt on external markets necessitated a rethink. It became clear that, with export revenues falling because of lower oil prices, companies would accumulate excess currency in their accounts. The supply of currency in the market from exporters (many of whom also had large debts) declined sharply, while demand from the debtor companies increased.

In October 2014 the Central Bank was forced to spend another $26 billion to support the rouble. After that, preserving the country’s reserves became the priority, so in November, the bank’s intervention fell to $10 billion. So everything was in place for a currency crisis and this is why the Russian Minister for the Economy called it “the perfect storm”. The storm was only halted by a sharp increase in the Central Bank’s interest rate and by informal pressure on companies that brought about a speedy decline in foreign exchange trading.

…So the double devaluation of the rouble will be felt in rising price and shrinking consumption. According to the Gaidar Institute for Economic Policy, this will add at least 10–12 percentage points to normal inflation, which will reach 15-20 percent. Import substitution options are relatively limited: large-scale import substitution would require significant investment and, at the moment, the resources for this are not there. And a fall in consumption (as a result of the falling purchasing power of households) will cause a decline in production.

According to the Central Bank’s December forecast, GDP in 2015 may fall by 4.5–4.8 percent. This is what the bank calls a “stress scenario”, and it assumes that the oil price will stay at $60 a barrel and Western sanctions will remain in place. In fact, this scenario seems to be the most realistic; any other scenario would involve either the lifting of sanctions or a rise in the oil price to $80 or even $100.

The dismal theme was inevitably taken up by CFR – The Russian Crisis: Early Days in early January:-

The most likely trigger for a future crisis resides in the financial sector. December’s $2 billion bailout of Trust Bank, coupled with news of large and potentially open-ended support for VTB Bank and Gazprombank, highlight the rapidly escalating costs of the crisis for the financial sector as state banks and energy companies face high dollar-denominated debt payments and falling revenues. Rising bad loans, falling equity values, and soaring foreign-currency debt are devastating balance sheets. As foreign banks pull back their support, the combination of sanctions, oil prices, and rising nonperforming loans is creating a toxic mix for Russian banks. So far, a crisis has been deferred by the belief that the central bank can and will fully stand behind the banking system. If any doubt creeps in about the strength of that commitment, a run will quickly materialize.

…Sanctions are a force multiplier. Western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, Western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Russia could have weathered an oil shock or sanctions alone, but not both together.

…Measured by the severity of recent market moves, Russia is in crisis. But from a broader perspective, a comprehensive economic and financial crisis would cause a far greater degree of financial distress for the Russian people. Companies would find working capital unavailable; interest rates of 17 percent (or higher) and exchange rate depreciation would cause a spike in import prices; and capital expenditure would crater. All this would generate sharp increases in unemployment and a far greater fall in gross domestic product (GDP) than we have seen so far.

Chatham House – Troubled Times Stagnation, Sanctions and the Prospects for Economic Reform in Russia – published at the end of February, goes into more depth, concluding:-

Over the past three decades, a precipitous drop in oil prices (and a concomitant sharp reduction in rents) has resulted in economic reforms being undertaken in Russia. Mikhail Gorbachev’s perestroika emerged after the fall in oil prices in 1986. Putin’s earlier, more liberal economic policies were carried out after oil dropped to close to $10 a barrel in 1999. And Dmitri Medvedev’s modernization agenda was strongest in the aftermath of the global recession of 2008–09.

Unfortunately, the prospects for a similar surge in economic reform in Russia today are less good. The unfavourable geopolitical environment threatens to change the trajectory of political and economic development in Russia for the worse. By boosting factions within Russia’s policy elite who favour increased state control and less integration with the global economy, poor relations with the West threaten to reduce the prospects for a market-oriented turn in economic policy. As a result, the prevailing system of political economy that is in such urgent need of transformation may in fact be preserved in a more ossified form. Instead of responding to adversity through openness, Russia may take the historically well-trodden path of using a threatening international environment to justify centralization and international isolation in order to strengthen the existing ruling elite.

Thus, while Western sanctions were not necessarily intended to strengthen statist factions within Russia and force the country away from the global economy, this may prove to be an unintended but important outcome. Consequently, Russia appears to be locked into a path of economic policy inertia, as powerful constituencies that benefit from the existing system are strengthened by the showdown with the West. While Russia may have ‘won’ Crimea, and may even succeed in ensuring that Ukraine is not ‘won’ by the West, the price of victory may be a deterioration in long-term prospects for socioeconomic development.

This is how the USDRUB has performed during the last 12 months, the first interest rate cut (from 17% to 15% took place on 30th January, the RUB fell 3% on the day to around USDRUB 70, since then the RUB has appreciated to around USDRUB 55-55:-

USDRUB 1yr

Source: Yahoo Finance

What caused the RUB to return from the brink was a recovery in the oil price and a slight improvement in the politics of the Ukraine. The Minsk II Agreement, whilst only partially observed, has curtailed an escalation of the Ukrainian civil war. Capital outflows which were $77bln in Q4 2014 slowed to $32bln in Q1 2015. Ironically, the rebound in the currency and appreciation in the Micex index will probably delay the necessary structural reforms which are needed to reinvigorate the economy.

Brazil

At the end of February the Economist – Brazil – In a quagmiredescribed the challenges facing President Rousseff’s weak government:-

Brazil’s economy is in a mess, with far bigger problems than the government will admit or investors seem to register. The torpid stagnation into which it fell in 2013 is becoming a full-blown—and probably prolonged—recession, as high inflation squeezes wages and consumers’ debt payments rise (see article). Investment, already down by 8% from a year ago, could fall much further. A vast corruption scandal at Petrobras, the state-controlled oil giant, has ensnared several of the country’s biggest construction firms and paralysed capital spending in swathes of the economy, at least until the prosecutors and auditors have done their work. The real has fallen by 30% against the dollar since May 2013: a necessary shift, but one that adds to the burden of the $40 billion in foreign debt owed by Brazilian companies that falls due this year.

…Ideally, Brazil would offset this fiscal squeeze with looser monetary policy. But because of the country’s hyperinflationary past, as well as more recent mistakes—the Central Bank bent to the president’s will, ignored its inflation target and foolishly slashed its benchmark rate in 2011-12—the room for manoeuvre today is limited. With inflation still above its target, the Central Bank cannot cut its benchmark rate from today’s level of 12.25% without risking further loss of credibility and sapping investor confidence. A fiscal squeeze and high interest rates spell pain for Brazilian firms and households and a slower return to growth.

Yet the president’s weakness is also an opportunity—and for Mr Levy in particular. He is now indispensable. He should build bridges to Mr Cunha, while making it clear that if Congress tries to extract a budgetary price for its support, that will lead to cuts elsewhere. The recovery of fiscal responsibility must be lasting for business confidence and investment to return. But the sooner the fiscal adjustment sticks, the sooner the Central Bank can start cutting interest rates.

More is needed for Brazil to return to rapid and sustained growth. It may be too much to expect Ms Rousseff to overhaul the archaic labour laws that have helped to throttle productivity, but she should at least try to simplify taxes and cut mindless red tape. There are tentative signs that the government will scale back industrial policy and encourage more international trade in what remains an over-protected economy.

Brazil is not the only member of the BRICS quintet of large emerging economies to be in trouble. Russia’s economy, in particular, has been battered by war, sanctions and dependence on oil. For all its problems, Brazil is not in as big a mess as Russia. It has a large and diversified private sector and robust democratic institutions. But its woes go deeper than many realise. The time to put them right is now.

Earlier this week the Peterson Institute – The Rescue of Brazil summed up the current situation:-

The Brazilian economy has all the characteristics of a country under the tutelage of an International Monetary Fund (IMF) program. The list of its economic imbalances is endless: a rampant current account deficit in excess of 4 percent of GDP, an exchange rate that has long been overvalued but that has collapsed in just a few months, a public debt ratio to GDP in a rapid upward trend, a fiscal deficit of over 6 percent of GDP despite a high tax burden, an annual inflation rate of nearly 8 percent that has unanchored inflation expectations, an accelerated growth of wages well above their very low productivity. The scandal of the oil company Petrobras, the latest in a long series of political corruption scandals, is the straw that could break the back of investors’ patience, the tolerance of Brazilian citizens, and the stamina of the world’s seventh largest economy. The Petrobras scandal has far-reaching ramifications throughout the economy and society, paralyzing activity and collapsing both business and consumer confidence to unprecedented levels. The mass street demonstrations of recent weeks are the most graphic example of this dissatisfaction.

In another Op-ed Peterson – Brazil’s Investment: A Maze in One’s Own Navel the authors point to the relatively closed nature of the Brazilian economy for the lack of international investment:-

Consider the most common explanations for why Brazil’s investment rate shows persistent apathy: Excessive taxes levied on businesses discourage fixed capital formation; poor infrastructure—including ongoing problems in the energy sector—increases production costs; high wages relative to worker productivity weigh on firms, hampering investment; an opaque business environment characterized by obsolete and excessive licensing requirements reduce firms’ incentives to invest; an institutional environment marked by subsidized lending that favors certain firms over others misallocates scarce domestic savings; “state capitalism” and excessive government intervention crowd out the private sector. Evidently, all of these reasons have a role in explaining investment inertia. But, importantly, they are all homegrown.

Perhaps Brazil’s sclerotic investment has something to do with its long-standing lack of openness. It is no mystery that Brazil is one of the most closed economies in the world according to any metric that one chooses to gauge the degree of openness. It is no coincidence that this is also the most striking difference between Brazil and its emerging-market peers: Brazil is more closed than Mexico, Colombia, Peru, and Chile; all members of the Pacific Alliance, their growth rates are higher than Brazil’s. Brazil is also less open than India, China, Turkey, and South Africa.

There is an extensive academic and empirical literature on the relationship between investment and openness (see, for example, the Peterson Institute’s video on trade and investment). Several research papers show that the more open an economy is to international trade, the more foreign direct investment it receives. The more foreign direct investment it receives, the greater the availability of resources for domestic investment. Competition is also crucial: Economies that are more open induce greater competition between local and foreign firms, creating incentives for innovation and investment by domestic companies.

Unfortunately, Brazil is still fairly close-minded when it comes to these issues. Fears of losing market share and the old litany of “selling the country to foreigners” still dominate the national debate.

The weakening of the BRL has continued for rather longer than the decline in the RUB, perhaps as a result of the Petrobras “Car Wash” scandal, but a modicum of stability has been regained since early April, as the chart below shows:-

USDBRL 1yr

Source: Yahoo Finance

Commodity correlation

Both Brazil and Russia are large commodity exporters. The table below is for 2011 but a clear picture emerges:-

Commodity Russia Brazil
Oil & Products $190bln $22bln
Iron Ore & Products $19bln $54bln

Source: CIA Factbook

Platts reported that Iron Ore prices (62% Fe Iron Ore Index) had risen since the end of April to $57.75/dmt CFR North China, up $2.25 on 4th May. It is probably too soon to confirm that Iron Ore prices have bottomed but with oil prices now significantly higher ($60/bbl) since their lows ($45/bbl) seen in March. Copper has also begun to rise – perhaps in response to the performance of the Chinese stock market – rising from lows of less than $2.50/lb in January to $2.94/lb this week.

The chart below shows the relative performance of the CRB Index and the GSCI Index which has a heavier weighting to energy:-

GSCI and CRB 1 yr

Source: FT

The general recovery in commodity prices is still nascent but it is supportive for both Brazil and Russia in the near term. Both countries have benefitted from devaluation relative to their export partners as this table illustrates:-

Russia Exports Brazil Exports
Netherlands 10.70% China 17%
Germany 8.20% United States 11.10%
China 6.80% Argentina 7.40%
Italy 5.50% Netherlands 6.20%
Ukraine 5%
Turkey 4.90%
Belarus 4.10%
Japan 4.00%

Source: CIA Factbook

Asset prices and investment opportunities

Real Estate

Russian real estate prices have been subdued during the last few years, but the underlying market has been active. The lack of price appreciation is due to a massive increase in house building. 912,000 new homes were built in 2013 – the highest number since 1989. Prices are lower in 10 out 46 regions, however, this new supply should be viewed in the context of the housing bubble which drove prices higher by 436% between 2000 and 2007:-

russia-house-prices-2

Source: Global Property Guide

Brazilian property, by contrast, has risen in price. In inflation adjusted terms, prices increased 7.6% in 2013, although these increases are less than those seen during 2011/2012. Rio continues to outperform (+15.2% vs +13.9% nationally) and the forthcoming Olympics should support prices into 2016:-

brazil-house-prices-1

Source: Global Property Guide

Neither of these markets present obvious opportunities. Brazilian prices are likely to moderate in response to higher interest rates whilst increased Russian supply will hang over the market for the foreseeable future. The rental yields in the table are somewhat out of date but clearly offer a less attractive income than government bonds:-

BRAZIL November 16th 2013
SAO PAULO – Apartments
Property Size Yield
80 sq. m. 5.68%
120 sq. m. 4.71%
200 sq. m. 6.15%
350 sq. m. 6.23%
RIO DE JANEIRO -Apartments
60 sq. m. 4.40%
90 sq. m. 3.82%
120 sq. m. 3.91%
200 sq. m. 4.89%
RUSSIA June 24th 2014
MOSCOW – Apartments
Property Size Yield
75 sq. m. 3.84%
120 sq. m. 3.22%
160 sq. m. 3.07%
275 sq. m. 3.42%
ST. PETERSBURG – Apartments
60 sq. m. 6.20%
120 sq. m. 4.36%
175 sq. m. 3.46%

Source: Global Property Guide

Stocks

The chart below compares the performance of Micex and the Bovespa indices over the past year. The devaluation of the RUB has been greater than that of the BRL – this accounts for the majority of the divergence:-

MICEX vs BOVESPA 1yr

Source: FT

Looking more closely at the components of the two indices there is a marked energy and commodity bias, the table below looks at the largest stocks, representing roughly 80% of each index:-

Ticker Stock Weight Sector Free-float
GAZP GAZPROM 15 Energy 46%
SBER Sberbank 14.01 Financial Services 48%
LKOH ОАО “LUKOIL” 13.97 Energy 57%
ROSN Rosneft 5.84 Energy 15%
URKA Uralkali 5.19 Commodity 45%
GMKN “OJSC “MMC “NORILSK NICKEL” 4.79 Commodity 24%
NVTK JSC “NOVATEK” 3.93 Energy 18%
SNGS Surgutneftegas 3.49 Energy 25%
RTKM Rostelecom 3.03 Telecomm 43%
TATN TATNEFT 3.01 Energy 32%
VTBR JSC VTB Bank 2.97 Financial Services 25%
MGNT OJSC “Magnit” 2.22 Commodity 24%
TRNFP Transneft, Pref 2.21 Energy 100%
TOTAL WEIGHTING 79.66
Ticker Stock Weight Sector
ITUB4 ITAUUNIBANCO 10.764 Financial Services
BBDC4 BRADESCO 8.2 Financial Services
ABEV3 AMBEV S/A 7.368 Brewing
PETR4 PETROBRAS 6.045 Energy
PETR3 PETROBRAS 4.416 Energy
VALE5 VALE 3.971 Commodity
BRFS3 BRF SA 3.741 Commodity
VALE3 VALE 3.558 Commodity
ITSA4 ITAUSA 3.433 Financial Services
CIEL3 CIELO 3.37 Financial Services
JBSS3 JBS 2.705 Commodity
UGPA3 ULTRAPAR 2.487 Energy
BBSE3 BBSEGURIDADE 2.47 Financial Services
BVMF3 BMFBOVESPA 2.393 Financial Services
BBAS3 BRASIL 2.344 Financial Services
EMBR3 EMBRAER 1.823 Aerospace
VIVT4 TELEF BRASIL 1.733 Telecomm
PCAR4 P.ACUCAR-CBD 1.663 Retail
KROT3 KROTON 1.49 Support Services
CCRO3 CCR SA 1.48 Transport
BBDC3 BRADESCO 1.445 Financial Services
LREN3 LOJAS RENNER 1.364 Retail
CMIG4 CEMIG 1.207 Energy
CRUZ3 SOUZA CRUZ 1.027 Tobacco
TOTAL WEIGHTING 80.497

Source: Moscow Exchange and BMF Bovespa

The Russian index is clearly more exposed to energy, 48% and commodities, 12%, than the Brazilian index, where the weightings are 14 % each for energy and commodities. It is important to note that the Bovespa index adjusts for the “free-float” for each stock whilst Micex does not, however under Micex rules no stock may account for more than 15% of the index. The free-float adjusted weight of energy and commodities is therefore 18% and 4% respectively.

On the basis of this analysis, currency fluctuation has been the predominant influence on stock market returns, followed by energy and commodity prices. The PE ratios of Micex and Bovespa at roughly 8 times, are undemanding but neither the economic nor the political situation in either country is conducive to long term growth. I expect both markets to continue to recover, although Micex will probably fair best. Longer term, economic reform is required to raise the structural rate of growth.

Although not mentioned in any of the articles quoted above, Russian demographics are unfavourable as this article from Yale University – Russian Demographics: The Perfect Storm – makes clear:-

One measure of an economically secure homeland is women’s willingness to raise children with the expectation of opportunities for good health, education and livelihoods. On that front, Russia confronts a perfect storm – as fertility rates plummeted to 1.2 births per women in the late 1990s and now stand at 1.7 births per women. “Russia’s population will most likely decline in the coming decades, perhaps reaching an eventual size in 2100 that’s similar to its 1950 level of around 100 million,” write demographers Joseph Chamie and Barry Mirkin. The country has high mortality rates due to elevated rates of smoking, alcohol consumption and obesity. Investment on healthcare is low. Over the next decade, Russia’s labor force is expected to shrink by about 15 percent. Other countries with low fertility rates turn to immigration to pick up the slack. While immigrants make up about 8 percent of Russia’s population, the nation has a reputation for nationalism and xenophobia, and fertility rates are even lower in neighboring Belarus, Ukraine and Lithuania, all possible sources of immigration.

Brazil has better demographic prospects in the near term, but its population growth is now not much above the world average and by 2050 it too will be entering a demographic “Götterdämmerung” of declining population. A freer, more open economy is the most efficient method of deflecting the effects of the long term demographic deficits – stock markets reflect this in their risk premiums.

Bonds

Brazilian government bonds offer a real return after adjusting for inflation (10 yr real-yield 4.77%) however, as this March 2015 article from Forbes – With Currency In Gutter And Bad News Galore, Brazil Bonds A Buy makes clear, there are significant risks:-

…the major headwinds against Brazil are domestic. The fact that China is slowing down is no longer a fright factor. What keeps investors up at night is the possibility of Brazil losing its investment grade.  But last month, Standard & Poor’s credit analysts were in Brasilia and left saying that a downgrade to junk was unlikely.

There is the risk of impeachment and the resignation of Finance Minister Joaquim Levy, but that is already priced into the market with local interest rate futures trading over 14.35% compared to the actual benchmark rate of 12.75%.  Moreover, the impeachment of Dilma Rousseff and the resignation of Levy are worse case scenarios with low probabilities. Worries over energy rationing have subsided.

I believe Brazilian bonds offer good value, even at these levels, the central banks has taken a draconian approach to inflation and the BRL has recovered some of the ground it lost during the last year. Exports to the US should improve and signs of a recovery in European growth will benefit the BRL further.

Russian government bonds look less compelling – with headline inflation at 16.9% and 10 yr yields of only 10.71% one might be inclined to avoid them on the grounds on negative real yield – but a case can be made for lower inflation and a resurgence in the value of the RUB as this article from RT – Russia’s ‘junk’ bonds paying off handsomely suggests:-

“It’s very simple advice. Bonds are much more attractive than a year ago. Risks related to the ruble have subsided, inflation is likely to moderate, the BoP (Balance of Payments) and budget situation look reasonably strong and that is why the outlook is quite favorable,” Vladimir Kolychev, Chief Economist for Russia at VTB Capital

“Unless geopolitics interferes, we forecast Russian rates are likely to repeat Hungary’s three-year bull market run in the years ahead,” Bank of America’s head of emerging EMEA economics David Hauner

In a March 11 note, Russia’s Goldman Sachs analysts wrote “Russian bonds are both cyclically and structurally under-priced,” in a big part due devaluation expectations of the ruble stabilizing.

I remain less convinced about the value of Russian bonds but with a low debt to GDP ratio they may perform well.

Here are the recent price charts for 10 year maturities:-

russia-government-bond-yield

Source: Trading Economics

brazil-government-bond-yield

Source: Trading Economics

As inflation declines in both countries their bond markets will continue to rise in expectation of further central bank rate cuts. This will also support stocks but bonds will lead the rally, especially if future growth in Brazil or Russia should disappoint.

German growth prospects – the ECB and Russian gas

400dpiLogo

Macro Letter – No 19 – 12-09-2014

German growth prospects – the ECB and Russian gas

  • The ECB cut rates and implemented the first phase of OMT
  • Russia continues to retaliate against European sanctions
  • European Natural Gas prices have risen but shortages seem unlikely

Last week I started researching the risks to German growth of a gas embargo by Russia. This could become a reality if the geo-political situation in the Ukraine should deteriorate further. Before I could put pen to paper, ECB Governor Mario Draghi had implemented a pre-emptive strike; cutting the repo rate to 0.05% and announcing the ECBs intention to embark on outright monetary transactions (OMT) initially in the asset backed securities (ABS) market. The ECB – Statement – provides fuller details. It’s still a little light on content but JP Morgan estimates that the ECB will purchase Eur 47bln of newly issued ABS securities over a three year period.

Whilst these measures stopped short of purchasing Eurozone (EZ) sovereign bonds, European government bond markets reacted favourably. French T-Bill rates turned negative, so too did the yield on 2 year Irish Gilts. The Spanish, not to be outdone, issued 50 year Bonos at a yield of 4%.

Here is a table of some European short term rates from Monday 8th September: –

 

Security Yield Spread vs Germany Inflation Real Yield
Austria 1Y -0.032 0.027 1.8 -1.832
Belgium 3M -0.05 0.029 0 -0.05
Belgium 6M -0.025 0.038 0 -0.025
Belgium 1Y -0.043 0.016 0 -0.043
Bulgaria 1Y 1 1.059 -1 2
Croatia 6M 0.95 1.013 -0.1 1.05
Croatia 9M 1.15 1.218 -0.1 1.25
Croatia 1Y 1.38 1.439 -0.1 1.48
Czech Republic 3M 0.01 0.089 0.5 -0.49
Czech Republic 6M 0.03 0.093 0.5 -0.47
Czech Republic 1Y 0.11 0.169 0.5 -0.39
Denmark 3M -0.06 0.019 0.8 -0.86
Denmark 6M -0.01 0.053 0.8 -0.81
Denmark 1Y 0.15 0.209 0.8 -0.65
France 3M -0.027 0.052 0.5 -0.527
France 6M -0.03 0.033 0.5 -0.53
France 9M -0.011 0.057 0.5 -0.511
France 1Y -0.029 0.03 0.5 -0.529
Germany 3M -0.079 0 0.8 -0.879
Germany 6M -0.063 0 0.8 -0.863
Germany 9M -0.068 0 0.8 -0.868
Germany 1Y -0.059 0 0.8 -0.859
Greece 3M 1.47 1.549 -0.7 2.17
Greece 6M 1.86 1.923 -0.7 2.56
Hungary 3M 1.52 1.599 0.1 1.42
Hungary 6M 1.55 1.613 0.1 1.45
Hungary 1Y 1.84 1.899 0.1 1.74
Ireland 1Y 0.08 0.139 0.3 -0.22
Italy 3M 0.083 0.162 -0.1 0.183
Italy 6M 0.144 0.207 -0.1 0.244
Italy 9M 0.193 0.261 -0.1 0.293
Italy 1Y 0.217 0.276 -0.1 0.317
Latvia 3M 0.2 0.279 0.8 -0.6
Latvia 6M 0.374 0.437 0.8 -0.426
Latvia 1Y 0.258 0.317 0.8 -0.542
Lithuania 6M 0.3 0.363 0.2 0.1
Lithuania 1Y 0.4 0.459 0.2 0.2
Netherlands 3M -0.072 0.007 1 -1.072
Netherlands 6M -0.092 -0.029 1 -1.092
Norway 3M 1.259 1.338 2.2 -0.941
Norway 6M 1.118 1.181 2.2 -1.082
Norway 9M 1.248 1.316 2.2 -0.952
Norway 1Y 1.276 1.335 2.2 -0.924
Poland 3M 2.65 2.729 -0.2 2.85
Poland 1Y 2.044 2.103 -0.2 2.244
Portugal 6M 0.15 0.229 -0.9 1.05
Romania 6M 2.289 2.352 1 1.289
Romania 1Y 2.25 2.309 1 1.25
Spain 3M 0.058 0.137 -0.5 0.558
Spain 6M 0.072 0.135 -0.5 0.572
Spain 1Y 0.153 0.212 -0.5 0.653
Sweden 3M 0.211 0.29 0 0.211
Sweden 6M 0.202 0.265 0 0.202
Switzerland 3M -0.11 -0.031 0.1 -0.21
Switzerland 6M -0.05 0.013 0.1 -0.15
Switzerland 1Y 0.05 0.109 0.1 -0.05
UK 3M Yield 0.43 0.509 1.6 -1.17
UK 6M Yield 0.546 0.609 1.6 -1.054
UK 1Y Yield 0.509 0.568 1.6 -1.091

Source: Investing.com and Trading Economics

I have omitted Finland since I was unable to locate prices for shorter maturity than 2 year. Two year Finnish bonds yield -0.026% and inflation is running at +0.8%.

Europe and its periphery are benefitting from low or negative real interest rates. Even this seems insufficient to stimulate robust, sustainable growth.

The Economic Cost of Geo-politics

When I last wrote about the Ukraine earlier this year, I concluded: –

I believe the Ukrainian situation may reduce the likelihood of a rapid increase in tapering by the Fed and increase the prospects for ECB Outright Monetary Transactions. In aggregate that amounts to more QE which should support stocks and higher yielding bonds.

To date, the economic impact on Europe has been limited. The fed have continued to taper in the face of a robust recovery from weak US Q1 GDP data. The EZ, however, has struggled to follow the US lead and the ECB has been forced to act repeatedly to avert further disinflation.

As we head into the winter, it seems an appropriate time to review European Natural Gas, in light of the escalation of tension between Russia and NATO. This is especially pertinent to Germany where, along with its north European neighbours, winter Natural Gas demand is three times greater than during the summer.

This week has seen an escalation of European sanctions against Russia. The European Commission (EC) has curtailed the ability of three of the largest Russian Oil companies to raise capital beyond a one month maturity. Since around half of all longer term gas contracts are priced in relation to the oil price this seems a strange way to avoid disrupting the European gas price. The Russian’s have responded by threatening to ban aircraft access to Russian airspace and, more significantly, to disrupt gas supplies. The Financial Times – Russia aims to choke off gas re-exports to Ukraine picks up on this theme: –

In an effort to offset lost volumes from Russia, Ukraine has sought to secure more gas from the EU, principally through “reverse flows” – re-exports of Russian gas via countries such as Poland, Hungary and Slovakia. But Gazprom, Russia’s state gas company, has long complained about the re-exports, with Alexei Miller, its chief executive, denouncing them as a “semi-fraudulent mechanism”. Senior officials in the European Commission and in eastern European governments say Russia has been raising the prospect of reducing export volumes so their customers have no gas left over for reverse flows to Ukraine. “They say this pretty openly,” said one central European ambassador.

To understand the importance of Russian energy exports to Europe the following table is a useful guide: –

Main origin of primary energy imports - Source EuroStat

Source: Eurostat

An insight into EU energy policy is provided by the European Commission – Energy Economic Developments in Europepublished in Q1 2014. The section on Natural Gas starts at Page 33:-

In the European Union the majority of natural gas is supplied through bilateral long-term contracts which are negotiated between two parties, importer and exporter, and traditionally indexed to the price of oil. Currently, half of natural gas supply in the EU is still indexed to oil while across the EU a wide variation in import prices of piped gas and LNG has been observed. This is remarkable as at the same time a growing share of gas is traded on spot markets where short-term contracts are concluded on the basis of the market price determined by actual demand and supply. Spot market prices in the EU have been constantly lower than long-term contracts’ prices, at least since 2005.

In both the US and in the EU, spot-market gas prices have progressed in a similar fashion over the past decade and have followed the movements in the oil price.

In 2005, however, these gas prices have started to clearly fall below the level of the oil price. Between 2008 and 2009 they fell significantly in both regions, likely as a consequence of declining demand due to the economic downturn.

The fall in energy consumption has led to an excess supply of gas on the gas markets around the world and both US and the UK spot markets temporarily converged, trading at around 4/5 USD/MBtu in mid-2009, while the German hub prices fell less evidently, trading still above 8 USD/MBtu in 2009. From 2007 onwards, the US gas spot price has fallen under the price level of the other gas spot markets, which most likely reflects the effect of the surge in domestic shale gas supply. This becomes quite clear after 2009, when energy consumption picked up again following the recovery of the economy. Statistics from more recent years show that while the US spot prices remained low (around 4 USD/Btu in 2011), the EU spot prices (both in the UK and German hub) kept increasing. Wholesale gas prices have continued to rise in the EU while economic activity contracted and consequently natural gas consumption in the EU has been declining: the first half of 2012 represented the EU’s lowest first half year consumption of the last ten years. It was 7% and 14% less than the first half of 2011 and 2010 respectively.

The continued rise in EU wholesale gas prices despite the slump in gas demand and the lower gas spot prices vividly depicts the kind of vulnerability the EU is exposed to due to its high import dependency: as the Asian markets offer higher returns and more robust demand, gas producing countries have increased their trade with Asia lowering supply to Europe. As a consequence wholesale gas prices in Europe have increased while in the US, which now can rely more heavily on domestic production, prices have remained low. US prices were shielded from potential upwards pressure from export demand because of export restrictions (generally expected to be gradually lifted). Furthermore, the impacts on the EU have been further aggravated in this context due to the oil-price indexation of many long-term gas import contracts.

This chart from Schneider Electric shows the divergence in gas prices between US (yellow) EU (red) and Asia (blue): –

Natural Gas price comparison - Schneider Electric-page1

Source: Schneider-Electric

European Natural Gas prices are down from their December 2013 highs but have recently started to recover from the July 2014 lows. The chart below is for Dutch TTF (Title Transfer Facility) Gas: –

TTF Gas Daily Reference Prices - source EEX

Source: EEX

By way of comparison here are the one year charts for US Natural Gas and West Texas Intermediate Crude Oil: –

US Spot Nat Gas 1 yr

Source: Barchart.com

Understandably, the US Natural gas market is less concerned about Russian sanctions, and also cognisant of the long lead time between receiving an export license and the US capacity to increase exports of LNG.

WTI Spot 1 yr

Source: Barchart.com

The US Crude Oil market is seemingly unperturbed by the politics of Russia or the Middle East. Or, perhaps, it is the combination of continuous improvements in US supply coupled with rising concern about the slowing of China. A similar pattern is evident in the Brent Crude price.

Returning to Europe: establishing a generic price for European Natural Gas is difficult as this article from Natural Gas Europe – European Natural Gas: So What’s the Real Price? explains. It is also worth noting the seasonality in gas prices. The last major spikes occurred in February/March 2013 and January/February 2012, coinciding with the advent of cold European winter weather.

The EU Commission and national governments are taking no chances this year, as this article from Reuters –  Europe drafts emergency energy plan with eye on Russia gas shut-down makes plain:-

A source at the EU Commission said it was considering a ban on the practise of re-selling to bolster reserves.

“In the short-term, we are very worried about winter supplies in southeast Europe,” said the source, who has direct knowledge of the Commission’s energy emergency plans.

“Our best hope in case of a cut is emergency measure 994/2010 which could prevent LNG from leaving Europe as well as limit industrial gas use in order to protect households,” the source said.

European Union Regulation number 994/2010, passed in 2010 to safeguard gas supplies, could include banning gas companies from selling LNG tankers outside of Europe, keeping more gas in reserve, and ordering industry to stop using gas.

The Russian threat to reduce gas supplies to the EU in order to reduce the re-sale of gas to other countries seems rather hollow when the EC would appear to be preparing to take these steps anyway. Nonetheless, if Russia reduces supply what can the EU importing countries do?

Norway is not in a position to make up the shortfall. 96% of Norwegian gas is already exported. At the Flame gas conference in Amsterdam this May, Statoil spokesman Rune Bjornson told delegates, “I think many producers, including us, can adjust on the margins, but most of the production capacity from Norway is typically designed to produce at maximum in winter and that is what we’ll do.”

European governments have, however,  been actively improving storage capabilities. This process has been on-going since the first Russian/Ukrainian dispute in 2006 – according to recent estimates EU-28 storage is at 90% of capacity which is around 74 bcm. Businessweek – EU Need for Russian Gas Via Ukraine Wanes as Stores Fill gives a good overview: –

EU-28 Gas Storage-Bloomberg

Source: Bloomberg

Europe’s reliance on Russian natural gas shipments via Ukraine is declining after the region pumped a record volume of the fuel into underground inventories, minimizing the risk of shortages during the coming winter.

Given that Geo-politics seems to have had little impact on the performance of world financial markets in the long run should we be worried in the short run and especially with respect to Germany this winter?

The Council for Foreign Relations – The Geopolitical Paradox: Dangerous World, Resilient Marketsopines on this subject this week. The article is concerned mainly about disruption to the oil market: –

It is often noted that the vast majority of postwar recessions have been associated with energy shocks. Rising turbulence in the Middle East has raised the prospect of a long-term disruption in the region, where national borders could be rewritten through violent upheavals. The threat of a Russian cutoff of gas to Europe also hangs over markets. Consequently, it is surprising that energy markets, and oil markets in particular, do not ask for a premium in futures markets for secure energy supplies. At present, current oil contracts are higher than longer-term futures contracts, and though there are technical reasons for this downward trend (“backwardation”), it hardly is suggestive of disrupted or anxious markets.

They go on to discuss Europe describing it as the weak link: –

There are a number of reasons why Europe is the channel through which political risk could reverberate in the global economy. Europe is most vulnerable to disruptions in trade and financial relationships with Russia, though I have argued elsewhere that these costs may be small relative to the costs of inaction. Weak growth in China and elsewhere in the emerging world could significantly affect exports, particularly in Germany. Significantly, though, Europe also faces these challenges at a time of economic stress and limited resilience. Growth in the region has disappointed and leading indicators have tilted downward. Further, concern about deflation is beginning to weigh on sentiment and investment. The persistence of low inflation—well below the ECB’s goal of around 2 percent—is symptomatic of deeper structural problems facing the eurozone, including an incomplete monetary union, deep-seated competitiveness problems in the periphery, and devastatingly high unemployment. Homegrown political risks also threaten to add to the turmoil, as rising discontent within Europe over the costs of austerity is undermining governing parties and fueling populism. The result is a monetary union with little capacity or resilience to defend against shocks. The ECB has responded to these risks with interest-rate cuts and asset purchases, and is expected to move to quantitative easing later this year or early next, but the move comes late, and is unlikely to do more than address the headwinds associated with the ongoing banking reform and continued fiscal austerity. Overall, a return to crisis is an increasing concern and political risks could be the trigger.

The limited impact on financial markets since the beginning of the Ukrainian crisis in February can be seen in the table below: –

Market/Security Price 28 Feb Price 9 Sept Change % Change
TTF Gas 22.85 19.78 -3.07 -13.44
GPL Gas 23.23 20.06 -3.17 -13.65
US Nat Gas 4.74 3.96 -0.78 -16.46
WTI 102.58 91.71 -10.87 -10.60
E.ON 13.82 14.31 0.49 3.55
RWE 29.02 31.43 2.41 8.30
DAX 9692 9700 8 0.08
S&P500 1859.45 1995.69 136.24 7.33
10yr Bund yield 1.63 1 -0.63 -38.65
Gold 1327.6 1249.4 -78.2 -5.89

 

Source: EEX and Investing.com

Germany – the weakest link?

Since the Hartz reforms of 2002 Germany has emerged from the strain of unification to re-establish its credentials as the powerhouse of European growth. Latterly – and especially since 2008 – its preeminent reputation has become tarnished. The Bundesbank raised its growth forecast in June to 1.9% for 2014 vs its December 2013 forecast of 1.7%. Their optimism has been dented since then by concerns about the politics of Eastern Europe. The Deutsche Bundesbank – August 2014 Monthly Report makes the following observations: –

The global economy appears to have got off to a good start in the second half of the year. As regards the industrial countries, Japan’s economy is expected to rebound in the third quarter. The US economy is likely to remain on a growth path, although it will probably be impossible to maintain the rapid pace of growth attained in the second quarter of the year. Following second- quarter stagnation, the euro area is looking at a resumption of positive economic growth, albeit not at the pace predicted by many analysts in the spring. The underlying cyclical trend in some euro- area countries is turning out to be weaker than expected. At the same time, the geopolitical tensions in Eastern Europe owing to the Ukraine conflict as well as in other parts of the world are now appearing to weigh more heavily on corporate sentiment. Although they will only affect a small percentage of EU exports directly, the recently enacted EU sanctions and the Russian response are likely to dampen sentiment.

The Bundesbank are still predicting an increase in GDP growth for 2015 before moderating once more in 2016. Below is a chart of annual GDP since 2002: –

German GDP - 2002-2014

Source: Trading Economics

The momentum seems to be dissipating. According to the Federal Statistics Office, in 2013, 69% of Germany’s exports were to other EU countries.  Asia came second with 16% and the USA third with 12% – a slow down in Asia, specifically China, would be problematic, but the UK, US and peripheral EZ countries might be able to absorb the slack. What is clear, however, is that Germany is vulnerable.

This brings me to the risks to Germany this winter due to rising Natural Gas prices and a curtailment of supply. The IEA – Germany Oil and Gas Security Report 2012 provides a comprehensive overview of the German market: –

Germany has very little domestic oil and natural gas production and relies heavily on imports. It has well diversified and flexible oil and natural gas supply infrastructure, which consists of crude, product and gas pipelines and crude and oil product import terminals. Natural gas is imported into Germany exclusively by cross-border pipeline. The country has no LNG infrastructure, although some German companies have booked capacities in overseas LNG terminals.

Oil continues to be the main source of energy in Germany although it has declined markedly since the early 1970s. It now represents approximately 32% of Germany’s total primary energy supply (TPES).

Natural gas consumption in Germany has declined 10% since 2006. Demand was 90 bcm in 2010, down from 100 bcm in 2005. According to government commissioned analysis, the total consumption of natural gas in Germany is expected to continue to decline over the long term. The share of natural gas in Germany’s TPES is currently around 22%.

The decline in Natural Gas demand is evident across Europe. Earlier this year the Oxford Institute for Energy Studies estimated that, across 35 European countries, demand had fallen from 594 bcm in 2008 to 528 bcm in 2013 – an 11% decline. This is largely due to the high price of Natural Gas relative to Coal and the Europe-wide policies mandating increases in renewable energy production. For those who want to read more about EU renewable energy developments,  Bruegal – Elements of Europe’s energy union , published this week, looks at the policy challenges facing Europe between now and 2030.

Germany’s declining demand for Natural Gas and increase in storage capacity will mitigate some of the potential disruption to supply – in 2012 Natural Gas represented 22% of supply vs Oil 32% and Coal 24%. Added to which Germany has adopted some of the most aggressive policies to develop renewable energy, offset, to some extent, by their closure of Nuclear Power plants: –

Under existing government policies the trend towards an increasing share of renewables looks set to continue. The Energy Concept 2010 established a goal for Germany to increase its share of electricity generated from renewable sources to at least 35% of total consumption by 2020. Conversely, the trend towards an increasing share of nuclear in the energy mix looks set to reverse following the government announcement in 2011 of its decision to phase out all German nuclear power plants by the end of 2022.

Germany imports Natural Gas primarily from Russia (39%) followed by Norway (35%) and the Netherlands (22%). Germany has no Liquefied Natural Gas (LNG) capacity but the GATE (Gas Access To Europe) terminal in Rotterdam – opened in 2011 – was operating at 10% of capacity in April 2014 and is purported to be capable of supplying 12 bcm (Billion Cubic Metres). This is still a drop in the ocean – Russia supplied Germany with 140 bcm last year. German domestic demand is less than 100 bcm leaving a substantial amount for re-export. Further LNG supply is available from Spain but there are bottlenecks with the trans-Pyrenean pipeline.  In any case, Spanish LNG prices are high. The table below shows the divergence in prices for LNG globally, even more than in pipeline supply LNG prices are a function of logistical supply constraints: –

World LNG prices - June 2014 AEI and FERC-page1

Source: FERC and AEI

Germany’s Natural Gas storage capacity (2012) is 20.8 bcm, making it the highest in Europe, although there are plans to increase this further. In H1 2013 German Natural Gas consumption was 50 bcm – the high levels of storage suggest that Germany is well placed to weather a Russian go-slow this winter.

The complex and diverse nature of Germany’s cross-border pipeline capabilities are shown in the map below, however the largest pipelines by potential capacity are (2012 data): –

 

Country Pipeline Capacity
Ukraine Bratstvo 120 bcm
Norway Norpipe, Europipe I and II 54 bcm
Russia Yamal 33 bcm
Russia Nord Stream 27 bcm

 

Source : IEA

Germany - Gas Grid - IEA-page1

Source: IEA

 

Conclusions and financial market implications

After two interruptions to Russian Natural Gas supply in less than a decade, Germany – along with other gas importing countries within the EZ have taken precaution. The most vulnerable countries in the event of a complete cessation of gas supply by Russia are probably the Baltic States, Hungary and Bulgaria. However, Russia is also very dependant on the EU for sales of Gas, Oil and Coal. Nearly 60% of state revenue comes from this trade. This trade is worth $80bln per annum to Gazprom alone. Germany is Russia’s third largest trading partner, whilst Russia ranks 11th on Germany’s list.

If Russian sanctions lead to a cessation of Gas exports then a number of large German utility companies will suffer – most notably E.ON and RWE. However it is most unlikely that German supply will run out. Price increases will either be passed on through higher prices or lead of margin compression due to the disinflationary forces emanating from elsewhere in the economy.

John W Snow – the US Secretary to the Treasury under George W Bush – is quoted as saying, “Higher energy prices act like a tax. They reduce the disposable income people have available for other things after they’ve paid their energy bills.” This is the potential that a reduction in Russian gas supplies and commensurate rise in prices is likely to have on the wider German economy. The ECB has cut rates and started down the road to QE even before the onset of winter. Mario Draghi knows that monetary policy works slowly and many commentators believe the ECB are demonstrably behind the curve due to their attempts to impose austerity on the more profligate member states.

German Bunds may have hit their high for this year, especially since the ECB are now buying ABS, but they remain a “hedge short” at best. The quest for yield hasn’t gone away, EZ high yielding sovereign names will be supported still.

European Equities will be nervous in this environment despite some 52% of Eurostoxx 600 companies beating their earning forecasts for Q2, according to Reuters data. After a summer shakeout, the DAX has regained its composure, but it is already trading on a P/E ratio of nearly 22. Technically it’s a “Hold” until a break of 9,000 on the downside or 10,000 on the upside. But don’t forget that when Mr Draghi uttered, “whatever it takes” the DAX was toying with 5,000

European Natural Gas prices should be supported through the winter but a full-blown “Gas Crisis” is unlikely. A “Winter Squeeze” such as 2012 or 2013 could see spot prices double under normal market conditions. German growth will continue to be hampered by political uncertainty but, all other things equal, it should rebound on any sign of detente and will benefit from the continued recovery of the UK and US economies.