Following a strong rally in hard-currency Russian corporate debt throughout the second quarter, Mitch Reznick, Co-Head of Hermes Credit, visited Moscow to gain an insight into the nation’s economic troubles and assess whether the market is being too optimistic.
The Russian economy is on a rough road: GDP is likely to fall by 3%-4% this year, inflation could be as high as 15% for 2015, unemployment is rising by more than 1% to reach over 6%, and budget deficits are certain for the foreseeable future. Geopolitical tensions in eastern Ukraine, the severe decline in oil prices and a weak rouble led Moody’s and S&P to “junk” the country’s sovereign debt ratings. The agencies also feared that Russia was rapidly depleting its wealth of foreign-exchange reserves, which have supported domestic companies as sanctions bar them from global fixed income markets.
As you would expect, the sentiment expressed by companies and investors in Moscow last week was that the worst is behind them. What was less predictable is how aligned credit markets are with this view. The spread between Russian corporate debt and the BofA Merrill Lynch Emerging Markets Corporate Plus Index (EMCB) has collapsed from 800bps in mid-December 2014 – when the rouble was in freefall, oil prices had collapsed and bank failures were being discussed – to about 170bps now.
Option-adjusted spreads: Russia v emerging markets
What is behind this strong relative outperformance of Russian spreads?
The Minsk II ceasefire agreement of early February was the catalyst: the basis between Russian corporate debt and the EMCB rallied some 175bps in that month. Also, beyond these negotiations lay Russia’s substantial foreign-currency reserves, which it has used to cushion domestic companies and its economy from the hard road they are travelling.
At the end of 2012, Russia had $473bn in reserves, providing a foreign-exchange facility for banks locked out of global capital markets and helping to defend the rouble. The country’s reduction in its reliance on foreign debt – from $130bn in 2000 to $10bn in 2007 – has also lowered default risk for external creditors. But rough roads will, in time, wear down even the best shock absorbers: Russia’s reserves are forecast to decline to $300bn by the end of 2015, and it seeks ways of rebuilding them while things are relatively quiet.
The rest of 2015 will be tough going for Russia – but the forecasts for all of 2015 are no longer as bad as they were. Russians themselves have made some adjustments that have helped ease the pain of the macroeconomic conditions. Although consumption is much lower year-over-year, one economist described the adjustment as an “import substitution” because Russians are buying more domestic goods and are taking holidays in Russia as opposed to abroad. Also, while the weaker rouble is helping to boost revenue for exporters, we will keep an eye on the impact inflation is having on wage growth. To date, however, the growth in unemployment has suppressed wage growth. This, combined with inflation, could erode living standards and therefore the popularity of Vladimir Putin’s government. With a struggling domestic economy and oil being much cheaper than what it was before Russia’s annexation of Crimea, Putin’s extraterritorial ambitions are likely to be more subdued. That said, if Russians lose patience with their deteriorating welfare, he could stoke the fires on the western border as a distraction. But this would spur talk of further sanctions, and we are not convinced that Putin wants to further isolate Russia from much of the world.
Given these dynamics, what are the implications for Russian corporate credit?
Following a powerful springtime rally, Russian credit spreads have generally outperformed. Although we still see some value, our exposure has fallen as spreads have collapsed. More specifically, we continue to favour higher-quality global exporters and, as ever, security selection is as critical as choosing the right companies – as the recent tenders for front-end bonds from several companies has shown.