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Fixed-Income Insights

Heavily dependent on oil and gas, riddled with corruption, and hard hit by sanctions, Russia needs structural reforms to boost economic growth.

No matter how ongoing Russia investigations and sanctions turn out, Russian president Vladimir Putin faces more pressing issues at home in the world’s largest country. While he may be able to establish laws without review or approval by other governmental bodies, he can’t repeal or replace the laws of economics that drove Russia into recession three years ago. And, of course, he still needs international investors.

Heavy dependence on oil, mining, and gas may have worked well when commodity prices were high.  However, when those markets rolled over and U.S. sanctions over Russian aggression in the industrial and agriculture powerhouse of Ukraine kicked in, Russia’s inability or unwillingness to diversify its economy led to a crisis marked by a massive balance-of-payments shock, steep inflation, a rather deep recession, and a much weaker currency. All of which spelled opportunity for active managers, particularly ones that specialize in emerging-markets currencies and emerging-market local bonds.

The ruble lost 39% of its value on a real trade-weighted basis in the second half of 2014. While recovering throughout 2016 and the first quarter of 2017, the exchange rate is still 17.5% below the mid-2014 peak, according to Bloomberg. (See, in Chart 1, how one broad measure of the effective exchange rate has evolved.)

Now the real interest rate on a two-year ruble-denominated government bond is about 5.5 %, up from -4.0% in the middle of 2015 (see Chart 2), which is a testament to the Russian central bank for maintaining a tight monetary stance to keep inflation near all-time lows and the currency stable.

Following significant depreciation of the ruble, the central bank hiked interest rates dramatically, and Russia became one of the preferred places to buy two-year government bonds for almost all international  investors. Over the last two years, yields went from 16% to 8%, according to Bloomberg.

Even so, Russia had trouble when it tried to sell 10-year, dollar-denominated bonds in 2016—its first international bond since the Ukraine sanctions. According to initial documentation, the proceeds of the bond would not be directed to “any activity that would be prohibited for a U.S. or E.U. person or entity under sanctions laws, directives or regulations applicable to them.”

But as Lord Abbett portfolio manager John Morton recalled, the deal was still difficult. “They were not able to obtain Euroclearable1 status for the transaction initially, making it difficult for international investors to participate,” said Morton.  “No Western investment bank sought the business, so the deal was done single-handedly by VTB [a leading Russian investment bank]. Given the amount of Russian money held offshore in dollars, they did get the deal done.”  

Since then, a number of investment managers have been reducing their Russian overweight positions due to the valuations in U.S.-dollar terms. However, investment into ruble-denominated bonds have continued, with the percentage of bonds held by non-residents reaching an all-time high of 30.7% in June 2017, according to the Central Bank of the Russian Federation.

 

Chart 1. Russia’s Exchange Rate Is Still 17.5% below Its Mid-2014 Peak



Source: Bloomberg. As of July 17, 2017.
Note: The JP Morgan Russia CPI-Based Real Broad Effective Exchange Rate is an index of the value of the Russian ruble versus a basket of the currencies of Russia’s main trading partners, each weighted by its trade with Russia and adjusted for relative changes in inflation between the country and Russia. It can be interpreted as a measure of Russia’s competitiveness.

 

Chart 2. How Tight Monetary Policy Has Kept Inflation Near All-Time Lows and the Ruble Stable
Inflation versus the Russian central bank’s policy rate versus two-year sovereign yields, 2012–17

Source: Bloomberg. As of July 17, 2017.

 

Breaking Vlad Habits
After the lower oil prices and Western sanctions precipitated a sharp decline of the ruble (and raised costs of imports), Russia stopped importing agricultural goods from Turkey and the European Union (EU), which helped boost some parts of the Russian economy that previously hadn’t been competitive. 

This approach is generally referred to as “import substitution”—a throwback to the Great Depression—and extended to such sectors as pharmaceuticals and electronics, favoring local producers through procurements and subsidies.2

According to Reuters, there were 2,500 import-substitution projects in Russia in September 2015, and the government plans to spend 2.5 trillion rubles (US$38 billion) to support them.

"For us, import substitution isn't a fetish. It concerns the most important technologies," Putin said at the time. "One way or another we had to do it ... but now we will have to do it more quickly."

Of course, it remains to be seen how import substitution works in the long run, especially if proposed sanctions over Russia’s alleged interference in the U.S. 2016 election are enacted. Some economists believe import substitution can impede growth through poor allocation of resources, and its effect on exchange rates harms exports.4

In any case, when it comes to “important technologies,” Russia recently incurred the wrath of Germany after it was revealed that four Siemens gas turbines Russia bought were illegally shipped to Crimea, despite previously imposed sanctions on energy technology by the EU.

While Siemens said it is halting deliveries of power equipment to Russian state-controlled customers and reviewing supply deals, Russia's energy minister Alexander Novak suggested that such an act might not make a difference.  "What Siemens supplies can be delivered by other companies," Novak recently told reporters in St. Petersburg. "As for electricity generation, we ... have now learned to produce the necessary equipment."5

Nevertheless, the EU added four Russian individuals and three Russian entities to its sanctions list after the Siemens turbines traveled from Russia to Ukraine's occupied Crimean Peninsula.

Making Russia Great Again?
Like its “frenemy” neighbor China,6 Russia will decide its next leadership regime later this year, and likely will avoid any disruptive change until the process is complete. Putin is widely expected to win another term, but when Russia goes through an election cycle, the regime wants to make everything look super rosy. But it won’t undertake any reforms until after the election.

From an investment standpoint, Russia has, in our view, three things going for it: 1) a relatively attractive nominal and real interest rate (which is very important); 2) its economy is recovering from very depressed levels, and has been forced to start diversifying—something Russia has avoided in favor of oil and gas; but now it’s in the early stages of building up its domestic agriculture, technology, and services sectors, so it doesn’t have to import as much; and 3) its central bank wants to limit the volatility in the currency for fear of another rapid depreciation. The central bank doesn’t want to see a lot of appreciation either, all of which underscores the fact that local bond investors are generally content with a very good interest rate, provided there remains relatively low volatility.

For Russian corporate bonds denominated in dollars, it’s a slightly different story, because growth in Russia is still very low, although there are signs of a slight pickup. There are still some areas of the finance sector (e.g., overextended banks) that need to be cleaned up, and valuations are not as attractive on the dollar side as they are on the local currency side.

Our investment team met a few months ago with the Russian finance minister and deputy governor of the Russian central bank. Of course, it’s great to have such access and hear about reforms in the pipeline, but we always try to verify key elements of the Russian investment story. Close examination of actual data and what’s happening on the ground reveals that Russia is not doing much about infrastructure, education, or pension reform (something it has been talking about for years).  Five years from now, none of that may get done. 

As a result, Russia’s growth is likely to remain anemic, without some major structural reforms. It’s hard to get very excited about 2% growth in a major emerging market, but in the shorter term, it’s still a fairly attractive story relative to what we see in our investment universe.

For the long term, the International Monetary Fund recently offered some suggestions for Russia to capitalize on the end of its recession and its more competitive exchange rate:

  • Improving the investment climate, including stronger property rights and contract enforcement to reassure investors and reduced regulation and burdensome business operating and licensing standards, which often discourage international participation in the domestic economy.
  • Investing in its aging infrastructure, particularly its vast but unevenly distributed transport network of roads, railways, and ports, which would increase connectivity and improve the profits of firms through reduced transportation costs, improve access to domestic and international markets, and allow people to relocate for better paying jobs.  (While China’s "belt" of proposed rail and pipeline networks in former Soviet socialist republics crisscrosses Central Asia and spans Belarus and Ukraine, links in Russia appear mostly limited to its southern periphery, along with Moscow and St. Petersburg and new pipelines to Kazan and Irkutsk.7)
  • Reducing burdensome procedures associated with trade, such as complicated customs clearing procedures on imports and exports, which would increase both exposure to international competition and the efficiency of domestic firms.
  • Extending preferential trade agreements beyond immediate neighbors, which would open the door to new international  markets and integrate the country into global commerce.
  • Supporting innovation by allocating more resources to research and development, focusing on science and technology.8

The bottom line: Russia remains a good short- to medium-term story, but faces a lot of problems in the long term. As a result, there’s still a “Russian premium” in the market, because there is still a segment of the investment universe that will not go near the country, given its checkered history with capitalism, geopolitical adventurism, and corruption. But so far, Lord Abbett has been able to capture such premiums, while managing  “Putin risk.”  

 

1 Euroclear is a Belgium-based financial services company that specializes in the settlement of securities transactions as well as the safekeeping and asset servicing of these securities. Euroclear settles domestic and international securities transactions, covering bonds, equities, derivatives, and investment funds.
2 Jason Bush, “Russia's Import-Substitution Drive Will Take Years—and May Be Misguided,” Reuters, October 1, 2015.
3 James M. Roberts, “Import Substitution Made Countries Such as Argentina Poorer,” heritage.org, May 24, 2017.
Gabriela Baczynska, “Exclusive: Germany Wants More EU Sanctions on Russia over Siemens Crimea Turbines,” Reuters, July 24, 2017.
5 Ibid.
6  The Australian Business Review once described China and Russia as “the world’s best frenemies.”  But as columnist Julian Snelder put it, “Some observers dismiss the partnership as an 'axis of convenience' or a charade of camaraderie. Others point to the widening power disparity between the two, and doubt that Russia will accept subordination to China.”
7 Peter Baumgartner, “China's Massive 'One Road' Project Largely Bypasses Russia, but Moscow Still on Board,” Radio Free Europe/Radio Liberty, June 26, 2017.
8 "Russia: Five Reforms to Increase Productivity, Diversify Growth"; IMF Country Focus, July 10, 2017.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. Investing in international denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries.

No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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