Sanctions Impact on Russia – Step by Step?

March 1 will lead the rally. The table showing the best and worst performing Russian DRs is at the end of this note.

Investment outlook

    •    Russian sovereign Eurobond debt will only modestly react to Stage 2, or even Stage 3, sanctions. Any dip on sanctions news is a buying opportunity. The current oil price + weak ruble combination improves budget execution.
    •    The ruble has been, and will remain, the most sensitive asset to any sanctions news. Stage 2 sanctions, which mostly fall into the “inconvenient” category, should have only a limited impact on the currency, i.e. after any initial knee-jerk move, and the Central Bank should be able to contain the damage. A political agreement will see a rally back above R/$36.0 and, possibly, towards R/$35.0. Economically disruptive Stage 3 sanctions would see the exchange rate hit R/$37.0 quite quickly.
    •    The local ruble debt market yields will reflect the movement in the ruble.
    •    The equity market is also highly sensitive to political newsflow and the big EM investment funds are unlikely to consider a return to Russia until political risk is fully calmed. The market is currently drifting lower ahead of the sanctions decision.  If serious sanctions are put in place we would see another knee-jerk move down in equity indices as earnings assumptions would have to be revisited in many sectors. Even under a positive sanctions scenario investor inflows are unlikely until either after the May 25th Ukraine elections or, perhaps in the weeks leading up to the election if the outcome suggests a rebuilding of political relations.
    •    We have replaced Eurasia Drilling with LUKoil in our list of top Russian DRs for 2014 and added Raven Russia and Global Ports as defensive names. LUKoil benefits from rising ruble based export revenue, has a near 6% dividend yield and is one of the companies which may initiate a share buy-back if there is further weakness. Gazprom remains on that list as a lot of the potential bad news is “priced in” while political rapprochement in Europe or a China gas deal in May are not.
    •    Ukraine’s Hryvnia has rallied from a closing low of 10.7 against the US$ last Friday to 9.2 earlier today. There is no justification for the rally other than it is drifting in the temporary distraction caused by the Crimea crisis. The IMF is unlikely to soften its previous demand for a removal of Central Bank exchange controls.
    •    The yield on Ukraine Eurobond debt has widened a little from Friday’s close. Over the medium term it is a tough call as the IMF/EU/US seems more likely to inject some emergency aid to allow Kiev service near term debt. That news would see a quick debt price rally. The real risk to the bond market will come later, i.e. after a new government is elected, when the more substantive financial aid talks will take place. Debt restructuring is a definite possibility at