The Heart Attack in Putinastan

Russia is a position trader's paradise. The largest corporations have cheap valuations, and command sufficient state support that they are not going to default. If you think a company is going to be around in five years, at these levels you buy the equity and hold on. So in this unusual instance, I'm parting from credit to some extent. Russian credit is the prism through which equities are evaluated.

There is very little default risk in Russia, even though the market is pricing it like junk (see below). Given FX reserves and the dense network of patronage support that is easily tapped and will continue to be tapped by oligarchs whenever needed, default isn't the worry. Seems much more liekly that the market is pricing in is not the end of Russia, but the end of the Putin regime.

The risks are pretty well understood: it is the problem of systemic risk due to sanctions, crashing oil prices, and epic repricing. The net effect is a collapsing ruble, high inflation, locked-up capital markets, and an entire economy on the verge of depression. Offsetting this is large FX reserves and state willingness to step in when needed, especially in the financial sector. Just last week, the Wall Street journal has reported the GazpromBank received a $500 million bailout. This will become a common refrain in 2015.

Markets reflect systemic risks with volatility and correlation. In more developed and liquid markets there are tradable instruments avaialble to hedge both volatility and correlation in a couple of different ways. One way is to be long these instruments and pick up price appreciation as volatility and correlation spike. The other method is to be short these instruments because their implied levels nearly always over- or under-shoot the realized volatility and correlation of the market. That is to say: the option market tends to price in deeper declines that what actually occurs. Return are generated by pocketing the difference between the option premium and market losses.

In this case, the risk may be understood, but there are limited ways to hedge it synthetically with any level of liquidity. Russia requires a position-trading viewpoint that can sacrifice short-term losses in exchange for long-term gain. Sacrifice can only go so far, and this requires timing. Timing, and methods to evaluate appropriate timing, is the matter at hand.

The challenges are clear: 5Y government bonds (give or take basis risk) have decoupled from the common stock of the largest state-owned bank and energy company. This is indicated by the correlation and subsequent de-correlations of these assets. At this very heart of the Russian economy, we see a profound change in the system akin to the country de-coupling from Putin himself. Correlations spiked at the point of greates systemic fear about Russia. After this "heart attack", these same correlations broke. Think about this: the ruble-based reference rate of return is losing its meaning.

Rolling 30 day Correlations between Russian Gov Debt and Common Shares

Russian CDS correlations.jpg

In fact, the credit market is speaking volumes here about Russian idiosyncratic risk, leaving rating agency opinion behind. Despite Russia’s sovereign ratings remaining in investment grade, with a Baa1 rating from Moody’s and a BBB from S&P, credit spreads on the sovereign now trade wider than nearby junk-rated sovereigns such as Hungary, which is rated as Ba1 and BB by the same agencies. Note that almost 80% of Hungary’s petroleum comes from Russia. Yet 5Y CDS Spreads on the Russian Federation have moved out just over 200 basis points since the start of the year, from 164bp to 375bp. Meanwhile, Hungarian spreads have come in slightly from 256bp to 238bp. Russian bonds are priced like junk bonds.

High carry on Russian local bonds offer a risk premium buffer. Life lesson: Bonds with lower carry can outperform cheap junk. Russia is priced like junk. The growth/inflation/export environment has deteriorated so much that RUBUSD outlook is ultra-bearish. The main hurdle for taking Russian duration exposure outright remains this currency outlook.

The Russian central bank delivered what it could, but the rate hikes have been inadequate, as the political pressure applied drives the epic RUB weakening. Despite choking the economy with an increase in the potential amount of intervention to defend the upper boundary of the RUB basket corridor has helped stabilize the currency. Yet, the macro picture has hardly changed. The current account surplus is evaporating and capital outflows have reached crisis conditions. BoRUS is handicapped by elevated inflation and unable to unwind monetary tightening any time soon, falling into the category of policy makers unable to benefit the much milder external environment, the time to purely clip coupons and chase carry in Russia is still appear premature.

When it comes to Russian rates, the dilemma is this: choose between cheap valuations or the reserve buffer against FX depreciation and deteriorating fundamentals. The market’s focus is as much on the geopolitical crisis as much as the oil price impact on Russia’s fundamental dynamic. The market isn’t thinking about the Russian fundamentals. It is thinking about Putinastan and how little room that government has to maneuver.

To understand the room-to-maneuver, take Hungary as a contrast to Russia. Like a chess player with a well-worn opening line, Hungary remains the most willing central bank to deliver rate cuts especially in the face of a more accommodative external environment. With the highest real yield on offer, ECB's QE or credit easing could further translate into risk premium compression in Hungary. Add to this the NBH is determined to divert local institutions' demand to government securities and keeping money market flushed with liquidity. Russia can only dream of this freedom right now.

The interesting play is that the magnitude of common stocks correlation to govvie bond moves is getting weaker, either breaking away from the bond space or needing to catch down. Take your pick, that’s the bet. At this stage, already decimated common equity is a welcome shield against exposure to the continuing collapse of nominal values, provided it can stay solvent. The data below shows, this butthe chart is a couple of weeks dated.

Russian CDS and stocks 1.jpg

Further, we have seen multiples get squeezed out of valuations. The current verbiage I’ve heard is that Russian stocks as a rule trade at about 75% of tangible book. I’ve never seen a company underestimate book value, but we have to be getting close to a true reflection of real assets at this point. Plus, on a historical basis, Gazprom and Sberbank are extremely cheap. Sberbank, in particular, is deeply, deeply oversold.

Sberbank Common. Symbol: SBERP / ISIN: RU0009029540

sberbank.jpg

There is no doubt that the Russian market is under unrelieved pressure. Sanctions haven't eased, there is an expensive new invasion to support in Ukraine, the global economy is not supportive of a recovery. It may be that the market is pricing in the end of the Putin regime. This is not the end of Russia, just the beginning of the end of a deeply corrupt, authoritarian, and increasingly hostile leadership.


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