The winning trade for the geopolitics on top of us all right now means ignoring boobocracy, going tactically short thugocracy, and being long India. Pray let me explain.
Did you know that German sovereign bonds (two issues, a 1923 and a 1930 sterling) traded on the London Stock exchange from 1933 to 1945? True. The price action never once reflected any approval of nor moral judgment of the Nazi regime. The market always priced credit risk. The more in control Hitler appeared to be, greater was the likelihood of debt repudiation. As it looked more like Germany was going to lose WWII, the bond prices increased—admittedly from distressed levels. This is due to the fact an allied victory was discounted as recovery-value positive for the bonds. Market participants only vaguely thought of their trading as geopolitical wagers regarding the future of civilization.
They impersonally assessed the credit risk of a distressed bond and saw a German defeat as enhancing recovery value. Markets are amoral: they reflect prevailing views on geopolitics all the time, updating with every miniscule newsbyte. Setting aside their amoral nature, their weakness is myopia: markets tend to process tactical skirmishes best and miss the strategic endgame of the entire war until it is upon us. Although there is nothing like WWII going on right now, markets have plenty of tactical skirmishes to process between Russia and NATO. It is missing the endgame.
The winning trade for the geopolitics on top of us all right now means ignoring boobocracy, going tactically short thugocracy, and being long India. Allow me to explain.
Once again, on a non-trivial level it is about oil. There is also a superficial element of insulted pride involved. Russia has a growing military presence in Syria, trying to obstruct the building of a natural gas pipeline from the Middle East to Europe that will cut the out of the European energy business. Turkey and the Saudis have doubled down on a murderous crew called ISIS. Obama, perhaps to lure Putin into an epic quagmire, is just indecisively sitting in the middle of it all. Looking ever more stupid, Obama backs a hodge-podge of Kurds, Wahhabi nut-jobs a hair’s breath as murderous as ISIS, and Iraqis who won’t fight for anything. So this week a Russian jet entered Turkish airspace and was shot down—with an ease that should give Putin concern over the viability of his aircraft in a fight with NATO.
Yet Russian debt is in epic compression mode. What gives?
It’s a feature of market myopia, actually. Russian financial sanctions are effectively over. Obama lacked the ability to make them stick. This has nothing to do with prudent monetary policies or a new anti-ISIS brotherhood forming that will allow Putin to sit at the adult’s table: far from it. The economy will continue to grind lower as long as oil and natural gas prices are depressed. Even worse for Russia, the EU in all its ineptitude demonstrated it is willing to fight for a natural gas pipeline straight from the Middle East, replacing Russian imports. What the yield compression indicates is that Putin’s Thugocracy is winning this round of the geopolitical battle against Obama’s Boobocratic community organizers.
And what a win it is. Russian 5Y credit spreads have compressed from over 600 bps in January of this year to below 300. In the spring of this year, I wrote that Sberbank common was a position trader’s dream. It took a while, but it is on a ramp.
So in the short-term, Putin is firmly in control. The Obama administration has so little respect that among even America’s closest allies that he couldn’t keep the financial sanctions in place much less apply the conceived financing stranglehold on the Putin regime. This ineffectiveness against a person Obama clearly considers a personal enemy.
But think about this: short-term sanctions are dissolving some financing problems, but Russia’s cash-flow and balance position is dismal. The price of oil is sub-$50, half of what it used to be. And Russian fiscal balance is predicated on the price of oil being $110. In 2014, it ran a 4% deficit relative to GDP, which can only be worse now that Putin has committed to a costly Syrian intervention. And make no mistake, oil is what makes the Putin regime operate. 51% of fiscal revenue derives from oil, and 68% of total Russian exports are based on fuel.
This yield compression in the debt is going to tap out: It is time to close out the long position in Sberbank. Any Fed rate move will be a catalyst to get short Russian equity. Once this thing blows, it is going to go fast. Markets will reflect that Putin is just a Cold War lizard rehashed because of the emptiness of the times.
In the medium term, Europe’s unfriendly neighborhood gas station looks to be replaced. This means curtains for the Putin regime. It is based on tribute to the center and payouts guaranteeing compliance all the way down from there. Without oil and gas exports, not only do the oligarchs get restive, but also there is no guarantee of compliance from anyone. Russia’s thugocracy means that government agents act like jackals. The cost of forming cooperative coalitions that foster greater wealth for the majority without making the minority worse off is so high that it doesn’t happen. There is no possibility for punctuated growth in this environment. People with a good idea or entrepreneurial skills go into hiding instead of growing their business. They spend their time figuring out how to hide their gains from crooks rather than expand and grow their business. If they are caught for not paying the proper tribute, like Khodorovsky, they end up in jail. If they stand up to fight, the get shot on the bridge right outside Putin’s window, like Nemtsov. Russia cannot escape the middle income trap. The thugs won’t let them.
What paper will benefit? This kerfuffle is too small to really matter for US paper—boobocracy is already discounted. The real beneficiary will get a boost from cheap energy imports, is big enough to play off multiple suppliers, and can weather an increasingly nasty Chinese slowdown. India has this strategic depth and serviceable debt levels.
India’s outstanding paper stands at 450 billion, about 28% of GDP. 20% of this is FX debt. Government debt is all local currency denominated. Most corporate debt is FX with an average weight maturity about 3.5 years. India runs a terrible current account.
Local currency and USD corporate debt is show below, overlaid by IDR/USD currency moves since 2012.
The prevailing market view equates Putin to Russia. The market—just like the international community—simply ignores Obama at this point. The epic contest of thugocracy versus boobocracy benefits India.