Andrew Pyle
March 11, 2022
A Black Russian Hole
A few weeks back, we discussed the similarities and differences between the current Ukraine-Russian conflict and what happened back in 2014, when Mr. Putin last felt the urge to go property stealing in Ukraine. At the time I wrote that blog, the invasion had not yet begun; but in four weeks we have gone from anticipation to observation of unthinkable acts of aggression. With this aggression have come a barrage of economic sanctions against Russia and certain individuals. We are only seeing the tip of the iceberg when it comes to costs that the country is feeling – costs that are already in excess of the punishment inflicted after the Russian annexation of Crimea.
In July 2014, sanctions were implemented by the US, Canada, European Union, and other Allies that were aimed at restricting access to western financial markets, placing an embargo on western exports to Russia of high-tech oil production equipment, as well as specific military goods. Some sanctions were extended through 2015 and studies have shown that the economic and financial effects were significant. Real GDP in the country contracted starting in 2014 and the recession deepened into 2015. At the worst point, year-over-year growth in GDP was minus 3.1% in the second quarter of 2015.
Real GDP growth had peaked at just over 5% in 2012 and slid to zero in the first quarter of 2014. This is important in the context of the discussion of what is going to happen to Russia this time around, since the country is coming off some spectacular growth around the middle of last year. Given increased size and scope of sanctions today, including this week’s decision by the US to halt all imports of Russian fossil fuels, we are going to see a rapid contraction in the country’s real GDP.
As of last year, Russia was the 11th largest economy in the world, but the size of the economy in nominal dollar terms was only about 2.2% bigger than 13th place Australia. It is quite conceivable that this will be the new placement of Russia in the economic world order this time next year. Its ranking in the Morgan Stanley Capital International (MSCI) emerging markets index was still only about 3% last year – a tenth of the weighting that China carries. With the plunge in Russian stocks prior the country’s exchanges being halted over two weeks ago, it is a mere spec on the horizon. From October, the benchmark index was already down close to 50% and when they finally re-open, the losses will be even more severe.
For this reason, Russia has been kicked out of the MSCI emerging markets index and MSCI has placed a value of zero on all Russian stocks. Just today, MSCI also announced that it was booting Russian bonds from its corporate bond indexes. Being taken out of a market index is a big deal, just like inclusion in an index can propel the value of a country’s securities. For passive index funds, if a country is no longer in an index, then there is no need to buy its securities. Indeed, the fund would sell the securities. The problem is that the Russian stock market is not operating (hence why stocks have a zero value).
Clients have asked how much exposure we had to Russia in the portfolio and the answer is zero. That is because the emerging markets component of our equity model comes from an active ETF that had no Russian exposure. In fact, a minority of actively managed emerging markets funds and ETFs held Russia according to the latest statistics from Morningstar. What about those passive ETFs and funds that just track Russia? Well, even though the Russian market has been halted, the iShares Russia ETF continued trading up until March 3rd, when it was halted due to regulatory concern. At that point, it had already lost 80% of its value since February 16th.
Let’s come back to the Russian economy and how the market fallout will circle back and further impact activity. The Russian ruble has been a miserably performing currency for the past three decades. It peaked at parity to the US dollar in 1993. By 1998, it had fallen to below 20 US cents per ruble and then the country defaulted on its foreign debt. It then plunged to below a nickel per ruble. After it invaded Crimea, Russia’s currency dropped below 2 cents and this week it fell to less than a penny. With the currency declining, the prices of imported items into Russia will climb and exacerbate an already bad inflation environment.
Russia is no stranger to high inflation. Back in the early 1990s, it saw annual inflation rates north of 2500%. It fell to around 6% before the 1998 debt default crisis, but then jumped back above 100 as the currency depreciated. After the Crimea conflict, inflation would again rise to over 15%. At the start of this year, Russian inflation was already approaching 10%, but the odds suggest a massive spike to well beyond what we saw in 2014. This is part shortage and part currency and, even though some say that China will increase its exports of key products to Russia, they still have to be paid for with less valuable rubles.
Like 2014, the Russian central bank will likely be forced to raise interest rates to arrest the decline in the currency and to pull back inflation. That will exacerbate an already fragile economy, leading to losses in employment and incomes. Yes, tax revenues will fall too, creating pressures on government finances. Russia’s fiscal position coming into 2022 was actually not bad, with a deficit to GDP ratio of only 0.7%, down from a peak of 3.8% at the end of 2020. That will change abruptly and deficits in the area of 3-4% will likely return.
If 2014 is a guide, this development will also see the Russian central bank tapping into its foreign reserve holdings. Non-gold reserves were close to US$500 billion at the start of 2022, just north of where they were prior to 2014. By 2015, they had fallen to just above $300 billion, and we could see the same thing happen this time around.
Bottom line, the course has already been laid in for Russia’s economy, regardless of whether the current conflict is resolved or not. How the feedback loop from economy (and civilian sentiment) and decisions regarding Ukraine plays out is unclear. In terms of the spillover effect on to the global economy and markets, I would agree with the view that we are already seeing that priced into markets. There are more than 200 companies that have shut down business with Russia, but most exposures are small relative to overall global revenues. It’s not the impact of Russia on corporate revenues that we need to be concerned about, nor the state of the Russian economy. It’s the effects this conflict is having on commodities and domestic inflation that pose the greatest risk to what is happening here at home.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew
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