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Macro Ideas – Russian Equities, Sanctions And Ukraine

Putin's annexation of Crimea and use of masked gunmen/provocateurs to destabilize eastern Ukraine has created a new Cold War, more ominous that even the bombing of Belgrade, the secession of Kosovo from Serbia, the expansion of NATA to Poland and the Baltic States and Russia's invasions of Georgia and Chechnya. Russian financial markets have paid a painful price for Putin's imperial foreign policy towards the Kremlin's former Soviet satellite states. Russian equities trade at 4.5 times earnings, 0.6 times book value and a 20% earnings yield. Capital flight in 2014 alone is estimated at $70 billion. Standard and Poors and Fitch have slashed Russia's sovereign credit rating barely above junk. The rouble has plummeted against the dollar and led to a local money market liquidity squeeze. The Kremlin's ten year government bond yiled has now soared to 9.5%. The Russian economy is on the precipice of economic recession. US and EU sanctions have turned Russia into a de facto pariah state in international finance, in the same "rogue state" league as Iran, Zimbabwe, North Korea, Baathist Iraq, Cuba and Syria.

Conventional wisdom argues that Vladimir Putin intends to recreate the Soviet Union, to repeat the European imperial conquests of Stalin, Tsar Alexander and Tsarina Ekaterina. This is nonsense though Putin's talk about Novorossiya, a Tsarist word for Ukraine, fuels the geopolitical Cassandras in the West who equate eastern Ukraine with the Czech Sudetenland and Austrian Anchluss. Russia has tangible strategic and energy interests in the Ukraine, whose Kievan Rus state even preceded the medieval Grand Duchy of Moscovy and was actually the cradle of the Orthodox Church that Putin's ultra-nationalist ethos now embraces.

While fascinated with Russia, I can never forget that Putin, the Kremlin siloviki Russian bankers and oligarchs play by rules that are not exactly consonant with the values of the Marquess of Queensberry. Will Ukraine escalate into a Russian invasion? I doubt it. Putin will not risk regime survival in Moscow by ordering Gazprom to cut off gas supplies to, say, Poland or Germany. Putin will not risk his state/oligarch companies forced to delist from Western stock exchanges or Russian banks frozen out of SWIFT or the international banking system.

If Russia is headed into recession, inflation will also fall, now that the central bank was forced to hike interest rates by 150 basis points to defend the rouble. The longer duration Russian Eurobonds could soar in price and offer contrarian investors in the Gulf a 10 - 15% dollar return since default risk is nonexistent in a state with $500 billion in central bank reserves and a mere 10% public debt to GDP ratio. I can even make the argument that the ten year Russian government rouble bond is a deep value buy at a 9.5% yield. Remember Ireland in 2008 and Greece in 2010? The big money is made when things go from Godawful to just plain awful. This maxim could hold true for Russia in the summer of 2014.

Russian equities have been in free fall since riots in Kiev's Euromaidan morphed into overthrow the Viktor Yanukovych's kleptocratic regime and Putin's subsequent Anschluss of Crimea. Geopolitical risk cannot be quantified in the stock market. However, the soft rouble is nirvana for oil, gas and metal exporters with dollar/Euro revenues and rouble costs. Russian dividend payouts are among the lowest in the planet and payouts will rise, though draconian sanctions could escalate capital flight, foreign fund exodus and the cost of debt refinancing in the Eurobond market.

As a student of fallen angel EM, I remember Argentina after its sovereign default, Venezuela under Hugo Chavez, Malaysia after Dr. Mahathir's capital controls or Pakistan after Kargil war/Chagai Hills nuclear test. Pakistan and Argentina trades at 10 times and 7 times earnings. Pakistan faces a Taliban insurgency and Argentina is ruled by populist Peronists blackballed by the Eurobond market. Russia is a $2 trillion economy, the world's leading gas producer, a nation with $500 billion in hard currency reserves, 140 million souls with a per capita of $20,000. Yet Russia trades at 4.5 times earnings and 0.5 times book value, near post Lehman meltdown lows. This is as surreal as Feodor Dostoevsky's literature. Russia traded at a multiple of 6 in 2011. As inflation and rouble rates fall while Ukraine stabilizes, I believe select Russian stocks could rise by 30 - 50%. It is always darkest before dawn in Holy Rus.