Russian Bear And Russian Bull: Sanctions Outlook - Part I

by: Michael Borisov, CFA


Russian equity market has had a strong (20%) performance YTD, but this is merely a bounce back from the slump last December.

Could Russian assets profit from sanctions being lifted in 2015?

Part I: Is there a chance that sanctions will be lifted? This is about politics. Economics and investment conclusions will be discussed in Part II.

Bears argue that sanctions against Russia are unlikely to be lifted in 2015. Both Ukraine and Russian-backed rebels have incentives and means to continue warfare.

Bulls argue that the ceasefire can last, as war fatigue and costs are on the rise for both Ukraine and Russia.

Russian Bear & Russian Bull: Short preface

The Russian investment thesis recently got mired in heightened political risk, tectonic macro shifts, and last but not least, a wave of Ukraine-related emotional heat. For some, Russia has become untouchable as an asset class. Misconceptions abound. Yet, investors would benefit from a balanced and professional discussion from someone who is local. I have teamed up with my friend and Moscow-based portfolio manager Andrew Vashevnik, PhD, to write a series of articles on Russian macro, financial markets, and politics.

Seeing once is better than hearing twice, as the saying goes. Then seeing twice must be even better. Andrew and I are both Russians with a similar background, but you will notice that our views sometimes differ significantly - hence the name Russian Bear & Russian Bull. We hope it will become one of the ingredients for an interesting and insightful read.

Russian equities (NYSEARCA:ERUS) have had a 20% run-up year-to-date (one of the world's best major stock markets).

Russia country ETF (<a href='' title='iShares MSCI Russia Capped ETF'>ERUS</a>) vs. other Emerging market country ETFs Year-to-Date in 2015

Of course, so far this is nothing more than a bounce from the deep hole they dug themselves into last December at the peak of the FX-related panic. The last year's selling was fairly indiscriminate, with exporters crushed alongside consumer stocks. The rebound was more differentiated, befitting a game-changing 50% devaluation. This implies many stock-picking and relative-value opportunities are available for a minimally diligent investor.

ERUS vs EM Country ETFs in 2014

Selected Russian equities available in the US - price dynamics of Top Five and Bottom Five:




Price at 31-Dec-2013

Price at 09-Mar-2015

% Change in price

Bottom 5


Industrial Metals & Mining







CTC Media, Inc.





Software & Computer Services

Yandex N.V.






Sberbank of Russia ADR





Financial Services

QIWI plc




Top 5



OJSC Polyus Gold ADR





Oil & Gas Producers

Tatneft ADR






AO Mosenergo ADR





Industrial Metals & Mining

JSC MMC Norilsk Nickel ADR





Software & Computer Services

Luxoft Holding, Inc.




This time, however, Andrew and I are going to take the top-down route. Could Russian assets profit from anti-business sanctions being lifted in 2015? Of course, this is really two questions. First, is there a chance for sanctions to be lifted this year? This is very much about politics and "cui prodest" (who stands to gain). We present our (conflicting) views, you decide who is more convincing.

Second question: In case sanctions are lifted, will there be a significant impact on Russian-listed companies and foreign companies with significant exposures to Russia? This is a much more technical and economics question. Did the sanctions and counter-sanctions have a fundamental impact in the first place? (They did). Here, we dig into the origins of Russia's recession and FX debacle, and look whether some of the forces are reversed should sanctions be lifted.

Enter Andrew Vashevnik, The Russian Bear:

Will sanctions against Russia be lifted in 2015? I feel that this is very unlikely. I can see 3 scenarios when sanctions would be lifted.

1) Capitulation by Putin: Russia agrees to full Ukrainian control over Donetsk & Lugansk ("Donbass").

Putin would never agree to this. First, Putin doesn't like to accept defeats, he is very rigid in this regard. Second, this will be viewed as a betrayal of the Russian population (because many ethnic Russians who fought for the rebels will be killed as Ukrainian military overruns Donbass). Third, this will be viewed as a "sellout of Russian strategic interests" by Russian elites. Fourth, as a next step, Ukraine would press for Crimea, but giving back Crimea is simply not an option for Russia without a big war.

So this scenario is possible only if Putin loses power, which is very unlikely in 2015.

2) Capitulation by Poroshenko. Ukraine gives autonomy to Donbass, potentially allows other ethnic Russian regions to get autonomy as well, and makes a promise not to make any deals with NATO or EU.

Poroshenko would never agree to this. He has held a very negative stance on Russia and he cannot change it on the spot. He will not survive as Ukrainian president if he does.

Again this scenario is possible if Poroshenko resigns. So far US and EU look determined to give money to Ukraine supporting Ukraine's regime. Stopping support is not going to happen in 2015, so economic implosion should be averted this year. However, it is quite possible in 2016 or later. Actually, this scenario is what Putin is aiming at.

3) Peace scenario. The war stops, Donbass gets autonomy; Kiev government is free to make any deals with West.

This is the least likely scenario while either Putin or Poroshenko is in charge.

First, peace is not acceptable for Poroshenko. Ukraine is in desperate need of money. The main selling point for Poroshenko is that Ukraine is defending Europe from Russian aggression. To quote him, "you should believe in Ukraine because we are defending the democracy, we are defending the freedom, and we are going to defend not only our territory, integrity, sovereignty but we are defending maybe European continental or maybe global security" (BBG link). This strategy has worked well so far. On the back of Minsk-2 ceasefire agreement, the IMF/EU promised very significant assistance to Ukraine (close to $50 billion in total). Remarkably, Ukraine was not required to commit to a comprehensive reform programme though some painful regulated price hikes were agreed. This stands in sharp contrast with tough multi-week negotiations with EU member Greece.

In the end, this strategy helps current Ukraine elite to live very nicely. I have recently spoken with two people working for top global luxury brands. Both are saying that sales in Kiev are soaring. Sales of one top global luxury brand went up 5 times in 2015, sales of another brand went up 3 times. A peace deal is unacceptable for Poroshenko, because after the deal, there would be no reason for US or Europe to give money to Ukraine over Greece or any other country.

Peace is also unacceptable for Putin. Most importantly this scenario does not prevent Ukraine from hosting NATO bases, which was the primary reason why Putin decided to grab Crimea and support rebels in Donbass. Also Russia would have to take care of the peaceful development of Donbass under this scenario. Developing Crimea is already a huge burden for Russia at the moment.

What is the most likely scenario? A frozen conflict without making peace. Transnistria or Abkhazia are good benchmarks.

Michael Borisov, here in the shoes of The Russian Bull:

The situation in Donbass after Minsk-2 accord is indeed very ambiguous. Field commanders on either side talk of "getting ready for the spring campaign". However, I believe war fatigue may start kicking in on both sides.

1) Ukraine

Ukraine's population is increasingly skeptical of the Kiev government due to increase in military drafting activity and serious economic mismanagement. Those most affected are Western-minded, educated, working Kievans, the core support group of the initial Maidan movement. My friends in Kiev stress that the disillusionment is with this government, not with the idea of a strong, united, westernized Ukraine.

It is worth remembering that Maidan started as a largely anti-corruption movement. But the current government has had close to zero progress on reforms for over a year in power now - a track record that even a war cannot justify. Most bureaucrats, including revolution leaders PM Yatsenyuk and Security Council Secretary Turchynov, are from the same cohort serving under Yanukovych or Yushchenko before him, and corruption is as rampant as ever. This is in sharp contrast to Georgia after the Rose Revolution of 2003, which was followed by a huge reshuffle of the government officials, truly new figures in charge, and a blitzkrieg of some brilliant reforms.

Similarly important is the fear of being drafted and sent to fight in Donbass. The first year of fighting relied heavily on volunteer battalions and reservists drafted from the countryside. However, the recent drafting waves also target big cities. Poor military leadership (bordering on treason) led to several spectacular defeats with thousands dying in vain. The recent proposal to restrict foreign travel of draft-aged men did not improve moods. Again, the war effort continues to enjoy strong support and crowd funding, just not the state military machine.

In my opinion, by now, President Poroshenko himself would be happy to shift the government's focus from war to the reform agenda. He understands that another wave of popular discontent may cost Ukraine its statehood - a scenario strategically beneficial for Putin. However, the structure of Ukrainian politics makes it hard to remove the "war hawks" from power.

The population does start to show war fatigue; do the elites? Given that Ukraine will spend 2015 on IMF's financial lifeline, and IMF can condition its assistance on reforms, it seems the global financial institutions have a say in the peace effort. If the IMF gets serious reform commitments from Ukraine and enforces execution, it would exert some pressure for peace on Ukrainian elites.

2) The rebels

Field commanders on any side of a civil war usually want more war. The population of Donbass may be not just tired of war, but utterly exhausted, yet they have little say in the matter.

However, it is fairly obvious that the rebels would not be able to sustain fighting without support from Russia. By directing the support, individual rebel commanders have been "brought into obedience". I assume that Russia can restrain them if it chooses to.

3) Russia

The Russian population has poor understanding of sanctions because they are not targeting consumers directly (meanwhile, "counter-sanctions" restricting food imports from the EU and US have the most prominence). Hence, the only anti-sanction pressure the Russian government may feel would be from the power elites.

Russian elites are of two types - business and the notorious "siloviki" (security forces). The motivation of the "siloviki" is little known except they are somewhat obsessed on competing with NATO and have an important red line in their Ukrainian strategy: no Western military bases, let alone NATO membership. The sanctions on them are pretty meaningless personal travel restrictions and (so far very minor) foreign asset seizures.

Meanwhile, business bears the brunt of the sanctions in the form of much higher cost of capital due to essentially closed external debt markets. (Note that US-imposed restrictions in oil services are of less importance given that high-tech projects like Arctic shelf are a no-go anyway in the current oil price environment). The key Moscow Interbank rate surged from 4-6% in 2011-2014 to 30% in December before settling around 17% this year. Along with a 50% devaluation, this is a game changer for many industries.

Bloomberg ran an article in January that Putin currently would listen to the "siloviki" (BBG link). However, it is worth remembering that Putin has been known for masterful maneuvering between the two groups. Recently, talk emerged that German Gref, formerly the economy minister and currently very successful CEO of Sberbank, could return to the government to lead the reform effort to drag Russia out of recession.

4) EU

Together, Russia and Ukraine constitute a very big market for the EU. Ukraine's ultimate collapse and Russia's deep recession are not at all in EU interests. (Logically, the US may be more ambiguous on this). The EU, with Germany's Angela Merkel in the lead, could and should become the main driver of the peace effort.

All in all, for me, the most likely scenario is a "frozen conflict" in Donbass, with occasional fighting, but no more big battles. The September Minsk-1 accord had the crucial weakness that the rebels' position was too vulnerable, with a shredded front line and Ukrainian strongholds deep in rebel territory in Donetsk airport, Debaltseve etc. From a purely game-theoretic view, that accord could not be sustained: The vulnerable side would seek to reduce the vulnerability at all cost while the other side would seek to exploit it. That is exactly what happened. The Minsk-2 accord has far more chances to survive.

And if the conflict is "frozen" enough, I see a fair chance of key anti-business sanctions being lifted this year. A mutually face-saving solution could look as follows:

  • In Russia, after a year of patriotic madness, the focus shifts to the poor state of the economy. Quietly, Russia agrees to the westernization of Ukraine as long as the short-term effect is invisible (and long-term planning is not Russia's strong side), and it does not involve military bases.
  • In Ukraine, new parliamentary elections are called after the current government steps down. An inconsequential change in Constitution mentions a special status of Donbass and Crimea who become de-facto autonomous and very Russia-dependent.
  • The EU and later the US quietly drop the anti-business component from the sanctions, keeping only travel restrictions for a few dozen Russians and maybe narrowly targeted sanctions against insignificant players such as "Bank Rossiya".

Andrew the Bear uses a chance to respond:

I don't agree that Poroshenko would like to shift focus to the reform agenda. There is a big difference between current Ukraine and Georgia in 2003. Georgian economy was OK and the reforms were an attempt to make things better. Ukrainian economy is a complete meltdown. National currency collapsed 4 times during the year, GDP is down 15.2% in the 2014 Q4, industrial production decreased by 21.3%, 5-year CDS trade above 4,000 level, implying very high probability of default.

So I would compare Ukraine with other countries experiencing a similar meltdown. Zimbabwe under Mugabe is a good example. The strategy of the government is the opposite: They are shifting focus from economy to politics, explaining to people that inflation is the result of foreign evil and treason. It seems Ukraine has already chosen Zimbabwe's path. Recently, people demanding resignation of Ukraine's National Bank leadership were dispersed by police.

Ukraine's plan A under Poroshenko has always been receiving support from the West. Plans B and C never existed. "Ukraine economic reform" is only a marketing maneuver to get money. I have seen long-term Ukraine's strategy. Here is the link. The plan for Ukraine is to increase USD nominal GDP per capita by 2 times by 2020, increase military spending 5 times (from 1% to 5% of GDP), win 35 medals in 2020 Olympic Games, make 20 films which would receive worldwide broadcast and advance in several ratings (like Doing Business). This doesn't look like a good plan.

"Our long-term economic plan is working" is a good stance for a politician. This is a key point of David Cameron for example. While Cameron has economic data to back his claim, Poroshenko is highly unlikely to get good results in the economy anytime soon. So he will go back to the old Zimbabwe and North Korea tricks of blaming evil foreigners and local traitors for all economic problems.

Russia needs sanctions to be lifted, and by now, fully understands it. But there are two ways for Russia of doing it. Russia can either force rebels to make peace with Ukraine and then hope everyone sticks to it. But even if a peace deal is made by Putin, Merkel and Obama, the deal should be obeyed by Kiev and Donbass commanders. Local commanders are not fully controlled by Kiev or Donetsk authorities (for example, see recent story about "Batman"), so peace is extremely tough to implement.

Alternatively, Russia can bet on Ukraine to collapse and make a better deal with the new government. My feeling is that Putin would choose the second path.

The impact of the removal of anti-business sanctions will be discussed in the upcoming Part II. We hope you enjoyed the "political" part; please stay with us for the macro part!

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Both Andrew and Michael may have Russian securities in portfolios under their management (not personal portfolios), which may constitute a conflict of interests.