Last November, I covered the Russian equity market in "RSX: Bullish Economic Backdrop In Russia Looks Even Better." The VanEck Russia ETF (BATS:RSX) had decent performance over the preceding two months but reversed all gains on Monday falling a staggering 17.5%. Similar losses were seen in the small-cap Russia ETF (RSXJ) which fell about 18%.
This came after years of strong economic and financial performance from Russia. The Russian economy was in a prolonged recession until about 2016 due to the oil-price collapse and Crimea-related economic sanctions but has managed positive growth since then. This has resulted in high recent equity performance regardless of currency denomination.
First, take a look at RSX and RSXJ's returns compared to the S&P 500 since January 2019:
As you can see, both were generally outperforming the S&P 500 despite a weak oil market. Importantly, the Russian economy is very sensitive to the oil price since it makes up over half of its exports. Even more, the Russian energy sector makes up about 40% of RSX's total holdings.
Importantly, the Russian Ruble has a significant impact on RSX's price since the earnings of its underlying holdings are denominated in Rubles not Dollars. While RSX has seen large corrections since 2015, the MOEX (Russia's Ruble-denominated equity index) has been in an aggressive bull market:
I believe this chart is more illustrative of the recent shock than the RSX price chart. This is because of its acceleration higher and extremely rapid recent decline that indicates its bull market is likely over.
Let's dive deeper into the economic backdrop surrounding the companies in RSX and try to get a clearer picture of what this recent shock will mean for Russia. In my opinion, it largely negates my previous bullish stance.
The Problem Of Non-Diversified Economies
As I mentioned earlier, the Russian economy and equity market are entirely dependent on crude oil. While the country does export many different goods, over half are energy-related meaning its trade balance is entirely dependent on crude oil's price. Take a look at Russia's export breakdown by product:
Further, we can see that Russia's balance of trade is a product of oil prices:
Note, Russia's last BoT data came out in December, so the next three months' data are likely to show significant declines due to the virus/OPEC-related declines in crude oil prices.
Of course, declines in crude prices do more than impact Russia's BoT; it also lowers GDP and fiscal budget. This creates a dangerous situation for the Russian ruble which is a product of those factors.
As you can see below, the last significant decline in crude prices resulted in an even larger devaluation of the Ruble:
Because RSX holds Ruble-based assets that are denominated in dollars, a decline in the Ruble causes a nearly one-for-one decline in RSX:
To put it together, RSX is falling not only because its equity market is declining (i.e MOEX), but also because the country's exchange rate is dropping. This "double whammy" is what caused significant declines in RSX from 2013-2016 and evidence suggests that such events may reoccur.
In fact, Russia's likely upcoming recession may be worse than its 2014-2016 one. The country's manufacturing PMI recently fell from the 50 level to the 45 level which is very bearish. Its services PMI is stronger than it was in 2015 at 52, but it looks like it's headed much lower:
Importantly, Russia was able to keep Coronavirus out during January and February but it has recently seen an uptick in cases. While it has closed its southern border with China, the country currently has at least 20 cases. Given containment efforts have failed in most Western nations, I doubt they will be able to avoid it without closing all borders.
This may not severely impact its March PMI data, but once April and May roll around, I would not be surprised to see their PMIs drop below 40 as they have in China. This will likely occur for most countries, but it is more problematic for Russia because it will concur with an extreme oil price decline.
How Low Can RSX Go?
The most obvious risk for RSX is the Ruble. Currency risk is the primary risk for all emerging market investments since there is no limit to how far a currency can decline. The Russian central bank has increased its total FX reserves to $570B which will allow it to stave off declines for a while, but not indefinitely.
As you can see below, currency devaluations such as the one we're seeing today usually correspond with $100-$200B in FX reserve sales in order to stop declines:
Again, I believe the current situation for Russia's economy is worse than it was in 2015 so the country may need to sell even more than in the past.
In the end, it is impossible to give the Ruble an accurate price target as it largely depends on whether or not it will hike rates to boost its currency. If it does, it could stop the Ruble's devaluation but at the expense of drastically lowering its economic growth. In either event, the situation is bearish for RSX.
Take a look at RSX's sector breakdown:
As you can see, RSX has very low exposure to "risk-off" sectors. Energy is obviously the largest risk factor today, but materials is highly influenced by energy prices as commodities are all correlated with crude oil. Thus, around 63% of RSX is at risk due to the recent declines in crude. In reality, just 11% of the fund is in "risk-off" sectors like Utilities and Cons. Staples.
Importantly, Russia usually has about the lowest global production costs for crude oil which explains why it has been able to generate positive GDP growth despite low oil prices. Though Russia triggered the recent drop in oil prices, the country's energy sector needs crude over $40-$45/barrel to stay profitable. This means large companies in RSX like Gazprom (OTCPK:OGZPY), or Lukoil (OTC:LUKOY) may finally see negative operating cash flows this year with Brent crude at $37.
Now, the firms in RSX are undoubtedly cheap with a low weighted-average "P/E" ratio of 6.7X. That, and other metrics are shown below:
While RSX's weighted-average "P/E" is a third of that of the S&P 500's, keep in mind its extreme cyclical and energy exposure. In fact, the U.S.-based energy producer ETF (XOP) has an even lower weighted average TTM "P/E" of merely 4X. While RSX's is low, it is more-or-less at a typical level given its sector exposure and high historical volatility. Further, the recent declines in crude are likely to drive the earnings of RSX's holdings much lower.
Of course, there is also the less-predictable high geopolitical risk in Russia. The country is strategic allies with Iran which, just two months ago, was on the brink of war with the U.S. While the January missile attack was certainly the closest Iran and the U.S. came to war, there have been similar situations over the past few years with boats.
Historically, Russia and China are competitors which has been beneficial to the U.S. and was a major reason for the eventual end of the cold war. However, the two have become much closer in recent years and recently pledged to grow their 'special relationship' despite Russia's closure of its Chinese border.
For now, Saudi Arabia generally maintains a positive relationship with both the U.S. and China, but decay in either relationship would likely be the last peg that causes a clear global alliance split. Since the Russia-Saudi relationship just collapsed, there is a risk that it spirals into a wider issue where these entangled alliances exacerbate current economic problems.
This geopolitical risk is not necessarily bearish for Russian equities, but it will certainly exacerbate volatility and potentially cause a rapid decline in FDI from Western nations.
Overall, it seems that investors are best avoiding RSX and other Russia-related investments. Primarily because the recent drop in crude prices is likely to spur a devaluation of the Ruble which is usually deadly for RSX. Secondarily because the earnings of its holdings and GDP growth rate are likely to decline. Add on potential geopolitical volatility, and we have a very poor investment environment for RSX.
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