Moscow-based partner and senior advisor at East Capital, Jacob Grapengiesser comments on the impact of the Minsk agreement on his asset allocation choices.
Thursday morning Merkel, Hollande, Putin and Poroshenko announced there had been an agreement reached after a 16-hour meeting. The actual documentation, which we have read, consists of one declaration of the above group and a 13 point agreement with the so-called contact group (which includes representatives for the Donetsk and Lugansk regions). We hope this will mark the beginning of the end of the conflict between Russia and the Ukraine.
The high level declaration is very short, and the key point is emphasizing the sovereignty and territorial integrity of the Ukraine. The points in the contact group agreement are:
1.Cease fire from February 15;
- Transfer of heavy weapons from 50 to 140 km from the front line, to be completed within 14 days after the cease fire started;
- Effective monitoring of the cease fire and removal of heavy weapon;
- Introduce local elections;
- Amnesty for anyone involved in the conflict;
- Exchange all prisoners;
- Facilitate humanitarian help;
- Re-establish system for social payments and tax transfers;
- Transfer of control of the Russia-Ukraine border to Ukrainian authorities after a local elections and a change of the Ukrainian constitution;
- Removal of all foreign forces and weapons;
- Constitutional reforms in Ukraine until the end of 2015, key points is decentralization and special status for the Donetsk and Lugansk regions,
- To agree upon how to conduct local elections in Donetsk and Lugansk. These should be monitored by international observers; and
- Intensify the work of contact group.
We do not yet know if the different parties will stick to the agreement, and there is a clear risk that the cease fire doesn’t hold. The Russian market is today up 3.2% at the time of writing, and has gained 16.6% in February. Hence the market clearly believes in the agreement.
Assuming all parties would stick to the agreement, this would imply a real de-escalation of the conflict. The relationship between Moscow and Kiev is likely to remain frosty for quite some time, but importantly the fighting will stop. The risk of further sanctions from the EU and US will be diminished, and instead we will see a gradual removal of sanctions. The European sanctions would quite likely simply expire by July 31, 2015, in a best case scenario they could be lifted even before that. The US is likely to follow the EU, although probably at a somewhat slower pace. This is good news for the Russian economy, and especially the banks that have been struggling to refinance themselves abroad. It would likely open up the Russian bond and refinancing market, which for the time being is shut for both sanctioned and non-sanctioned companies. Russian bonds have been trading at distressed levels since mid-December. If the bond market recovers, it implies companies can operate in a normalized environment and the risk premium/discount rate will come down. All in all very positive for equities.
Our current scenario for Russia is as follows: gradual implementation of the new Minsk agreement, gradual removal of sanctions and the oil price probably somewhere around 60 USD/bbl for Brent. The first question is what this implies for the ruble? The ruble is likely to gradually strengthen somewhat, but it is closely correlated to the oil price. The oil price was quite steady around 110 USD during the first half of 2014. During that period the ruble fluctuated from 33 to 36 versus the USD, despite sanctions and the Ukrainian conflict. We think the ruble will strengthen somewhat from the current 66 per USD, perhaps to 60 i.e. close to half of where it was a year ago.
What does this imply for the portfolio? In 2009 the consumer related companies were hit the most but for the ones with strong management and financial position the recovery was dramatic. Some of our holdings recorded share gains of 10x in the next four years whereas the index doubled. We will likely not see the same return pattern this time, but many of our holdings are down 80%. These companies are best in class, will take market share and eventually share prices will recover. Quite likely such companies will outperform the market in the next 12-24 months.
The -most likely- permanently lower level for the Ruble is good news for exporters. We have been significantly increasing our positions in non-oil exporters. These have been outperforming the market recently but we believe there is still upside due to brokers and investors revising their numbers. In USD terms their cost base has in many cases close to halved whereas they sell diamonds, steel and other metals in USD on a global market. In USD terms we are likely to see a dramatic increase of earnings in 2015.
Russian oil companies remain cheap, but one needs to differentiate between them. We like some of them, but completely avoid others due to high leverage and bad management. Index heavyweight Gazprom is likely to suffer due to lower prices received for its gas with a 6-9 month lag compared to oil price.
Overall we have an optimistic view on the Russian market on the back of this agreement. It should be noted that many global investors are very underweight in Russia, and if only a small part of that money would return it would imply good upside for the market.