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Gordon Pape
Gordon Pape

Russia, Ukraine, and Political Crisis

While the world's attention was focused on the Winter Olympics in Sochi and nations were competing peacefully against each other (well, perhaps not so peacefully in the hockey!), several hundred miles away another less peaceful national drama was unfolding. The protests in Kiev's Independence Square against the pro-Russian regime of Viktor Yanukovich, which had started in November 2013, erupted into violence. The authorities unleashed the heavily armed special forces against the demonstrators, with observers estimating that between 70 and 100 protestors and troops were killed and hundreds injured.

As the Olympics closing ceremony was taking place on March 2, Yanukovich fled to Russia as crowds of ordinary Ukrainians wandered around his luxurious country estate. The Ukrainian parliament declared him deposed and appointed a temporary government ahead of elections this spring.

Russian president and Yanukovich sponsor Vladimir Putin was not prepared to see his ally removed without taking action. A week later, armed militia took control of the parliament of Crimea, the southern region of Ukraine which is primarily Russian in ethnic origin, having only become part of Ukraine by the dictat of Soviet ruler Nikita Krushchev in 1954. A pro-Russian faction was declared as being the government of Crimea and promptly requested "assistance" from Russia. The Crimean port of Sevastopol harbours the Russian Black Sea fleet, with 25,000 military personnel. As a result, the takeover of Crimea by troops with their insignia removed, but who were using Russian military vehicles, was swiftly achieved. Crimea was cut off from Ukraine and a referendum on Crimea splitting from Ukraine and coming under Russian protection is set for March 16.

The new government of Ukraine has reacted with caution and nothing more than warning shots were fired in Crimea when Russian and Ukrainian troops met. However, the situation remains very tense, not least because 150,000 Russian troops held maneuvers on the Ukrainian border under Mr. Putin's personal supervision while the takeover of Crimea was taking place.

The western powers reacted with outrage to the takeover and President Obama warned President Putin of severe economic consequences in a testy hour and a half phone call. Meanwhile the European Union (EU) leaders also voiced their displeasure, but given that over one third of the gas used to heat and power Western Europe comes from Russia, they were notably less aggressive in their reaction.

What does the Ukrainian crisis mean for investors? First, it is exceedingly unlikely that any North American investor owns Ukrainian shares or even government bonds. Ukraine's economy has been performing poorly ever since the Yanukovich regime took over and has been badly hit by the financial crisis and its aftermath. GDP growth slowed to virtually zero in 2012 and 2013, hindered by Ukraine's financial problems. Essentially, Ukraine is bankrupt and was downgraded to B by Standard & Poor's in February, indicating a strong likelihood of default on its sovereign debt. In fact, the protests against the Yanukovich regime began when he chose to reject an offer of economic aid and debt restructuring from the EU in favour of a competing offer from Russia, essentially reinforcing Ukraine's dependence upon the latter and ending the chance of Ukraine joining the EU and potentially NATO, the Western defense alliance.

The impact on Russia

It's more likely that investors have some exposure to Russia, as one of the four largest emerging economies known as the BRIC (Brazil, Russia, India, China). Most emerging market equity funds have some exposure to the BRIC markets, and passive index tracking vehicles such as the iShares MSCI Emerging Markets Exchange Traded Fund (EEM)(TSX: XEM), which tracks the MSCI Emerging Markets Index, have a 5% weight in Russia.

Thus when the Russian index fell 11% on March 3, the day after the takeover of Crimea, and the ruble fell to record lows against the U.S. dollar, forcing the Russian central bank to raise interest rates from 5.5% to 7% to defend the currency, emerging market funds were badly affected.

However, many actively managed emerging market funds have been underweight Russian stocks, precisely because managers have had concerns about the political background, high levels of corruption, and low standards of corporate governance in that country. Russian equities, as a result, had become quite cheap on valuation grounds, with the index selling for less than 10 times 2013's earnings. Some Russian energy companies such as gas giant Gazprom (OTC: OGZPY) are trading for only two times 2014's cash flow.

The iShares MSCI Russia ETF (ERUS) is off 24% this year (to March 12) and down 50% over the last three years, massively under-performing both developed markets but also other emerging markets such as India and China, which are down 15% and 25% respectively over the same period.

Investors looking for a really cheap emerging market might consider Russia at this point, but only if they have the ability to stomach extreme volatility and such underlying issues as high levels of corruption, political interference, and low standards of corporate governance.

At some point, the valuations will become cheap enough that Russian stocks will perform well. There are some privately owned Russian-headquartered businesses such as retailers Magnit (LSE: MGNT) and Lenta (LSE: LNTR), newly listed on the London exchange the week before the Crimean takeover, that are worth watching. Also, mobile phone company Vimpelcom (VIP) which wrote down the 46% of the Ukrainian cellphone market that it owns by $2 billion to zero last week, or energy company Rosneft (OTC: OJSCY), of which BP owns almost 20%, have done well despite the difficult business climate in which they operate.

However, for the vast majority of investors, Russia (and Ukraine) fall into the "too difficult to bother about" basket. It's reasonable to steer clear of countries with such political uncertainty overhanging them until the picture is clearer.

The impact on major economies

What about the impact of all this on the major economies? My advice is to take some of your money off the table. The S&P 500 and European markets such as the U.K.'s FTSE100 and the German DAX are at or near all-time highs. Although the current levels in Europe are no higher than those reached in 1999-2000, investors should consider locking in some profits from the excellent performance of the last 18 months. Should the Western powers impose economic sanctions on Russia as the result of its takeover of Crimea, European banks will be badly affected. They are the largest lenders to Russia, which had US$653 billion in outstanding foreign debt at the end of 2013, of which US$150 billion must be rolled over each year.

While Russia has US$480 billion in foreign exchange reserves, the ruble has fallen 11% this year after declining 8% last year, making it more difficult to fund interest payments on the national debt. Five-year corporate bond yields have risen by 200 basis points (2%) even for blue-chip firms, making it more difficult for them to service their own debts.

Should Mr. Putin decide to stop repaying Russian debt, as occurred in 1998 when Russia defaulted on approximately US$75 billion of foreign debt and the ruble plummeted, continental European banks, which have to raise 100 billion in the next 18 months to meet Basel III capital requirements, would be under a lot of pressure. This in turn could lead to the reemergence of Eurozone debt worries, which have only been temporarily addressed by ECB President "Super" Mario Draghi's 2012 promise to "do whatever it takes" by buying unlimited amounts of sovereign debt to preserve the euro.

In New York, the S&P 500 is at the top end of its long-term valuation range and approaching 18 times 2014's earnings. Signs of froth are appearing with a resurgence of IPOs and biotech stocks in particular going parabolic on the upside. In these circumstances, investors would be well advised to sell 20%-25% of their non-Canadian developed markets equity positions. That should return their weighting to where it was at the beginning of 2013, as indices are up between 18% and 24% since then.

The likely outcome

As far as the likely outcome of the present crisis is concerned, investors may find it useful to revisit what happened the last time Russia had a dispute with a former satellite neighbor, ironically also in an Olympic year. In 2008, Western ally Georgia, located on the Black Sea a few miles down the coast from Sochi, became involved in a short and very unsuccessful war with Russia over two breakaway regions, Abkhazia and South Ossetia. Both states became nominally independent under Russian protection. Western leaders protested and muttered about sanctions and nothing ended up happening.

It's a good bet that Crimea will be in a similar situation in a few weeks, that Western protests will have little effect, and that Mr. Putin will again demonstrate that Russia will not take kindly to its former satellites getting too independent.

If the EU's offer of a US$15 billion economic aid package rescues Ukraine's economy, the new status quo may hold for a while, but investors should be prepared for further Russian moves in the eastern portion of the country if Ukraine's new government gets too close to the West. Russia regards Ukraine as an extension of itself and from a strategic viewpoint Russia is well aware that both Napoleon and Hitler had to cross Ukraine to get to Moscow. It will not lightly surrender its influence over such a strategic buffer.

Gavin Graham is an expert in international investing and the president of Graham Investment Strategy. He is also the co-publisher of the new newsletter, Emerging and Frontier Markets Investing.

About the author:

Gordon Pape
Gordon Pape is the best-selling author/co-author of many acclaimed investment books, including the recently-published Sleep-Easy Investing (Viking Canada ). He is also publisher and editor of five investment newsletters, including the Internet Wealth Builder, Mutual Funds Update, The Income Investor, and The Canada Report, which was created specifically for U.S. residents interested in investing in Canada . He is a columnist for several magazines and websites and a frequently quoted media source. He has been a featured speaker at numerous events including the World Money Show in Orlando . His websites can be found at www.BuildingWealth.ca and www.TheCanadaReport.com.

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