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Russia’s Economic Tailwind Hits a Bump. For Now.

Russia’s status as the latest darling of emerging market investors has hit a bump. Russian stocks, bonds, and the ruble have gotten pummeled ever since the United States levied a fresh round of sanctions on the country last Friday. U.S. officials cited several Russian aggressions as the reason for these additional sanctions, including election meddling, cyberattacks on U.S. infrastructure, a recent nerve-agent attack in the UK that left a former Russian spy and his daugher in critical condition, and military actions in Syria and Ukraine.

While Russia has weathered several rounds of Western sanctions since 2014, these are the toughest imposed by the U.S. to date, and seem carefully designed to impact individuals with close ties to President Vladimir Putin. The sanctions target seven Russian oligarchs – and a dozen of their companies – and 17 senior government officials.

Some of the most prominent individuals on the Sanction List include aluminum tycoon Oleg Deripaska; Viktor Vekselberg who heads the Renova Group; Kirill Shamalov, Putin’s son-in-law; Alexei Miller, Chairman of Gazprom, and Andrei Kostin, head of state-owned VTB. This succinct chart details who they are, how they’re connected, and the U.S. Treasury’s allegations against them.

The sanctions freeze any U.S.-based assets of the blacklisted individuals and entities, constrain their ability to access Western financing, and forbid Americans from doing business with them – including trade and investments. The ban also extends to non US-citizens who “knowingly facilitate significant transactions, including deceptive or structured transactions, for or on behalf of any person subject to US sanctions.”  This new provision by the U.S. Treasury significantly increases the impact of the sanctions.

The announced sanctions triggered a broad selloff across the Russian markets. The ruble has declined more than 8% over the past two days to a 16-month low of R62.87 per dollar; Russian equities, as represented by the MOEX, also tumbled more than 8%, recording their sharpest drop since 2014 when Russia annexed the Crimea; The yield on Russia’s 10-year sovereign bond jumped more than 30 basis points as the country’s credit risk was repriced.

The severity of the downdraft can be attributed to several factors. Past sanctions against Russian companies have only curtailed their ability to issue new debt and equity in the primary markets. Last week, officials in Washington went further, directing Americans to sell their holdings in companies related to Oleg Deripaska, one of the sanctioned individuals. With U.S. individuals and funds actually barred from owning and trading related securities, this would be the first time the sanctions extend to the secondary markets. Not only does this establish a game-changing precedent, the consequences can be devastating for targeted companies.

Consider, for example, the case of United Co. Rusal, an aluminum producer primarily owned by Mr. Deripaska. The company’s stock price has plunged more than 50% since the sanctions were announced on Friday. Rusal, which is responsible for 7% of global aluminum production and derives 80% of its business from international sales, has had to ask its customers to withhold all payments for now. Meanwhile, the London Metal Exchange has suspended all trading in Rusal’s aluminum. On Monday, Rusal warned that it is likely to default on its bonds, particularly since half of that debt is dollar-denominated. En+ Group Plc, a sanctioned energy company also connected to Mr. Deripaska, saw its share price shed almost a third of its value after the sanctions news. Some trading firms have already suspended coverage of Rusal, En+ and other affected stocks.

Adding to the market jitters is the fact that more companies could be added to the sanctions list as suggested by the U.S. Treasury’s warning that: “This list of 12 companies owned or controlled by the sanctioned oligarchs should not be viewed as exhaustive.” Perhaps that’s why shares in Mechel, a mining company majority-owned by Russian oligarch Igor Zyuzin (who is not on the sanctions list) fell more than 15% on Monday.

The seeming randomness of the latest sanctioned group has many investors and Russians wondering who will be next. This uncertainty, combined with the possibility that U.S. fund managers may eventually have to divest themselves of other Russian assets, including government debt, will weigh on the market.

Sanctions aside, Russia’s economic star has been on the rise. The country has emerged from recession and is enjoying a period of macroeconomic stability characterized by falling inflation, growing currency reserves, and a respected central bank. Russia relies on energy revenues to drive most of its growth, so rising oil and gas prices have been a boon for the economy. The oil and gas sector typically accounts for 16% of Russia’s GDP, 52% of its federal budget revenues, and 70% of total exports. In February, rating agency S&P Global raised Russia’s sovereign credit rating to investment grade, mirroring a similar investment grade rating by Fitch.

These factors have bolstered investor confidence in Russian assets. Prior to the new sanctions, stocks were near all-time highs and bonds were soaring, as evidenced by the fact that global investors pumped more than $20 billion into Russian bonds since the end of 2016. In the currency market, speculators were largely bullish on the ruble, with long contracts outweighing short contracts by 18,666, according to recent data from the Commodity Futures Trading Commission.

Looking ahead, Russia’s bright outlook is complicated by two things: These new sanctions and the possibility that others could follow are reasons to be concerned. It is too early to determine whether they will be disruptive enough to stall Russia’s economic expansion. The second complication stems from rising tensions in the Middle East – particularly in the wake of the recent chemical gas attacks in Syria – which could escalate into some form of U.S. military action that would impact Russia. Until there is greater visibility on these issues, MRP remains cautious about Russian assets. Once these issues clear up, however, Russia could become a promising LONG theme for emerging market investors, given its other economic tailwinds.

Investors can gain exposure to Russian equities via the VanEck Vectors Russia ETF (RSX).

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