The Eastern Pivot

Author: | Published: 18 Mar 2015
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Vladimir Potapov and Tim McCarthy of VTB Capital Investment Management discuss the outlook for Russian investment, and the country's commercial relationship with China

Predicting the bottom of the market has recently been a major concern for investors. Being ahead of the curve when the market re-rates and recovers is of prime importance. Will this amount to catching a falling knife? Will the recovery be u-shaped or v-shaped? When will sanctions be lifted? These are the questions most often asked and the answers require an explanation of how the market got to where it is, and the triggers that will release it from the grip of the downward spiral. However, the issue most overlooked by investors is the impact of Chinese investments on the Russian economy.

Turning crisis into opportunity

The Chinese word weiji has been interpreted as both crisis and opportunity, but more traditionally as turning point.


Russia is the largest country in the world and likely to be the world's largest owner of natural resources. It shares a 4000 kilometre border with China, the world's largest importer of natural resources. It seems inevitable, therefore, that these two super-powers should become closer trading partners.

In May 2014, Russia signed a 30-year, $400 billion agreement with China to provide 38 billion cubic metres of gas per year from eastern Siberia through a new $20 billion pipeline, called the Power of Siberia. In November 2014, a second gas deal was signed for another 30 billion cubic metres of annual supply from gas fields in western Siberia with delivery through the Altai pipeline. These two deals could add 0.5% to one percent to Russia's real GDP growth annually for the next five years. When these agreements become operational, China will become the largest importer of Russian gas, surpassing Germany. China is Russia's largest trading partner, so it is natural that Russia should focus its attention on the country and deepen the relationship. Total trade turnover with China could exceed $100 billion in 2014 and this relationship is growing at about 10 to 15% per annum.

The significance of these new gas deals should not be underestimated, both in terms of magnitude and duration. Many global investors think emerging markets are volatile and potentially lucrative for only short term gains, but such long-term agreements with China are multi-decade in duration and worth about 20% of Russia's GDP. For any deal with such magnitude and lifespan, both sides must have confidence in each other's ability to honour the contract and deliver as promised. With oil prices falling and geopolitics interfering with business in the west, this relationship with China has become more important and more strategic for Russia. China can see through the short-term problems and has determined that Russia will be a reliable provider and partner for the next thirty years. This is a tremendous vote of confidence from the second largest economy in the world.

Chart 1: Russian foreign trade turnover by regions, % of Total

Federal Customs Service of Russia, VTBC IM research estimates

In addition to these landmark gas deals, some 40 other infrastructure-related deals were signed in May 2014 during a visit by a Russian delegation headed by President Vladimir Putin to Chinese president Xi Jinping. China is also committing capital to projects with other countries in the region to secure natural resources and develop infrastructure to support higher volumes of trade throughout Asia. The recent creation of the Silk Road Infrastructure Fund, with a $40 billion investment from China, should go a long way to developing the region. The launch of the Asian Infrastructure Investment Bank, supported by 20 Asian countries, is another example of the commitment to further development in the region. At the Asia Pacific Economic Cooperation (Apec) forum in November 2014, China won approval for its plan to develop a free-trade zone that will rival the US's plans for a 12-country free trade zone that excludes China.

The US's plan to exclude China, its largest trading partner, is arguably shocking. It is therefore unsurprising for China to propose an alternative to assert itself as a global leader. But of course, global leaders lead by example and commit capital to back up their statements. China's financial resources are vast and its political will to fund projects is high. The People's Bank of China (PBoC) has over $3.9 trillion in currency reserves; the China Investment Corporation has about $650 billion in assets under management; SAFE, another Chinese sovereign wealth fund, is estimated to have over $560 billion in assets; and, the Hong Kong Monetary Authority Investment Portfolio is over $400 billion. Significant amounts of this capital will be put to work in China and the broader Asian region over the next few years in infrastructure projects, which will lead to a faster growing and more robust economy in Asia, and more reasons for Russia's eastern pivot.

Chart 2: Main investments to power of Siberia occur over next 5 years

VTBC IM research estimates

With low oil prices and a difficult geopolitical situation, the Russian market has sold off and Russian equities are trading near all-time lows – with forward earnings multiples under 5X and dividend yields over 4%. We are reminded of 2008, when oil prices dropped from $138 to under $40. That year, the ruble fell over 35% and the CBR used over $100 billion in reserves to support the ruble. In 2009, investors who took the risk were rewarded with a 133% return. This time around, the world is flooded with excess liquidity and Europe is just about to launch more QE, which should put a floor under emerging markets. Russia's relationship with China provides it with access to this liquidity at a time when other sources have been turned off by politicians and the relationship also provides the obvious fundamental demand for Russia's output.

Chart 3: Russia should trade at 10x-12x for next 12m EPS given the current EM valuations

Bloomberg, VTBC IM research estimates

Chart 4: Russia has a top dividend yield among emerging markets

Bloomberg

The Central Bank of Russia's free float of the ruble started in November 2014, six months ahead of schedule, leading to a weaker ruble.

Exporters, particularly non-oil exporters, benefit, as these companies have their expenses denominated in rubles and their revenues denominated in other currencies, causing profit margins to expand. The current account and the government budget also benefits from a weaker ruble and are likely to stay in surplus at very low oil price levels, meaning that less new government debt will be issued that could potentially 'crowd out' other corporate issues.

Chart 5: dollar/ruble exchange rate exceeded three standard deviations from the trend and looks undervalued

Bloomberg

The existing preferred sector allocation is to non-oil exporters with higher than average dividend yields. The traditional over-weighting of domestic economy sectors that benefited from years of high consumer disposable income growth, due to a low 13% flat tax regime for individuals, has taken a back-seat to the recent focus on non-oil exporters. Norilsk Nickel is a good example of a company that benefits from lower ruble denominated costs and dollar revenue. It is sitting on one of the world's largest platinum group metal reserves with high ore body concentrations. Phosagro, a leading global phosphate based fertiliser producer, is another example of a non-oil exporter endowed with tremendous economically viable natural resources. Dividend payout ratios have been on the rise in Russia over the last few years. This is due to better corporate governance, a maturing of industry after a period of high capital expenditures and demands from the government, by way of a new law for state-owned enterprises to deliver at least 25% of dividend payout ratios. Combining a focus on high dividend yields with non-oil exporters is a favoured tactic.


"The significance of these new gas deals should not be underestimated"


While the domestic economy sectors may be temporarily out of favour and are not paying the high dividends of cash-rich and mature exporters, they are still growing at rates that far exceed Russian GDP. Companies like Magnit, the largest public food retailer in Russia, are growing their top lines at rates over 30% and delivering in excess of 12% Ebitda (earnings before interest, taxes, depreciation, and amortisation) margins. Initially, Magnit used basic Western models for retail formats. Then they consistently outperformed market expectations year after year, becoming more and more efficient. They developed an in-house point of sale and inventory management systems that rival Walmart's systems. They have perfected supply chain management through central warehousing and just-in-time inventory delivery. They have gone vertical into agriculture for reliable sourcing and cost control of fresh produce with greenhouse production of 88 kilograms of cucumbers per square metre. This is more than your average retailer. Magnit is perfection, and an example of how Russians can develop their own model for success. Over time, we will see many more examples of this type of success in a variety of sectors in Russia.

Turning to the East

Russian companies have improved on many Western business practices, and now it is time for Russian companies to work with its Chinese partners. The new relationship between Russia and China will also improve Russia's relationship with other Asian trading partners, as much of this infrastructure will benefit the entire region. These Eastern relationships are built on foundations of pragmatism rather than ideology, largely born of souring relations with the West.

Authors

Vladimir Potapov
Chief Executive Officer


Tim McCarthy
Co-Chief Investment Officer

VTB Capital Investment Management
10, Presnenskaya emb.
Moscow, 123317, Russia
T: + 7 (795) 725 5540
W: www.vtbcapital-im.com

Over the last 20 years, Russia has become a part of the global economic system, a member of the World Trade Organisation, and has integrated its banks and trading partners, particularly in Europe. Significant direct investments have been made by European firms in Russian fixed assets and Europe gets 30% of its energy from Russia, and this is not something European leaders are willing to destroy on ideological grounds. Pragmatism will take the lead. In the meantime, Russia's Eastern pivot will soften the landing, before Russia takes off again.

So, in answering the question of "when to invest", it appears that the current confluence of events have created an opportunity that will surely not last forever. Oil prices will not remain below the average production cost curve for more than a few quarters, but it will take time for production cuts to kick-in.

High policy rates of 17% are unsustainable and will likely be cut within a few months or quarters. Markets are forward looking, so investors that wait for sanctions to be lifted will be behind the curve. To stay ahead of the curve, investors should get exposure well before sanctions are lifted, ahead of the forward looking market. Our core equity strategy has a liquid portfolio of high dividend yielding stocks with a bias towards non-oil exporters. Our investors will get paid to wait for the re-rating.