S&P also slashed its foreign and local currency rating on Russia to the lowest investment grade rating, citing severe outflows of foreign capital from Russia which put the nation’s growth prospect at risk.
The present rating of BBB- represents a negative outlook. The last time that S&P cut Russia’s credit rating was five years back. Before the S&P cut, Fitch ratings trimmed Russia’s credit rating outlook to negative in March, for the same geo-political reasons.
If these rate cuts were not enough, Russian central bank raised its key interest rate from 7% to 7.5% on April 25 to contain the plunge in the ruble and tackle inflationary woes.
The ruble has lost nearly 9% this year, the second-worst performer following Argentina’s peso among 24 emerging currencies. The nation has suffered more than $60 billion of capital outflows this year to date resulting in a crash in the stock market.
As we all know, while a nation can deal with inflation and currency concerns with the rate hike route, this endangers its growth profile at the same time. Notably, Russia’s growth fell to 1.3% in 2013, the slowest pace since a contraction in 2009, as per Bloomberg. With investments shrinking rapidly, there are all reasons for investors to be concerned about Russia going forward.
Bird’s Eye View of the Geo-Political Concerns
Russia has been in the center of the global talk to start this year thanks to the conflict with Ukraine which followed the Crimean seizure (which was earlier a Ukrainian territory) and the standoff with the West as the Crimean maneuver was viewed as an utter violation of international law by the West. As a protest against Russian act, the U.S. and the European Union (EU) imposed some travel bans and froze assets of some Russian diplomats (read: Is It Time to Flee Russian ETFs?).
While the situation was very tense in the initial phase of the year, some of Putin’s dovish comments regarding any sortie in Ukraine put this heightened geo-political tension to rest. But the tension again flared up of late when pro-Russia displays in the Ukraine turned hostile.
This has provoked skepticism that Russia might replicate its Crimea Annexation act in eastern Ukraine which in turn made the U.S. and EU impose further sanctions against Russia.
The U.S. now plans to enforce new restrictions on high-tech exports to Russia’s defense industry. Sanctions will be against individuals and companies. The all important energy and banking sectors are also targeted.
A new spate of bad news led all Russian ETFs to trade in red. The biggest Russian ETF Market Vectors Russia ETF (RSX) fell about 2.95% on April 25. Another Russian ETF based on small-cap stocks, Market Vectors Russia Small-Cap ETF (RSXJ), slipped 3.17% on April 25 while iShares MSCI Russia Capped Index (ERUS) lost 2.82%. The SPDR S&P Russia ETF (RBL) was off 3.33%. All these funds lost about 25% year-to-date and presently carry a Zacks ETF rank of 5 or Strong Sell.
However, there is also a way for short exposure in Russia – RUSS Daily Russia Bear 3x Shares ETF (RUSS) – through which investors can make well enough profit. RUSS is a triple leverage inverse equity fund of Russia. Direxion launched this fund in May 2011.
The fund has so far generated $21.6 million in assets and trades in a volume of 300,000 shares a day. RUSS charges 95 bps in fees. RUSS has gained 82% this year, however, investors should always remember that leveraged ETFs accompany increased appetite for risks. Investors should take a very cautious approach while resorting to this route.
Is the Cut Justified?
So far, we have discussed the market movement, investors’ sentiment and future gainers as well as losers out of this credit downgrade. Let’s see how much this credit downgrade is justified as analysts seem to be in two camps on this issue.
Some approve of the S&P stance thanks to the West’s growing issue with Russia and the lingering downside risk to Russia’s key sectors (read: Are Russia ETFs Signaling More Trouble Ahead?).
Per that group, if all global doors are closed, Russian companies will have to depend on domestic sources to clear over $115 billion in foreign debt as estimated by Merrill Lynch, due by the year end. Also, Russian stocks are known for their generous dividend payout as evident by RSX’s dividend yield of 3.41% (as of April 28, 2014).
Some said that if the financing world gets squeezed by several trade prohibitions, Russian companies might cut their dividend profile causing foreign investors to flee the nation’s stock markets even more. However, some appear to not agree with that idea and believe that Russian companies still have a pretty decent financial profile and the government is also liquid enough to pay off its debt in the coming years.
The bullish group believes that a rating of just one notch above the junk status (in line with Brazil) is unfair for a nation like Russia. Notably, Russia’s debt-to-GDP ratio stood at about 11% at the end of 2013 while the figure was as high as 56.8% in Brazil.
No matter if Russia deserves this rate cut or not, the economic outlook is surely glum. The Fed’s decision to wrap up its QE stimulus had already started to bite the economy, leading to an exit of foreign investors since late-last year. Capital leakage almost hit an all-time high too.
The latest developments, an already slowing growth picture, a rising inflation and a plummeting domestic investment nothing but compounded that previous pain.
Thus, Russia – a nation which is has become very blended with the global economy – may offer a nice bargain in the mid-to-long term, it would be wise to stay bearish on Russia at least for the near term. Even if some emerging market bond funds like Market Vectors Emerging Market Aggregate Bond ETF (EMAG) and iShares JPMorgan USD Emerg Markets Bond (EMB) manage to score some gains on value notion braving the rate cut warning, the trading will be rough ahead given the spread of geo-political issues.
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