Russia has been dominating global headlines in recent months and not for the reasons you'd like to see as an investor or potential investor.
The Russia/Ukraine conflict, which initially centered around the contested Crimea region, has dragged on — and the tragedy of a downed commercial airliner over the region has resulted in international outrage and a call for much stiffer sanctions against Russia.
It is against this troubling backdrop that we visited the country to get a better understanding of how these events are affecting the overall economy. Over the course of three days, we met with companies across the banks, fertilizers, energy and metals & mining sectors, as well as with several regulators. Specifically, our aim was to investigate the impact of current and potential sanctions on these sectors and individual issuers, understand the reliance of issuers on external funding and form a more complete view of the growth prospects for the remainder of 2014 and into 2015. In short, we wanted to assess the risks in the region and potential opportunities, particularly if conditions begin to improve.
We have held a cautious view on Russia since the beginning of 2014. This view has largely been based upon macroeconomic and geopolitical concerns. Following the trip, we retain a cautious stance, although future prospects are likely to vary significantly from sector to sector and issuer to issuer.
In our view, banks are the weak link in Russia's economy. The domestic economic slowdown has resulted in asset quality deterioration and we are concerned about the strength of the banks' capital positions. Systemwide, non-performing loans ticked up to 7% from 6.5% in the first quarter, according to the Central Bank of Russia, and in the retail space, that percentage is as high as 10% to 15%. In the corporate sector, exposure to construction (e.g. Sochi Olympics-related projects), metals & mining and agriculture are seen as three main areas of potential stress.
The capital position of the banking sector has been weakened by rising credit costs and high loan growth. Funding remains an area of stress as the Russian banks are unable to access international funding markets because of economic sanctions. The central bank has stepped in by increasing funding to the sector, which has helped to fill the gap. Central bank funding now accounts for close to 9% of banking system liabilities as of June 30 — up from roughly 0% in 2010, according to the Central Bank of Russia; we expect this to rise to 12% by year-end.
We believe Russian banks could be particularly vulnerable if no resolution is reached and they cannot return to international funding markets beyond 12 months. This is a risk we believe is currently underestimated by the market and is the key basis for our negative view on the sector. In our view, avoiding subordinated bonds of Russian banks is prudent until there is a more realistic solution to boost their capital base.
A different set of concerns tempers our outlook for the fertilizer industry. The three Russian producers that dominate this sector are world-scale and operate in the first and second quartiles in terms of cost. Access to key raw materials, low-cost energy and transportation infrastructure are keys to success in this commodity market, and all three companies are able to demonstrate these. The long-term demand trends remain positive — there is clearly the need for improved crop yields owing to increases in global population and the increased demand for meat from emerging markets given the large livestock feed requirement.
Areas of concern include the long-term capital spending projects all three companies have embarked upon — which will limit future cash-driven deleveraging — and continued pricing pressure in all three key minerals: nitrogen, phosphate and potassium.
From an investment standpoint, we remain cautious on this sector and would likely need to see improvements in capacity utilization and product pricing, along with signs of deleveraging, before getting more constructive.
Our views on energy, a critical sector for the Russian economy, are somewhat more positive. Russia's energy producers seem to be weathering the geopolitical storm at this point. Financial results likely will see a positive impact from the combination of high oil prices and the ruble devaluation as revenues are in U.S. dollars while costs are in local currency. To this point, there have not been any business disruptions from sanctions or the Ukraine conflict. Company management teams see sanctions restricting the export of Russian gas to Europe as unlikely given the lack of substitution and the potential negative impact on a fragile European economy should gas prices increase materially.
International capital markets essentially are closed to these issuers at the moment and corporate treasurers have been proactively managing debt maturities and liquidity. The majority of issuers in the sector have very conservative balance sheets and low refinancing requirements. Support from Russian banks is evident and is expected to be extended further should markets remain closed for longer.
Finally, there is a notable push toward Asia (i.e. China) as a future market for Russian energy and also a source of funding.
Overall, we remain comfortable with high-quality energy issuers in Russia given strong fundamentals and state support, but we expect volatility on political news and potentially some interesting entry points on weakness.
In the metals and mining sector, management teams with which we met were generally positive about performance year-to-date and the overall outlook for 2014. Steelmakers have seen robust demand from domestic markets, driven primarily by residential and infrastructure projects, and have benefited from rising steel prices. The largest steel companies have been focused on internal efficiencies and cost savings and now benefit from leaner cost structures; capital spending plans also appear to be conservative.
On the input side, expectations are for iron ore prices to remain broadly flat. Iron ore producers, however, are seeing good opportunities in pellets and benefit from the price premium of pellets vs. concentrate. The coking coal market remains depressed, and without capacity rationalization, unlikely to rebound.
While there is a notable distressed situation in the sector — the coal miner Mechel (approximately $10 billion of debt), which is widely expected to go to the state banks for restructuring — there are also several issuers with idiosyncratic credit positive news. These include Metalloinvest Management Co. LLC's upgrade to BB by Fitch Ratings Ltd.; Severstal's disposal of U.S. assets for $2.3 billion and a potential upgrade to investment grade; and MMC Norilsk Nickel's upgrade to BBB- by Fitch.
Despite lack of access to cash, liquidity buffers and committed lines of credit (mostly from Russian banks) should provide ample liquidity for roughly 12 months. We continue to see opportunities for select exposure to high-quality credits in this sector.
With prospects varying from sector to sector and issuer to issuer, and geopolitical tensions remaining high, investing in Russia now requires selectivity and rigorous credit analysis coupled with careful assessment of the changing macroeconomic and geopolitical environment.
Top-down concerns have made us more cautious on the region, and while spreads have widened recently for many Russian corporate bond issuers, they are not back to the levels seen at the time of the Ukrainian elections in late May. We think there could be further weakness especially if the geopolitical situation deteriorates further.
While there might be opportunities that exist in certain sectors where industry fundamentals are supportive and company balance sheets are strong, international sanctions can alter the equation significantly. We will need to get more clarity on these in the days and months to come as they affect not only the prospects for Russian issuers, but also the sectors and securities in which international investors can invest.
Brigitte Posch, portfolio manager and head of emerging market corporate debt at Babson Capital Management LLC, recently visited Russia along with four of Babson Capital's investment analysts to meet with a number of companies and regulators.
