Bowyer Research | On August 8, 2014

Photo by Mikhail Klimentyev/Getty Images

Background:

• The US sanctions of July 16th primarily targeted the ability of Russian companies to raise capital denominated in US dollars. Targeted companies will not have access to US capital markets for loans with 90-day or longer maturities.

• The American sanctions do not completely forbid American firms from doing business with targeted Russian counterparts, and President Obama stated that the sanctions were designed to minimize damage to U.S. companies.

• The European Union and U.S. sanctions of July 29th are more severe than the actions taken on July 16th. They ban major Russian banks from selling equity and selling long-term debt in European markets. There is also an embargo on any new deals for arms and weaponry between Russian and European entities; existing arms deals will not be affected.

Interpretation:

While the EU sanctions seem to be severe on paper, there are several less reported factors that undermine their strength, and explain the better-than-expected performance of the Russian stock market.

Among these is the history of EU-member states violating European sanctions. Take, for example, Iran and France. Iran has been able to maintain a significant trade relationship with France, the third largest economy in the EU, despite the relatively powerful sanctions imposed on it by both Europe and America since 2009.

The arms embargo also has the loophole regarding any deals signed before July 29th. Existing arms deals between the European Union and Russia, such as the French plan to sell warships to the Russian Navy, will not be affected. European firms also have the option of avoiding sanctions by trading with countries not in the European Union, such as Norway. These firms could use Norway – a non-European Union country that has made clear its intention to maintain trade with Russia – to interact with Russian entities by proxy. Capital could flow from EU countries, through Norway and into Russia, thereby circumventing financial restrictions.

EU sanctions are also only guaranteed to be in effect for the next 6 months. After this period, they will be subject to review and possible repeal.

Following are brief descriptions and charts, from the Financial Times, of some of the most important firms targeted by the latest round of sanctions.

Data:

Sberbank
Largest bank in Russia, third largest in Europe. In control of roughly 50% of all bank assets in Russia. Central Bank of Russia owns a controlling stake of 51% in Sberbank

1 month performance:

VTB Bank

One of the largest banks in Russia, Russian government has a controlling stake of 60%. Sanctions caused a 98% drop in profits in the first quarter of 2014.

1 month performance:

Rosneft

Largest oil firm in Russia, Russian government has a controlling stake of 70%. Has a long-term relationship with ExxonMobile; the two have a joint project to frack for shale gas in Siberia and drill for oil in the arctic.

1 month performance:

Novatek
Largest privately owned natural gas producer, second largest overall, behind state-owned Gazprom.

1 month performance:

On July 28th, the day the EU sanctions were announced, the Micex dropped 1.9%. As the true nature of the sanctions was revealed in the following days, the Micex bounced back of 1.5%.This pattern resembles that seen in the Micex when sanctions were announced by the United States earlier in the month: in both cases, the Micex dropped severely in the days between the announcement of action and its implementation, and then rose in the following days after analysis indicated that the sanctions were weaker than expected.

10 day Micex performance against Dow Jones Industrial Average:

The Micex, Russia’s main stock exchange, and the Ruble are at their lowest levels since May. The Russian central bank has responded to the continued fall of the Ruble by aggressively raising interest rates, from 5.5% in March to 8% in August. Inflation in Russia is also high, meaning Russia has room to continue raising interest rates without encountering a significant deflation threat.The Micex has dropped 6.6% since May. The Russian government estimated GDP in the first quarter of 2014 to have contracted by .3%. By comparison, Russian GDP expanded by .3% in Q3 and Q4 of 2013.

1 month Micex performance against Dow Jones Industrial Average:

With Russia being the 8th largest economy and one of the world’s foremost natural gas and oil producers, there are serious concerns about the ability of the European Union and the United States to isolate the Russian Federation from international trade. China, by one measure the world’s largest economy, has already signed a natural gas deal worth $400bn and a currency swap with Russia.

The quick recovery in the Micex the day after the sanctions suggests that investors see them as less significant than the European Union and the United States have suggested. Given the difficulty with which the latest round of sanctions were implemented, the ability of the American, German, and British governments to get support for broader action against Russia’s energy sector, which is where the economic ties between Europe and Russia are most strong, is doubtful.

Bowyer Research