“This is essentially a panic situation, the central bank took the most drastic action they could think of.” – Uwe Parpart, Reorient Financial Markets
Throughout the year we have seen a growing divergence in the economic performance and public policies of the US versus pretty much everywhere else in the world. Our stock, bond and real estate markets have all performed relatively well this year. Our economy is growing, and jobs are being created which is even leading to a little bit of wage growth. Inflation is low. The political climate has calmed down substantially in comparison to recent years. Generally speaking things are going pretty well here in the United States. Although we are experiencing smooth sailing here at home, it’s important to realize that this is not the case when looking abroad. Europe remains mired in a deflationary economic funk and is dangerously close to slipping back into recession. Japan, meanwhile, has fallen back into contraction despite keeping monetary and fiscal policy as loose as ever. And while a handful of emerging economies are reeling in the face of collapsing oil prices, perhaps the most tenuous situation can currently be found in Russia.
A number of things have been working against Russia lately, with the situation growing exponentially worse in recent weeks. The nation’s GDP growth had already been weakening heading into 2014, and the international sanctions resulting from Putin’s military action in Ukraine were already enough to push the economy into recession by next year. But the real culprit has been the knock-on effects of oil’s price decline (see Oil’s Winners and Losers).
Russia derives roughly half of its annual budget revenue from oil and natural gas taxes, and roughly a quarter of the country’s economic activity is tied to the energy sector. The central bank was recently quoted as saying that 2015 GDP could contract by as much as 5% if oil were to stabilize at $60/barrel. But beyond the simple headwind to the country’s economic growth that lower oil prices represent, additional problems have come from the fact that investors have begun moving capital out of Russian assets back into the US. This movement of capital out of Russia has put significant downward pressure on the ruble vs the dollar as traders have swapped out their ruble-denominated securities into dollar-denominated securities.
There are a number of problems with the pace at which the ruble is declining. The most obvious, of course, is that a weak currency makes everything outside the country more expensive to domestic consumers, thus importing inflation. It also presents a problem for entities in Russia who have borrowed in dollars by issuing dollar-denominated debt. As the dollar strengthens against their home currency, their debts become harder and harder to pay back. Looking further down the road, an unstable currency will create problems for the Russian government and corporations if and when they need to access the global capital markets for debt refinancing or operating capital. Put simply, significant and rapid currency devaluation typically weakens a nation’s financial system and threatens their long-term growth prospects.
So amidst a struggling economy facing international sanctions, high inflation and declining revenues, the Russian central bank decided it was time to push the panic button by holding a secret meeting and raising the benchmark interest rate by 6.5%, from 10.5% to 17%. By increasing the interest rate on Russian deposits policy makers were hoping to stem the flow of capital out of the country, thus stabilizing the currency. As a show of support to the ruble the action was intended to scare off the bears and attract opportunistic investors who might see the move as a potential turning point for Russian assets.
But as the surprise announcement hit the markets this morning the ruble strengthened momentarily before nose-diving to a new record low against the Dollar. Rather than instilling confidence, it seems the interest rate hike is being seen as a sign of desperation amidst a hopeless situation. Additionally, the higher interest rates will further hamper sectors of the economy that are sensitive to changes in the cost and availability of credit. As Ian Hague of Firebird Management LLC was quoted as saying this morning, “This move symbolizes the surrender of economic growth for the sake of preserving the financial system.”
All of this has triggered numerous comparisons between the current scenario and the Asian financial crisis that led to the bankruptcy and Federal Reserve bailout of the mega-hedge fund Long Term Capital Management in 1998. While there are a number of similarities, there are also a number of reasons why the carnage is not likely to be as extreme. As we put the finishing touches on this post the ruble has already recovered much of its headline-producing loss from earlier in the trading session. As for our portfolio strategy, other than the indirect impact on broad benchmarks and global risk appetites, we have little to no direct exposure to the theme of falling oil prices or emerging market currency devaluation. We’ll be content watching from the sidelines as the Russian saga plays out into 2015 while appreciating the good fortune of a relatively uneventful Christmas season here in the US.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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