23 Theses and One Piece of Investment Advice – A View from the Kremlin Towers

towers 300x225 23 Theses and One Piece of Investment Advice   A View from the Kremlin Towers

Martin Luther nailed up no fewer than 95 theses and changed the world – but his was a time before the internet, and he didn’t have a portfolio to manage. We have thus confined ourselves to a mere 23…

We have sought long and hard for an overriding theme for the New World (dis-)order: the Revenge of History (after Fukiyama’s hilarious “End of History” blunder) has already been done to death; the “World Island” story strikes us quaintly anachronistic in an era of supersonic missiles and space travel; the purported implosion of the Neoliberal order seems dubious in the extreme at a time when Marxism has ceased to be considered a meaningful alternative anywhere – we are thus left with the obvious:

0. In 100 years time it will all seem quite simple – future historians (be them 2-, 4- or 6-legged) will view the early 21st century as marking the transition from an Americano-centric to a Sinocentric world order, and will wonder at how this was not immediately obvious to our contemporaries. The rest flows naturally from this fundamental geopolitical shift.

The View from 35,000 feet

1. The above premise leads to a range of corollaries which are anything but obvious: from the desperate quest for political correctness and the accompanying societal degeneration which have characterized every declining Empire since Rome/Byzantium/Ottoman Istanbul – to the populist uprisings (themselves largely a reaction to an official discourse totally removed from any day-to-day reality) now burning their way across the Western political landscape. Societies have a 6th sense which warns of impending decline.

2. The post-war single-power model was both deadly dangerous and unsustainable; an absolute hegemon invariably unites the outlying countries against it. The rise of China is to be welcomed, not because it is singularly virtuous, but simply because it provides a vital alternative for those countries which would reject the dictates of the current hegemon.

3. Certain truths are slow to penetrate the Western world-view; despite the boiler-plate in the press, China is no longer “the world’s second-largest economy”; China is the world’s largest – at least as expressed in Real, i.e. PPP-adjusted terms. It is equally the source of most global growth (GDP growth in China – at around 6.7%, is 3.5X that of the old economies, i.e. US/Japan/Europe averaged), the commanding force in virtually all commodity markets, the world’s largest goods exporter, with the largest middle-class, soon the top automobile market, already the leader in numerous technologies (including many one wouldn’t expect: biotechnology, vaccines, etc.) The list goes on and on. This will have major consequences for global power structures.

4. Bi-polar or mono-polar? From Japan to India, Germany to South Korea, countries previously entirely subsumed by the Atlantic Alliance are desperately seeking to hedge their positions. Washington is perceived as neither particularly reliable nor remotely predictable. China can appear threatening. Thus, Japan accelerates its outreach to Russia – India seeks to balance her relationship with Washington and Moscow; South Korea looks to Russia for a land-route to Europe.

5. Twenty years ago, Trump’s tariff war with China would have constituted a devastating blow to Chinese economic development. Today, it is likely to prove more an own-goal, accelerating the economic integration of Asia, and disrupting the business models of American companies which occupy the top of the value chain. Much like the threat of bankrupting ZTE by cutting off American chip imports, a short-term tactical victory will result in a major push by China to eliminate its dependency on imported chips (a deficit larger than China’s total oil import bill). US and South Korean chipmakers will pay a stiff price a few years down the road.

6. Following the demise of the USSR, any country falling out of Washington’s favour found itself dangerously isolated. It is doubtful that, even ten years ago, Russia (or, for that matter, Iran, Turkey, or Pakistan) could have held out against US political/economic pressure. There is now an alternative; China is not just Moscow’s key military ally, but also the largest source of Russian investment capital, by far its largest export market, even the top source of foreign incoming tourism.

7. The Left-Right dichotomy is a 19th century fossil. The new political dividing line is radial – between the Centre and the Periphery. To refer to the new European political parties challenging the Establishment as “far right” is nothing more than rear-guard rhetoric by an increasingly desperate mainstream media; regardless of their origins, these parties represent a strong “populist” (i.e. democratic) challenge to the established order. They are not going away. Similarly, whether Trump is to the left or to the right of the mainstream US Democratic party is a matter for debate – not so whether he represents the Centre or the Periphery. The traditional Democratic Party leftism of the 1950s-60s, is as dead as the Enclosures Act.

8. The US is embroiled in the first phases of a low-intensity civil war; the overriding objective is to score direct hits on the adversary, rather than to further any set of shared, common national interests. The elites are no longer remotely trusted by the masses. Given a post-war global architecture based upon American hegemony, this is deadly dangerous.

9. The level of political discourse has deteriorated to caricature; typically, America leads with way. Washington currently excels in political Theatre of the Absurd – with a cast of strippers, reality show guests, religious nutjobs, spies, renegade journalists and moles; a fractured Republican party faces an opposition party grown sanctimonious, irrelevant, obviously self-serving and deeply corrupt. Western Europe, though still somewhat less colourful, lags not far behind.

10. The US no longer boasts a unitary foreign policy. It has two antagonistic, mutually incompatible policies sharing the same bed. Nothing illustrates this better than the hysterical response to Trump’s initially successful Helsinki summit with Putin – the notion that one needs to actually speak with one’s adversaries is now considered treasonous.

11. Once assertive and proudly “Gaulliste” our French foreign policy has collapsed into irrelevance. Italy is (rightfully) obsessed with a domestic situation tending towards the tragic. The UK wishes nothing more than to remain America’s poodle (although the master may no longer be particularly interested). Thus, Germany is once again “Europe” – Merkel is the cork in the bottle. Her fall would open up the almost-revolutionary perspective of a renewed German rapprochement with Russia of the sort seen in the 1970s and ‘80s. This would necessarily involve China in an economic unification of the Eurasian continent from Vladivostok/Beijing to Lisboa.

12. A liquidity squeeze of cosmic proportions threatens: the dollar-based post-war financial architecture required that Washington run a chronic current account deficit so as to supply the necessary currency. This suited the interests of US political elite well enough – despite a continued erosion in the quality of employment, the proles were kept off the streets with jobs in the service sector – and reasonably content thanks to a bounteous supply of cheap imported consumer goods and cheap credit; China, on the other side, was able to build a world-class industrial infrastructure and buy not just technology and companies, but entire continents with the proceeds.
With Trump, this bargain is being challenged; a criminally irresponsible pro-cyclical expansionary fiscal policy (remember “Deficits don’t Matter”?) is now accompanied by increasingly restrictive monetary and trade policy. Something must give.

The World’s second-oldest profession

13. To be considered “respectable” in the mainstream media one must first pledge allegiance, prefacing any discussion by declaring that Trump is Evil, Putin is Evil. There is zero nuance. Zero space for dissent. Orwell’s writing was meant as a warning, not as an instruction manual.

14. Despite a laughable claim to “speak truth to power,” the press has generally been a handmaiden to the dominant economic oligarchy of the relevant country. From the Jacobin pamphleteers to the bellicose Viennese broadsheets (run-up to WWI), the Soviet media (demanding that the Prague uprising be crushed) to the American press (from the Hearst push for the invasion of Spanish America and Asia, to the recent devastation of Iraq, Libya, Syria, etc. with tragic consequences for the beneficiaries – as well as calls to “liberate” Iran and a host of others) the story is very much the same.
The corporate buyout of virtually all US media has put an end to any independent mainstream journalism, while job insecurity has killed off any attempt at dissent within that mainstream. A NYT journalist gone even slightly rogue knows he will soon enough be an ex-journalist.
At the same time, social media have now opened up an entirely new space for dissent, something the powers-that-be are desperately attempting to seal up.

15. The corporate English-language media have become comically partisan – they should be immediately recognizable by any Russian remembering the Soviet press. The anti-Trump hysteria in the media has precluded any attempt at serious analysis of whether or not there is some method to his madness.
In the Middle-Ages, once it had been determined that the Devil was involved, no further attempt was made to analyse his motives or intentions – he was Evil because it is in the nature of a daemon to be “evil”. Thus, the “analysis” regarding Trump…or Putin.

16. The tragic failing is not the corruption of our political elites but of the press. Politicians have been always and everywhere inclined towards corruption of one sort or another (like vegetarianism in cows, a taste for meat in lions, it is in their nature; they are ultimately paladins of the economic status quo.) Instead, what is deadly dangerous is the ever-increasing prostitution of the media – which allows for the easy manipulation of the electoral biomass.

17. What seems terrifying is that Western governments no longer feel obliged to be even remotely credible, knowing that they can, quite unchallenged, put forth the most outlandish claims, secure in the knowledge that these claims will be faithfully echoed by their tame media. From the Iraqi WMD, to purported poison gas attacks by Assad (carried out solely in order to provoke another wave of American bombings?) truth is the first casualty. Men in their millions actually believe that Russia stole the multi-billion dollar American presidential elections with its dense network of think tanks, lobbies, and tame journalists by placing $50,000 in Facebook ads.

Thus the “evidence” in the Skripal case – which would be contemptuously regurgitated by my Labrador – in fact, a totally illogical narrative apparently dreamed up by a May regime in serious political trouble, and accepted unquestioningly by their tame media. We are asked to believe that Russia, on the eve of a World Cup it had spent a decade preparing for – poisoned a traitor who no longer posed any conceivable threat, exfilitrating two operatives to London rather than using local talent, employing a previously-unknown chemical warfare agent readily traceable to Russia – despite the availability of numerous cleaner, more effective, and especially more discrete means. Now, we are further expected to believe that after contaminating their own hotel room (with no obvious ill effects), and going for a leisurely stroll around Salisbury to be photographed by the ubiquitous CCTV cameras,  the two highly trained GRU operatives left their high-tech weapon (which notably failed to kill either of the intended victims) – lying around in a fake perfume bottle, only to resurface months later when a local junky dived into the dumpsters. The appearance of the two on RT television left more questions than answers, but what WAS obvious is that the clownish duo were no more trained intelligence agents than they were Anglican bishops.
When several months ago Jeremy Corbin dared to question the narrative, the indignant outrage hit a fevered pitch – it was as if a pre-war German had the gall to claim that the Wermacht was not fated to save the world from Communism.

Donald Trump – #blamethemirror

18. While Trump’s tactics seem wildly unpredictable, emotional and scattered, this should not be confused with an absence of strategic goals. Whether or not one approves of his objectives (mostly we do not), one would be a fool to deny their existence.

Call it intelligence, animal cunning, whatever  – Trump’s abilities have been systematically under-estimated by his opponents – to their chagrin.

19. Trump is not an American Exceptionalist but rather – an American Supremacist.
His view is based on transactionalism. i.e. the US is no longer presented as a shinning city on a hill, virtuous by definition and to be universally emulated (at least by those not actually in league with Satan) but instead, a large, overwhelmingly powerful player – one to be treated with deference for fear of a devastating reaction. His America can be seen as a collection of businesses – rather than a unique model to be emulated by all mankind. This is a remarkably refreshing change from the previous politically-correct hypocrisy; it, at least, allows for frank discussion.

20. In his vision, other countries are neither “friends” nor “enemies”, but rather “competitors” – this applies to the EU, to Russia, to the Asian powers. During the Helsinki press conference, Trump clearly stated that Russia was a US competitor – for energy markets, and for geopolitical influence. Renault and Peugeot are also competitors – they are not “enemies.” Perhaps only China serves as the ultimate adversary in Trump’s cosmology.

21. Trump, to his credit, has understood at least one simple truth which, amazingly, seems to have evaded both the Democrats and the US Deep State: the hegemony of the United States is threatened by one country – and by one country only – that country is China, not Russia.
Oblivious to even the medium-term interests of the United States, the Democrat-Neocon alliance has successfully sabotaged Trump’s Russia policy, unnecessarily making an adversary of the Bear. Meanwhile, Trump’s belated attack upon China has created the conditions for a true alliance between the two giants, an alliance running 2/3 of the way across the Eastern Eurasian landmass.  Still in its early days, and scheduled for completion in 2035, the Chinese belt-and-road initiative, now getting underway in earnest, shall extend this new geopolitical bloc well beyond the confines of Eastern Eurasia.

22. For Washington to have driven Russia into an increasingly close alliance with the Dragon was insane – suggesting a deeply dysfunctional policy establishment. Worse than a crime – a mistake.
From Metternich to Bismarck to Kissinger, great-power foreign policy has been aimed at preventing alliances detrimental to the interests of the given Power. This has been reinterpreted in Washington as a singular, one-against-all approach, perhaps a hangover from the era of unipolarity.

The Eternal Russia

23. Reading the Western press, one would assume that Russia is struggling desperately in the throes of American sanctions; in fact, on the ground it looks quite different. Although the quantity of growth as measured by GDP is unimpressive (circa 2% per annum), the quality of growth is increasingly excellent. As anyone who travelled here for the World Cup can testify, not just Moscow but all of the second and third-tier cities have been transformed. The road system, the bane of Russia for the past 300 years, has improved beyond recognition. The new terminals at Sheremetovo airport put the dreadful Paris Charles DeGaulle to shame. The train system is far more punctual than the UK or Italy. The explosion of the new middle-classes is demonstrated by the uncountable new cafes and restaurants filling the streets of all major cities – perhaps 20 years later than the similar transformation of Prague or Budapest, but finally taking place. The urban housing stock is enjoying a much-needed renewal, while the countryside is gradually being transformed by Russia’s emergence as an agricultural powerhouse – the world’s largest wheat exporter, and a major force in an increasing number of agricultural commodities.

Whilst the gradual devaluation of the rouble has depressed consumer spending, it has worked wonders for the federal budget, the profitability of the commodity sector (dollar-term revenues, rouble-term costs) and the trade balance – all of which are far superior to the emerging markets average.

Birth rates have risen to beyond the European average, life expectancy is seeing a rapid increase, and although salaries remain depressed in dollar terms, unemployment is very low.

The renewal of the Russian state is still a work in progress, governance and public health are improving but from still weak levels. Vitally, Russians increasingly feel proud of their country. Patriotism is becoming fashionable. The widespread cynicism and despair of the terrible 90s is a fading memory. Never given to unbridled optimism, Russians now can look forward to the future with at least some degree of confidence. The investment opportunities are somewhat less glamorous – but rather more sustainable than in decades past.

Footnotes: Sanctions – Weapons of Post-Modern Warfare

Certainly, the greatest threat to any country non-compliant with the diktat of Washington is the weaponization of the dollar. While fabulously expensive (and profitable for the military-industrial complex) actual US military power has recently shown itself to be of sharply limited operational value – no war has actually been won since the limited objectives attained in the first Gulf War.  The US military is obviously unusable against purported allies or other nuclear-armed states; several antagonistic non-nuclear countries have recently developed a capacity for asymmetric counterattack which renders them almost equally unattractive as military targets.

As a result, the use of totally arbitrary economic sanctions has become virtually systematic with dozens of countries, companies, indeed entire economic sectors (e.g. European banks) now on the list in one form or another. The threat of secondary or tertiary sanctions has effectively cowed the European (and Asian) banks into complying with the extraterritorial demands of Washington. Although the Europeans have been protesting furiously, their bleat is notoriously worse than their bite, and the European corporate sector is exiting Iran at a fevered pace (though the Iran oil embargo is likely to fail at least partially given that neither India nor China intend to stop their purchase of Iranian oil).
Commerce meets high-politics: India has apparently reached a deal with Washington “allowing” it to purchase the Russian S-400 air defence system, in return for offsetting purchases from the US military-industrial complex (Mike Pompeo seemed somewhat less understanding of Turkey’s decision to buy Russian; the thin line between diplomacy and salesmanship is increasingly permeable).

This vulnerability , of course, creates a desperate need for an alternative financial system. While such alternatives are slowly falling into place (both Russia and China now have national payments systems independent of SWIFT while currency swaps allow trade in energy and goods without recourse to the USD) nothing like a satisfactory overall solution has been found. China has successfully introduced RMB-based trading in oil futures, as well as offering swap lines to numerous countries to facilitate trade in local currencies, however these alternatives are still in their infancy.  While the Euro could theoretically provide a viable alternative – indeed it was initially conceived as such – the successful blackmail of the European banks has neutralized this threat. While the alternative media are full of airily optimistic declarations that the dollar is being pushed off its perch by crypto-currencies, gold, counter-trade, perhaps sea-shells and virgins, this optimism may not be justified. Given the political disunity of the potential opposition, and the relative sizes of the economies involved, at least until China finds it in its own best interests to render the RMB fully convertible and to run a sizable current account deficit so as to provide the requisite currency, we do not see any obvious alternative. Economic aggression does, of course, engender coping mechanisms, so at best, awaiting full convertibility of the Chinese currency, we would expect the development of a range of alternative minor financial pathways rather than a fundamental disruption of the system.

Russia Sanctions – Wash, rinse, repeat

The primary reasons for the underperformance of Russian financial assets has been the threat of further US sanctions – and here we can counsel only patience.
Sanctions/counter-sanctions have proved a double-edged sword and may have actually been net-net beneficial to Russia. In particular, the agricultural counter-sanctions banning food imports from the US/EU in response to the Crimea sanctions have led to the explosive growth of the Russian agricultural and agro-industrial sectors. While USSR was the world’s largest wheat importer – Russia is now the top global exporter, virtually owning the EMEA wheat market. Russia is now self-sufficient in pork, a net exporter of poultry, and is closing on self-sufficiency in beef and dairy – quite an accomplishment for a country almost entirely dependent upon animal protein imports just a decade ago.  Shopping In Moscow one now finds an wide array of locally-produced dairy products, packaged goods and meats in no way inferior to those available in Europe. Locally produced products have become fashionable, as have a growing variety of health-themed and farm retail outlets.

This is of course counterbalanced by the decline in foreign investment and ownership of the equity market. Russian finance – once totally exposed to foreign boom/bust cycles, is now largely self-contained. Given the large trade surplus and balanced budgets, this is sustainable but suboptimal. The compensation is, of course, that Russia is largely insulated against economic blackmail or swings in commodity markets – the gradual ratcheting up of Western pressure has rendered the financial system increasingly resilient.

In short, and despite the manly growling from Washington, we suspect that the practical panoply of sanctions is largely exhausted. Russia is not Iran. It is a key player in the global economic system. One can perhaps find substitutes for half of Iran’s 2.5m bbd crude – try doing the same for all of Russia’s 11m…
While not wishing to engage in political fiction, the reader is invited to imagine the havoc were Russia to suddenly suspend all exports of oil and gas. Long before there was any substantial hit to the Russian budget Brent crude prices would top $200, much of European industry would shut down, with a global depression setting in. Already, the sanctions on Rusal threaten to disrupt the global aluminium supply with considerable damage to US industry. Extreme outcomes seem far-fetched, and there is room for miscalculation, but one must assume that economic suicide is on no one’s agenda – and the Russian alliance with China provides valuable insurance.

In short, we believe that the Russian equity market is priced for a ratcheting up of sanctions beyond anything realistically feasible – at a PE of 5.2 the downside seems sharply limited. That said, in the short term psychological factors overwhelm the fundamentals, so the risk of further volatility – perhaps severe – cannot be excluded.

Russian Equities – getting paid to wait

The Russian investment case in one picture: RTS
 

Year P/E Ratio P/E Ratio without Divs reinvested DY
2017* 5.2 5.2 5.2%
2018 3.5 3.7 7.4%
2019 3.3 3.6 9.5%
Data courtesy of Prosperity Capital Management, Moscow

During our ten-year stint on the sell-side (followed by a further ten on the buy-side) we have seen a great deal of money made and lost in Russian markets. To be successful, one must be either very fast…or very slow – currently, given the chaos in Washington, we prefer the “slow” option.

We had long argued for overweighting Russian fixed income at the expense of equities, including in our previous notes published by Marc Faber. The Russian equity market is the worlds cheapest major market – until about 5 years ago, for good reasons: corporate governance ranged between the patchy and the truly dire; a series of corporate scandals rendered investment more a matter of luck than of skill;  dividend yields were niggardly; market trading practices were frankly dodgy, with limited controls and virtually no compliance. The facts have now changed – quite radically – and following Keynes’ maxim, our views are changing with them.

Corporate governance has seen huge steps forward, with accountancy far more transparent, companies increasingly share-holder friendly, and mostly paying generous (occasionally huge) dividends. With the exception of Sistema (whose reference oligarch was involved in a fight with Rosneft head Igor Sechin; we would steer clear of the Rosneft universe) the constant stream of abusive takeovers and value destructive manipulations of the past is a distant memory; insider trading laws are now actually enforced; independent directors are truly independent – front-running is no longer accepted practice; for better or for worse, compliance now rules the roost. A new generation of Russian managers – frequently with international training and experience has taken over from the first, post-Soviet fraternity. It clearly shows…

Given the degree of uncertainty in global markets, high-yielding Russian equities are currently the best medium-term trade we can identify…although we have limited clarity as regards the short-term. For those not faced with a monthly mark-to-market, the opportunity is compelling.

Russian equities remain absurdly cheap (Bloomberg estimates the RTS P/E at 5.2 vs, as contrast such havens of stability as Italy (12), Greece (20) or Morocco/S. Africa/Egypt (16-17) given both outdated perceptions of corporate governance risk and some very real concerns regarding further economic sanctions. Dividend yield is particularly compelling – one can easily enough construct a portfolio of solid companies paying >10%. Norilsk Nickel, the best large metals and mining company in Russia, and a top producer of PGMs and Nickel, has an expected dividend yield of almost 14% – nearly three times the yield on Norilsk Nickel 2020 Eurobonds (4.9%). In our career in finance, we have never seen anything quite like it.

Dividend- and Corporate Bond yields – every picture tells a story!
Comparing Eurobond and equity yields for the same risks, we are forced to conclude that the two markets are simply not speaking to each other; there are some world class mispricings here!

Security Name Instr code  P/E 18  P/E 19  P/E 20 DY18 DY19 DY20 Eurobond  YTM
Sberbank SBER           3.8 3.4 3.3 8.0% 13.1% 14.2%
Sberbank (prf) SBERP           3.2 2.9 2.8 9.4% 15.4% 16.6%
Gazprom GAZP           2.4 2.3 2.2 6.0% 11.0% 11.1% 4.5%
Lukoil LKOH           4.8 5.0 4.7 7.2% 9.2% 9.8% 4.9%
Norilsk Nickel GMKN           7.1 7.8 7.3 10.5% 13.8% 13.1% 5.4%
Tatneft (prf) TATNP           5.6 6.1 5.4 10.0% 8.5% 10.0%
Surgutneftegas (prf) SNGSP           3.8 4.2 4.1 4.2% 8.3% 5.5%
Gazpromneft SIBN           3.5 4.1 4.2 8.0% 9.9% 11.4% 5.4%
NLMK NLMK           7.2 9.4  9.9 13.6% 10.6% 10.2% 5.6%
Severstal CHMF           6.1 8.1 8.9 13.2% 9.8% 8.9% 5.2%
ALROSA ALRS           6.9 7.2 6.9 13.0% 11.6% 12.3% 4.7%
MMK MAGN           5.9 8.9 10.2 11.5% 10.1% 8.0%
MTS MTSS           6.7 6.5  6.5 10.8% 12.1% 13.1%
VEON VEON US        11.8  8.7  6.9 10.5% 11.0% 11.8%
Acron AKRN           7.3  5.2  4.3      12.0%           13.5%           19.2%
E.On Russia UPRO           7.3  5.7  4.5        9.9%           12.8%           20.6%
Data courtesy of Prosperity Capital Management, Moscow

The Russian market is particularly unsuitable for the index-based approach to investment, given the weight of certain state-owned entities such as Gazprom and VTB bank – which function more as government effector organs than as private entities; this may make perfect sense from the standpoint of the Russian state – gas is a vital source of foreign currency revenue and political influence, and a policy bank is a valuable tool – however we think they would be better returned to full state ownership rather than remaining in limbo in a somewhat confusing public/private mix. We would instead aim to build a portfolio of private high-yielding metal and mining and oil producers, in particular the preferred shares.

The current absurdly low valuation of the Russian market is thus due almost entirely to external political factors; given the extreme volatility of American politics (and thus sanctions), predicting the short-term outcome is a fool’s errand. With the extraordinary dividend yields, one gets paid to wait. At some point the market will adjust – until then, in a low-yield universe, the cash-flow argument seems compelling.

The optimal approach would be purchase of a diversified basket of high-yielding private entities in the energy/commodities sector.  Investors unwilling to delve into detailed stock-picking would do well to consider one of the well-managed equity funds – a personal favourite are the family of institutionally-focused equity funds which have been managed since the mid-1990s by our long-time clients and friends at Prosperity Capital: akb@prosperitycapital.com

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