Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Ukraine and Russia – Assessment and Portfolio Adjustments

Tuesday, March 11, 2014


Ativo has taken steps to reassess the exposure of our portfolios to Russia and Eastern Europe in light of the developments over the last few months in Ukraine. We had an overweight in Russian equities when the crisis in Ukraine escalated on February 22nd, as Ukrainian President Viktor Yanukovych fled the country to Russia after a political coup and Russia subsequently occupied the Crimean region in southern Ukraine. Since then we’ve cut down our exposure to a slight underweight in Russia with the sale of Sberbank and Sistema JSFC from our portfolios. We’ve maintained our exposure to other Russian and Polish securities that we believe have minimum exposure to Ukraine; these securities are of course exposed to any further weakening of the Russian Ruble or the Polish Zloty. Sberbank has a $4 Billion direct exposure to Ukraine, amounting to roughly 1% of its balance sheet, but they are also exposed via their loans to Russian businesses that do business in the Ukraine. Thus a potential escalation in the crisis, or the fallout from sanctions, could have a strong negative impact on Sberbank.

The key facts of the current situation are widely known through extensive reports in the news media. Now let’s take a step back and look at geopolitics to understand the factors that led to this crisis and the probable steps to deescalate the situation.

Russia has felt increasingly threatened by Ukraine’s growing proximity to Europe. When the pro-western interim government took power in Kiev, Russia was terrified at the prospect of having no say in Ukraine. Russian President Vladimir Putin saw an opportunity to destabilize Ukraine and on the pretext of safeguarding Russian interests and protecting the large ethnic Russian population in Crimea he ordered Russian troops from the Black Sea Fleet stationed in Sevastopol to take over Crimea. Putin, who is trying to counter the influence of the EU with his pet Eurasian project, believes that Ukraine and some of the former soviet republics are central towards strengthening Russia’s influence in the region and the world. Like Henry Kissinger aptly stated in his op-ed piece in the Washington Post on the current crisis, it has to be understood that from Russia’s perspective Ukraine has been a part of Russia for centuries and can never be a completely independent country. Other geopolitical analysts acknowledge the Russian interest in maintaining Ukraine as a strategic “buffer zone” protecting Russia from European armies, and access to the warm-water port of Sevastopol is critical as well.  

Vladimir Putin has openly said that two of the great catastrophes of the twentieth century were the collapse of the Russian empire and the breakup of the Soviet Union. Putin’s long term goal is perhaps to reintegrate territories of the former USSR with large populations of ethnic Russians and perhaps form the Slavic state that Nobel laureate and Russian historian Alexander Solzhenitsyn advocated. Putin is fearful of western encirclement and understands that Russia’s economy, society and military are in decay. Having a strong or macho foreign policy is his way of stoking Russian patriotism and shifting the focus away from domestic problems like human rights violations, mismanagement and corruption. Russia is prepared to defend vital interests and is willing to accept high risks.

All these above factors probably explain the reasoning behind the extreme steps taken by the Russians in the current crises. Russian strategic planners had to have known that by occupying Crimea they would be further alienating ethnic Ukrainians and pushing them more towards the West. They also probably took the risk knowing that the response from the Europeans would not be harsh in terms of sanctions.

The Western Europeans are approaching this situation very differently from the U.S and Eastern Europeans for obvious reasons. Russian trade with Western Europe amounts to roughly $330 billion. Europe, particularly countries like Germany, gets 30% of its energy from Russia. The Financial and Real Estate sectors in the UK depend heavily on Russian money. Eastern European countries, caught between the West and Russia, are alarmed at the developments and are wondering if they are next in the cross hairs of Putin, particularly if they make further advances to integrate with the West. The U.S on the other hand is taking a very uncompromising approach to the situation. U.S trade with Russia is only $38 Billion, so not a lot of risk there from its perspective, except for the Automobile and Aerospace sectors that have sizeable exposures to Russia. U.S credibility and relations have been severely damaged due to the phone tapping allegations and the Obama administration sees the opportunity to improve credibility and re-engage with Europe. The Obama administration also sees this as an opportunity to turn back public and political opinion that President Obama has been soft on foreign policy after the missteps he made in dealing with Syria, Iran and Benghazi. Remember that U.S mid-term elections are fast approaching, and Obama’s popularity ratings will likely have a major influence over whether the Democrats can retain the senate. China, given its commercial interests in Ukraine, is urging Russia to negotiate on the issue, but is wary of interfering with another country’s sovereign affairs.

It is risky to isolate Russia and the western governments have to approach the situation pragmatically. This crisis is also a show of the extent of the West’s commitment to engage effectively in the region; their response will be watched closely by countries like Poland that feel threatened by the current scenario. Also Emerging Eastern Europe is poor and unstable, so many key players have an incentive to stabilize this region. It’s also a fantastic opportunity to undermine Putin’s standing within Russia and make his political career untenable to a lot of stakeholders within Russia. Russia is highly dependent on international trade, so the U.S and Europe should not overestimate the extent of the support Putin has for his actions within his country. A substantial proportion of the Russian population is attracted to the ideals of a liberal economic and political community that Europe has to offer.

However, Russia (i.e., Putin) holds several important cards.  Even though the U.S. may be inclined to make an aggressive response, Russian economic ties are important to the Europeans, and European support is essential for any effective sanctions.    Furthermore, some degree of Russian cooperation is still important in Syria, Iran and Afghanistan.

Steps that have already been taken are appropriate, particularly economic sanctions on Russia and selective sanctions on high-ranking individuals in Putin’s administration. Sanctions will hurt Europe in the short term, but will be beneficial in the long run and might prevent any further problems from Russia down the road. The West has to make it clear to Russia that Ukraine’s sovereignty is non-negotiable and at the same time make it clear to the Russians that they will have a say in any outcome. Russia must be given the time and space to deescalate the situation. Maybe give the Russians clear guarantees (not assurances) that Ukraine will not be asked to join NATO or be asked to host missile defense systems within Ukrainian territory.

We expect that the current scenario in Ukraine and Crimea is headed for a stalemate, unless something drastically changes for better or worse. Elevated investment risk around Russia and Eastern Europe will continue for an extended period of time. As economic sanctions could impact the European defense and industrial sectors, we are closely monitoring the performance of some of our holdings in these sectors like Safran, Linde AG and Vinci. Any retaliatory sanctions from the Russians might negatively impact the energy markets. Sanctions will also have an impact on EU and US markets; at a minimum, we expect risk levels and discount rates to remain at some elevated level until the situation is resolved.