Russia's Recession Just Got Worse

By MarEx 2014-07-20 05:22:00

Danske Bank Markets analyzes the impact of the downing of MH17 on Russia’s economy:

The downing of MH17, in our view, represents a renewed escalation in the conflict, and the likely outcome is a further downturn in the Russian economy and downward pressure on Russian markets. 

New sanctions against Russia very likely

MH17’s tragic event is likely to trigger new sanctions from both the EU and the US against Russia. In our view, the likely next step is to expand sanctions to the financial sector, which could seriously limit Russian financial institutions’ access to the international capital markets and thereby seriously further increase funding costs for Russian companies.
Furthermore, we would stress that the mere possibility of such sanctions will have an effect as they have already been implemented – international financial players are likely to reduce their exposure to certain Russian financial institutions, which have not yet officially been put on a sanctions list, but might be in the future. 

Russian recession deepens, but, more importantly, potential growth also falls

The Russian economy is effectively already in recession with the latest sanctions and the likelihood of renewed sanctions and the continued capital outflow from Russia is likely to continue to put downward pressure on Russian economic growth. In our view, it is fairly clear that the slowdown in the Russian economy is likely to continue in coming quarters and also spread to private consumption. Therefore, we do not see any near-term turnaround nor any pick-up in Russian growth this year.

Even more importantly, the overall Russian-Ukrainian crisis has been a serious blow to investor confidence in Russia. In our view, this is likely to have permanent long-term negative ramifications for foreign direct investments into Russia and the general increase in regime uncertainty is likely to put continued downward pressure on investments in Russia (both by domestic and foreign investors). This will seriously hamper potential long-term growth in the Russian economy, which is of course likely to have negative consequences on the valuation of Russian assets.

Rouble to stay soft going forward, but a lot is already priced in

Since the Russian-Ukrainian crisis started, we have been bearish on the outlook for the rouble and we remain fairly so. Given the outlook for more sanctions – and particularly given the risk of financial sector sanctions – it is hard to see a near-term turnaround in capital flows. Hence, we continue to expect continued outflows from Russia going forward. We do not necessarily see this as a (new) ‘sudden stop’ to flows into Russia (we have to a large extent already seen this), but rather a gradual ‘drying up’ of capital flows. 

Furthermore, we continue to see global oil prices trending lower, which is also likely to continue to weigh on the rouble even if the geo-political situation does not worsen. We therefore also continue to recommend to be positioned for further rouble weakness going forward – also relative to market pricing. 

Risk of new sanctions threatens commodity markets

Commodity markets reacted swiftly to the renewed escalation. Both European natural gas prices and wheat prices rose more than 2 percent immediately after the news broke. 

As we have argued before, there is definitely a risk of a spill over to commodity markets from the conflict between Ukraine and Russia due to the two countries’ dominant position in several major commodity markets (see Research Commodities: Ukraine crisis puts commodity markets on alert, 3 March 2014).

Russia is Europe’s key natural gas supplier and a leading exporter of crude oil to the world market. In addition, Russia holds a strong position on the global export market for aluminium and nickel as well as wheat. Ukraine sits on a large share of the global market for corn and wheat exports. 

So far, commodity markets have been relatively untouched by the crisis. However, there is a risk that new sanctions on Russia may constrain the country’s exports, as has been the case with the sanctions on Iran. In such a scenario, the above-mentioned markets could face a supply disruption, which could push up prices significantly. 

Given the already present supply concerns in the aluminium and nickel markets on the back of the Indonesian mineral ore export ban, these two markets look vulnerable; so does the energy market given Russia’s leading position in the European natural gas market and the world crude oil market. In the global grains market, the supply situation is currently very benign, which means that the threat to this market is less imminent.

This research report was prepared by Danske Bank Markets, a division of Danske Bank A/S.