Babson Capital's Brigitte Posch travels to Russia with an entourage and comes away with an insider's view of the investment landscape
The former head of PIMCO emerging markets finds some comfort in the substance of the Eurasian bear's central bank
Brooke’s Note: If there is a black swan out there — or not — it is Putin’s Russia in the context of his adventures in Ukraine. It already appears to have had a dampening effect on the European economy. We know it could get much worse. We don’t know how much. With that in mind, Babson Capital sent Brigitte Posch, former emerging markets analyst for PIMCO, to Russia for an insider view. She visited Russia on the 21st of July, and stayed for three days. She and her team typically will visit Russia at least twice per year. Brigitte sent a prepared Q&A detailing some of her takeaways but also answered a handful of questions by email that we placed on top here. She declined to be interviewed directly.
Brigitte Posch, portfolio manager and head of emerging market corporate debt at Babson Capital Management LLC, recently visited Russia along with four of Babson’s investment analysts to meet with a number of companies and regulators. This conversation addresses the key takeaways from the trip and investment implications across various sectors.*
Did you travel to Russia more to assess the health of Russian companies or to get a better sense of the macroeconomic scenario as a factor in assessing European and global markets?
Brigitte Posch: Both. Our primary goal was to understand the fundamental and political environment within Russia and what that meant for the rest of the world (i.e., developed and emerging markets).
What was the atmosphere like there both on Main Street and in the back offices? What exactly were the kinds of people you spoke to and what was their state of being under the crisis conditions? Did they seem more or less concerned than we are in the West about what happens next? Did they seem more eager or less eager to be debriefed than they have been in the past?
BP: We primarily saw senior executives. In general, the sentiment was mixed.
Can you discuss the main purpose of your recent trip to Russia?
BP: Russia has been dominating global headlines in recent months and not for the reasons you’d like to see as an investor or potential investor. The Russia/Ukraine conflict, which initially centered around the contested Crimea region, has continued to drag on—and the recent tragedy of a downed commercial airliner over the region has resulted in international outrage and a call for much stiffer sanctions against Russia.
It is against this troubling backdrop that we visited the country to get a better understanding of how these events are impacting the overall economy. Over the course of three days, we met with companies across the banks, fertilizers, energy and metals & mining sectors, as well as several regulators.
Our goal was to understand how the current political and economic environment is impacting these sectors and individual issuers. Specifically, our aim was to investigate the impact of current and potential sanctions against Russian companies, understand the reliance of issuers on external funding and form a more complete view of the growth prospects for the remainder of 2014 and into 2015. In short, we wanted to assess the risks in the region and potential opportunities, particularly if conditions begin to improve. See: Eavesdropping on the Barron’s Top Independent Advisor Summit and appreciating its vibe.
How have your views changed following your meetings in Russia?
BP: We have held a cautious view on Russia at Babson Capital since the beginning of 2014. This view has largely been based upon macroeconomic and geopolitical concerns. Following the trip, we retain a cautious stance though we would note that future prospects are likely to vary significantly from sector-to-sector and issuer-to-issuer, in our opinion.
In the near term, Russia should be fairly resilient to economic sanctions, even in the case of an expanded list of companies or additional sanctions from Europe. The central bank is standing firm, providing liquidity to the banking sector, which is filling the funding gap for Russian companies that typically rely on external sources. In our view, Russia can manage these foreign currency financing needs for the next 12 months, but beyond that, there would likely be material pressure both on the currency and interest rates.
At a sector level, banks are probably in the most difficult position, particularly as they face rising non-performing loans (NPLs), increased pressure to raise capital and exposure to the slowing domestic economy. Other sectors, including fertilizers, energy and metals & mining all face challenges but appear to offer brighter prospects for varying reasons, which I can discuss in more detail. See: What RIAs need to know about the Standard & Poor’s downgrade of US debt.
You speak of how the central bank can provide interim capital and that seems surprising. Do you believe that indeed Russia has such internal financial strength and what will put that under strain after 12 months?
BP: In the short term, we think Russian banks, with strong support of the central bank, can fill up most of the funding gap for the companies that previously relied on the external funding market, given Russia’s foreign reserve level and significant presence of the public sector banks. However, we are increasingly concerned if Russian banks and companies will still be denied for external funding beyond six to 12 months. The stress will likely be reflected in higher borrowing costs for the companies and capital constraints for the banks.
You mentioned that the Russian banking sector is facing a number challenges. Can you discuss these in more detail?
In our view, banks are the weak link in Russia’s economy; the domestic economic slowdown has resulted in asset quality deterioration and we are concerned about the strength of the banks’ capital positions. System-wide, NPLs ticked up from 6.5% to 7.0% between December 2013 and March 2014, according to the Central Bank of Russia, and in the retail space, that percentage is as high as 10& to 15%. In the corporate sector, exposure to construction (e.g. Sochi Olympics-related projects), metals & mining and agriculture are seen as three main areas of potential stress.
The capital position of the banking sector has been weakened by rising credit costs and high loan growth. Funding remains an area of stress as the Russian banks are unable to access international funding markets due to economic sanctions. The central bank has stepped in by increasing funding to the sector, which has helped to fill the gap. Central bank funding now accounts for close to 9% of banking system liabilities—up from roughly 0% in 2010—and we expect this to rise to 12% by year-end.
We believe that Russian banks could be particularly vulnerable if no resolution is reached and they cannot return to international funding markets beyond 12 months. This is a risk that we believe is currently underestimated by the market and is the key basis for our negative view on the sector. In our view, avoiding subordinated bonds of Russian banks is prudent until there is a more realistic solution to boost their capital base. See: Flash crash update: Why the multi-asset meltdown is a real possibility.
Can you discuss your views on the fertilizer sector following the team’s meetings?
BP: The three Russian fertilizer companies are world-scale producers and operate in the first and second quartiles in terms of cost. Access to key raw materials, low-cost energy and transportation infrastructure are keys to success in this commodity market, and all three companies are able to demonstrate these. The long-term demand trends remain positive—there is clearly the need for improved crop yields owing to increases in global population and the increased demand for meat from emerging markets given the large livestock feed requirement. See: Former Merrill Lynch analyst tells RIAs to steer clear of emerging markets.
The issues in the sector, in the opinion of our investment team, focus on the long-term capital spending projects all three companies have embarked on—which will limit future cash-driven deleveraging — and continued pricing pressure in all three key minerals: nitrogen, phosphate and potassium.
From an investment standpoint, we remain cautious on this sector and would likely need to see improvements in capacity utilization and product pricing, along with signs of de-leveraging, before getting more constructive.
Energy is a critical sector for the Russian economy. What were the key takeaways from your meetings in this sector?
BP: Russia’s energy producers seem to be weathering the geopolitical storm at this point. Financial results will likely see a positive impact from the combination of high oil prices and the RUB devaluation as revenues are in USD while costs are in local currency. To this point, there have not been any business disruptions due to sanctions or the Ukraine conflict. Company management teams see sanctions restricting the export of Russian gas to Europe as unlikely given the lack of substitution and the potential negative impact on a fragile European economy should gas prices increase materially. See: Why RIAs (Republicans, too) need to snap out of willful ignorance about climate change to claim the mantle of wealth stewardship.
International capital markets are essentially closed to these issuers at the moment and corporate treasurers have been proactively managing debt maturities and liquidity. The majority of issuers in the sector have very conservative balance sheets and low refinancing requirements. Support from Russian banks is evident and is expected to be extended further should markets remain closed for longer.
There is a notable push towards Asia (i.e. China) as a future market for Russian energy and also a source of funding.
BP: Overall, we remain comfortable with high quality energy issuers in Russia given strong fundamentals and state support, but we expect volatility on political news and potentially some interesting entry points on weakness. See: A style for all markets: momentum investing.
What were some of the key conclusions from your meetings in the metals & mining sector?
BP: Management teams in this sector were generally positive about performance year-to-date and the outlook for the remainder of the year. Steelmakers have seen robust demand from domestic markets, driven primarily by residential and infrastructure projects, and have benefited from rising steel prices this year. The largest steel companies have been focused on internal efficiencies and cost savings and now benefit from leaner cost structures; capital spending plans also appear to be conservative.
On the input side, expectations are for iron ore prices to remain broadly flat. Iron ore producers, however, are seeing good opportunities in pellets and benefit from the price premium of pellets versus concentrate. The coking coal market remains depressed, and without capacity rationalization, unlikely to rebound.
While there is a notable distressed situation in the sector—the coal miner Mechel (approximately $10 billion of debt), which is widely expected to go to the state banks for restructuring—there are also several issuers with idiosyncratic credit positive news. These include Metalloinvest’s upgrade to BB by Fitch, Severstal’s disposal of U.S. assets for $2.3 billion and a potential upgrade to investment grade, and Norilsk Nickel’s upgrade to BBB- by Fitch.
While, similar to other sectors, the metals & mining companies cannot access international capital markets, cash liquidity buffers and committed lines of credit (mostly from Russian banks) should provide ample liquidity for roughly 12 months. We continue to see opportunities for select exposure to high quality credits in this sector.
With prospects varying from sector-to-sector and issuer-to-issuer and geopolitical tensions remaining high, how do you approach investing in Russia at the moment?
BP: It comes down to selectivity and rigorous credit analysis while also carefully assessing the changing macroeconomic and geopolitical environment. At Babson Capital, we focus on bottom-up credit analysis across all of our strategies and consider this in the context of factors driving macro conditions. In the case of Russia, top-down concerns have made us more cautious on the region, and while spreads have widened recently for many Russian corporate bond issuers, they are not back to the levels seen at the time of the Ukrainian elections in late May. We think there could be further weakness especially if the geopolitical situation deteriorates further.
While there may be opportunities that exist in certain sectors where industry fundamentals are supportive and company balance sheets are strong, international sanctions can alter the equation significantly. We will need to get more clarity on these in the days and months to come as they impact not only the prospects for Russian issuers but also the sectors and securities that international investors can invest in. We will continue to monitor conditions in Russia to assess both the risks and opportunities.
Can we offer a takeaway for RIAs who see Russia as an all but impossible economy to analyze. Is this an area to hedge against or perhaps an area to find historically low valuations in the face of fear and uncertainty?
BP: When it comes to geopolitics it does not matter if it’s Russia or not, it is just a difficult situation to analyze. Rationality disappears thus economics become difficult to quantify (i.e. secondary role). Currently, Russia faces not only geopolitical risks and the international sanctions will have a significant economic implication, but also it needs to manage the slowdown of the domestic economy.
Brigitte Posch is head of EM Corporates at Springfield, Mass.-based Babson Capital LLC. She has 22 years of investment experience. Prior to joining Babson Capital in October 2013, Brigitte was an executive vice president portfolio manager — head of EM Corporates at PIMCO. Before joining PIMCO she was a managing director and head of Latin America securitization and trading at Deutsche Bank. She was previously a director with Ambac, responsible for developing asset- and mortgage-backed securities in emerging markets. Before joining Ambac, she was a vice president and senior credit officer with Moody’s Investors Service in New York, responsible for rating asset- and mortgage-backed securities in Latin America. She also worked in Sao Paulo, Brazil at Banco Inter-Atlantico/Credit Agricole, Citibank and ABN AMRO. She holds an undergraduate degree from Mackenzie University of Sao Paulo.
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August 10, 2021 – 11:46 PM
It’s great to see versatile sectors, like primary resources, holding steady in the face of sanctions and even offering some exciting prospects for investors.