Chris Weafer of Sberbank CIB
November 21, 2012
Oh, no, the dog howled mentally. Excuse me, but I won’t, I won’t let you. Now I understand it, to hell with them and their sausage. They’ve tricked me into a dog hospital. Mikhail Bulgakov, “Heart of a Dog”
How would Russia’s great writers look at 2013? As part of our look ahead into 2013, we thought to illicit the assistance of some of Russia’s most famous classic authors. What would they make of the parameters and scenarios facing foreign investors as they consider the opportunities and risks lurking in 2013? For the nine factors that make up the investment case ahead, we have chosen nine authors to make the case using one of their works. Of course, when it comes to Russia one might use all of Dostoevsky’s works or sum it all up with Gogol, about whom Dostoevsky said “We all come from Gogol’s overcoat”. If you read “Dead Souls”, you will see exactly what is meant both as a social commentary and also as an example of how one can make money of even the most unusual circumstances. Russia, for all the bad headlines regularly generated, has been the most profitable country investment (among the major markets) over the past 10 years, notwithstanding the collapse in 2008.
No happy endings in classic Russia literature. The one problem when using classic works from Russian authors is that it is very difficult to find a book with a happy ending. The only event that counts as a happy ending is the release from misery, and that is usually in death. Perhaps somebody will have cause to write one soon. We list the main market scenarios and investment themes as illustrated by classic Russian works.
External threats: War and Peace
Conflict first, peace later. Leo Tolstoy’s epic work is the obvious choice for how we anticipate the investment backdrop in 2013, i.e. a very volatile first half to be followed by a more peaceful second half. The first part of Tolstoy’s novel is set against the backdrop of the war with Napoleon and culminating in the battle of 1812. The war caused great economic and social destruction in Russia, but eventually the country prevailed. This is similar to the destruction caused by the 2008 global crisis, which led to a huge decrease in the country’s financial reserves and recession. But, as in “War and Peace”, the threats were restructured and the economy placed on a better footing to withstand the external threats.
A sort of happy ending. The peace in Tolstoy’s book was bittersweet with some of the author’s heroes not surviving. There was a better ending for Pierre and Natasha and, sort of, for Nikolai and Maria. But even here, the approaching Decembrist Uprising looked ominously likely to destroy the peace again.
Tolstoy argued that only all of the people can make changes. In an analysis later, Tolstoy argued that his novel illustrates that great actions and changes cannot be achieved by the work of any individuals or heroes, but only as the result of many smaller events driven by thousands of individuals. Perhaps a parallel can be drawn here with the emerging middle class in Russia and how this may eventually result in a new chapter, i.e. rather than as a result of a great leader.
Conflict will kick off 2013, but we hope for peace in 2H13. Our assumption for 2013 is that the negotiations in Washington between the White House and Congress, in parallel with the continuing efforts of EU leaders to contain the Eurozone crisis, will sustain continued volatility in global markets and the risk-on, risk-off rotation. The hope is that these issues will see a more sustainable structural resolution put in place by the summer, which can then create a more benign backdrop for markets in 2H12. The new Chinese leadership will formally be in place from mid March and German Chancellor Angela Merkel faces an autumn reelection campaign. She or her party will not want to start into that period with the current issues unresolved.
Oil vulnerability: Master and Margarita
Russia was seduced by oil. Mikhail Bulgakov’s novel is an appropriate metaphor for Russia’s oil revenues. Oil was referred to as the “Devil’s Blood” in the countries bordering the Caspian Sea. Just as Professor Woland arrived in Moscow with the prospect of improving the lot of the city’s literary elite, oil revenues grew rapidly through Putin’s first period as president and transformed the country’s economy. But the sting in the tail came in 2008, when oil collapsed and wreaked havoc with the economy. Margarita, the heroine of the novel, is as tempted by Woland’s promise of an eternal good life as Russia was tempted by seemingly never-ending oil revenue growth before 2009.
The Middle East aspect is very appropriate. Bulgakov’s novel is set in two locations, Moscow and Jerusalem, which is also appropriate given the current events in the Middle East and the effect they have on the risk premium for Brent and Urals.
Oil should be supported by uncertainties for six to nine months. Our assumption is that the risk premium can be sustained for at least 1H13, and perhaps longer, depending on what happens in Iran. At this stage, it seems more likely that a military strike will take place in 2013, which would drive the price higher, but only for a short period. The outlook for oil in 2013, therefore, is again favorable. Beyond the next six to 12 months, the outlook is much less so. If the growth projections for US, Canadian and Iraqi oil are realized, then the oil price will almost certainly face downward pressure before the end of next year and over the coming two to four years. That may well be the next big game changer for Russia, especially if budget preparations in the meantime are inadequate.
Russia’s reform agenda: Crime and Punishment
Tough issues avoided for a while. Fyodor Dostoevsky’s novel, according to an eminent reviewer, deals with Raskolnikov (the core character)’s “conflicting feelings of self-loathing and pride, of contempt for and need of others, and of terrible despair and hope of redemption”. This is a very apt analogy for the Russian reform agenda in that it is clear that these are issues which must be dealt with, but the preference is to avoid taking any action that may be politically or socially unpalatable.
Eventually they must be confronted. The novel follows Raskolnikov’s efforts, usually agonized, to confront what may have been his motives for the murder he committed and in the near certainty of what the consequences of his action are.
Do not expect much in terms of reform confrontation in 2013. We have little optimism that the promised reform agenda will be aggressively pursued over 1H13, or even for longer. The government’s priority is to maintain domestic (social and economic) stability, and it has the financial resources to achieve that via the budget so long as Urals stays above even $80/bbl. However, the reform program is very visible and the longer-term consequences of not achieving changes are very real.
Financial service changes are proceeding. Steady progress is being made in the area of financial sector changes and the Central Depositary has now finally been put in place, with access to the local bond market expected to be granted to Euroclear and Clearstream in early 2013. The major reform debate expected over 1H12 will be that of pensions. This is one of the “big elephants” in the room that has implications for budget spending, the retirement age and immigration policy, among other things. It cannot be ignored for much longer, but will provide a real test of both resolve and unity within the government structures.
Domestic economic expansion: The Queen of Spades
No shortcuts to prosperity. In this work, Alexander Pushkin relates the tale of an elderly countess who strikes a bargain with the devil and exchanges her soul for the ability to always win at cards. Then, an army officer murders her for the secret of winning but is haunted by the woman’s spirit. Here is the devil again: he features in so many Russian works. This is essentially a story of obsession about winning and always staying ahead, even at the cost of one’s sanity and soul. We could have used this work to reflect on a deal with the oil revenues and the consequences of not reforming away from gambling on continued high oil revenues.
The warning is that without reforms, growth may not last. The expansion of the domestic economy is one of the key investment themes in Russia. This, including the strong growth in consumer spending, has been one of the key drivers of GDP growth in recent years and is the basis of our preference for stocks and themes in this area. But, as also referenced in the other works mentioned, if there is no reform and one continues to rely on luck, then eventually the good fortune stops.
We still prefer domestic themes in 2013. But for 2013, we retain a strong preference for stocks in this theme: retailers, TMT, real estate, transport and banks. We expect strong double digit growth to continue over the medium term (see forecast table in the section 2013: Adaptability and Patience).
Strategic industries: Dead Souls
Investing in assets with no obvious value. Nikolai Gogol’s “Dead Souls” is certainly one of the definitive works of Russian literature that has a lot of relevance to events today. In the story, the author’s hero, Chichikov, dupes landowners into selling him seemingly worthless dead serfs. Chichikov explains that he intends on using the dead souls as a means to reinvent himself as a gentleman landowner in Siberia. Okay, not quite a neat jump to the state’s ownership of strategic industries, especially in oil and gas, but close enough. With a high-tax regime and state regulation, many of the stocks in these sectors have low valuations relative to EM peers and are more lowly valued by investors when compared with the fast growing domestic industries.
Everything has a value to someone. The state has a policy of pushing for higher dividend payouts and is promising sector restructuring as part of the eventual privatization program. If these do come to pass, then valuations will rise. Chichikov’s ruse was discovered by the landowners and he had to flee town with his plan incomplete. Gogol wrote a sequel to his work but burnt most of it. So we do not know how he imagined Chichikov’s plan would eventually work out.
The script remains unfinished in Russia also. In modern Russia, the state’s script for the energy sector has yet to be finished or published.
Regulated industries: One Day in the Life of Ivan Denisovich
Suppressed people and industries. An interpretation of many of Alexander Solzhenitsyn’s works may have metaphorical relevance to many of the regulated industries, such as the utilities.
Small victories can be worthwhile. No matter how unappealing the outlook for some industries may be, there are opportunities for small victories to highlight attractive investment opportunities in some areas. Just as in the case of Ivan Denisovich Shukhov, small victories can make an otherwise miserable day seem less bad at the end of it.
E.ON Russia and MRSKs. Shukhov might buy E.ON Russia and some of the MRSK distribution companies as examples of investments to brighten up an otherwise dim outlook.
Changing social order: The Cherry Orchard
Focus on social changes and how to cope with them. Anton Chekhov’s “The Cherry Orchard” may be used to illustrate many of the issues facing Russian society today. The story concerns an aristocratic family returning to the family’s estate – which contains a well-known cherry orchard – just before it is auctioned to pay off debt. While presented with options to save the estate, the family essentially does nothing and the play ends with the estate being sold to the son of a former serf and the family leaving to the sound of the cherry orchard being cut down.
Change is inevitable – it is how you handle it that matters. The play is often used as an example of the futility of trying to maintain a status quo when faced with the inevitable and especially if those in power refuse to accept what is happening and then suffer the consequence of losing everything. Of course, the problem is that those that then inherit the power do not really understand what they now have and, as it were, cut down the cherry orchard out of spite.
Economic tandem: A Hero of Our Time
Be careful what you wish for. This is a complicated work, and that is saying something in Russian literature. Mikhail Lermontov’s “A Hero of Our Time” is often used as an example of “be careful what you wish for”. The hero of the story, Pechorin, is in relationships with two women at the same time for a while and, when he rejects one of them, the other decides she does not want him after all.
It will be tough to satisfy the state’s wish to control strategic industries and also to bring in investors. This is a story that mirrors the government’s tandem of trying to keep state control in the strategic sectors, while also promising to push ahead with economic and business reforms to make Russia more attractive to foreign investors. Trying to satisfy two mistresses is impossible over a long period, and by the time you choose which you prefer, it may be too late and you could end up losing on both fronts.
Russia wrap: Home of the Gentry
Leaving the past behind only to have it follow you. Ivan Turgenev’s work centers on Lavretsky, who was brought up on his family’s country estate home by a severe maiden aunt, known for her cruelty. He leaves Russia for Paris with his wife, Varvara, who later betrays him. Returning to Russia he falls for another woman, and after reading of Varvara’s death, he plans to marry his new love. Unfortunately, Varvara turns up alive and comes back to extort money from him and generally make his life a misery.
The next chapter is yet to be written in modern Russia. Is there a parallel in modern Russia? Having left the cruelty and severity of the Soviet past to embrace a Western lifestyle, and with the ambition to live happily ever after, is there also a chance of a return to a less optimistic and less happy existence full of regret and longing for what might have been? In the 21st century, thankfully, that chapter has not been written yet.