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Russian Roulette
Toronto: March 10, 2014
By John Stephenson

Markets have been gyrating as rising tensions in Ukraine sent global stocks tumbling and boosted the value of gold and other precious metals as investors flocked to safe havens. Russia’s benchmark index fell 10.8% this past Monday as the country’s armed forces tightened their grip on Crimea. Ukraine’s deteriorating financial picture coupled with the Russian encampment triggered a wave of worry in financial markets globally that for months had viewed favorably the promise of a strengthening world economy with little geopolitical strife.

Oil moved above $100 per barrel as markets weighed the impact of possible Russian sanctions on crude prices. Palladium soared by more than 5.5% this past week, driven by a near perfect storm of strong global automobile demand and the possibility of supply disruptions out of both South Africa and Russia—the world’s number one and number two producing nations. Gold and U.S. bonds rallied this past week, while risk assets were largely for sale.

But despite the strong undercurrents of market uncertainty, the direct impact of Russia’s move into Crimea on the global economy is less clear.  The Ukrainian economy is tiny, ranking 54th in the world and accounting for just 0.4% of global GDP, while Russia’s economy clocks in at 2.9% of global GDP. Russia’s imports from the U.S. and Euro region are a paltry at $11 billion and €87 billion respectively, suggesting that the crisis in Crimea will have at best a minor impact on global growth.

Germany is the country most impacted by the crisis, since 50% of its oil imports come from Russia, as well as, 39% of its natural gas. Russia’s main export to the 28-country European Union and Ukraine is natural gas, and lots of it. About a quarter of all gas consumed in the EU—worth about $100 million per day—and half the gas in the Ukraine comes from Russia. Europeans are worried that if Russia decides to turn off the taps, lights and furnaces around the EU would go out, putting pressure on an already weak economic recovery.

While Russia boasts a near stranglehold on gas supplies to Europe and Ukraine it is doubtful that Mr. Putin would play that trump card by turning off the taps. Russia produces 11 million barrels per day of oil (with six million barrels per day delivered to Europe) and 650 billion cubic meters per year (19% of the global total) of natural gas. Energy is the lifeblood of the Russian economy and its biggest export earner, accounting for 50% of state revenue and Russia badly needs the euros and dollars from energy to help balance the books. The country’s current account surplus has slumped to 1.6% of GDP from 7% in 2008, while its government budget has slipped into deficit in the last year.

Russia has a lot to lose from trade sanctions or even worse from the seizure of overseas assets, valued at $270 billion, or roughly 13% of its entire annual economic output, making it unlikely that it would dare to cut off natural gas exports to Europe.  For Ukraine, the situation is very different, with Russia cutting off or constricting natural gas supplies several times in the past decade. On at least one previous occasion, the choked-off gas sent Eastern European utilities scrambling for replacement fuel.

It seems likely that Russia will press for control of Crimea, given that 60% of the population in that region are ethnic Russians and that the Black Sea Fleet is stationed at Sevastopol. But it seems unlikely that the crisis will spread to Ukraine as a whole given that Russia (1994 Budapest Memorandum) promised to protect the sovereignty of Ukraine in return for the receiving the Soviet nuclear weapons stationed on Ukrainian soil. And on a more practical level, Russia’s status as a military power has fallen enormously since Soviet times, with defense spending now just 50% above that of the United Kingdom but only one-seventh of what the United States spends.

I still believe the way for investors to profit from the current crisis is to stay the course by continuing to overweight equities, particularly U.S. equities.  The tactical indicators that I monitor are still showing equity sentiment at or below long-term averages and since the start of 2008 there has been $93 billion of outflows from global equity funds, suggesting that there is plenty of dry powder sitting on the sidelines. My U.S. earnings models are forecasting nearly 9.2% earnings growth this year, while corporate America has potential buying power of $1.5 trillion in cash on their books—money that could be spent on capital expenditures, dividend increases, buybacks or mergers & acquisitions. While the crisis in Crimea is unsettling, I believe that for savvy investors, the balance of the year looks much more promising.

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