Mea Culpa

First mea culpa, this blogging on a regular basis is a lot harder than it first appears. How Leo Kolivakis at Pension Pulse can do it every day is beyond me. As it used to say on my old school report – “Must try harder”

Second mea culpa, I also got the Ukraine situation badly wrong – the worst I foresaw was what euphemistically gets called “Collateral Damage” and we are certainly beyond that now.

Despite the situation having deteriorated farther than I anticipated, it hasn’t driven the markets down any farther. The attached chart of the Gazprom GDR shows that following the initial drop on the  invasion of Crimea it has mainly ignored recent events, although volatility has picked up. 

We have hung on to our basic positions in Russia, but more recently we have been “renting” stocks to take advantage of the volatility – buying small positions on down days they selling them out when they bounce; ideally we would be doing this as part of our option overlays, but there aren’t enough listed options on the GDRs.

Few precise details have emerged about the recent gas deal signed between Russia and China, but a couple of analysts who have run their slide-rules over what little we do know have suggested that it is at best a breakeven deal for Russia. Given that Putin was very keen to show the West that he has other choices of “friends”, it would not be surprising if China were able to drive such a hard bargain; in short, Gazprom remains a continuation of State policy by other means and as such will remain very “cheap”.

Some commentators have tried to use the deal to paint President Obama in a bad light – weak, ineffective, etc – the Realpolitik is that there is very little more he could do without Europe taking a stronger stand and there certainly doesn’t appear to be much appetite for that currently. Ironically, President Reagan warned of this kind of impasse when Western Europe first started negotiating to import Russian gas back in the 80’s

Now that Sunday’s Presidential Elections have returned the pro-European Petro Poreshenko things should calm down for a while. The forced closing of poling stations in several of the pro-Russian strongholds, such as Donetsk and Lugansk, only serve to legitimize a government that will probably be just as corrupt as the last one. It doesn’t make Russian stocks a screaming buy, but they should move slowly higher as things “normalize”

In recent weeks we have observed the Brazilian market get a bounce every time Dilma’s approval ratings drops, or word leaks out that preparations for either the World Cup or the Olympics are going badly; FIFA has said publically that the preparations for the World Cup are the worst they have ever seen, whilst the IOC has apparently informally approached the UK to see how quickly they could bring back on-line the facilities used last time around.

Congress has opened an investigation into the purchase of a refinery in Pasadena TX when Dilma was the Minister for Mines and Energy and Chairperson of Petrobras. The company was forced to acquire 100% of an operation they only wanted to acquire 50% of, paying out $1.25BN instead of their expected $360M, for an asset that was possibly only worth $42M. As a long-term follower of Petrobras, none of this surprises me.

Expectations of a first round win for Dilma have faded, although she is still currently expected to win in the second round. IF the Government is forced to introduce any kind of electricity rationing because of the poor rains, the October race will be wide open. Dilma, again in her previous role as Minister for Mines and Energy, intervened in the market to ensure that returns on investment were below those required to bring in new capital, so now the country faces a shortage of back up capacity and a $20Bn subsidy bill.

I remain confident that the World Cup will be a success, in the sense that it will happen, someone will win, and that people will have fun. Should Brazil get to lift the trophy again, they will probably deem it to be the greatest series ever.

I am happy to see the election of Narendra Modi as the new Prime minister of India. To call the Gandhi clan that has been at the core of India’s mismanagement for so long “tired and corrupt” would be an understatement. India needs someone who is not permanently trying to hold the poor back, but is actively trying to give them opportunities. Modi comes with baggage that is for sure, but he deserves the benefit of the doubt at this stage.

I used the bounce in many of the Indian names in my portfolio to cut back exposure, not because I doubt Modi’s abilities, but because I recognize that he has a herculean task ahead of him. Despite all the good wishes, we won’t know if he is actually going to be successful for quite a while as the vested interests fight to maintain their privileges.

Finally, I am surprised it took the Thai military so long to intervene in the dispute between the Government and their opponents. Given how the country has become increasingly polarized whilst the economy has slowly stagnated  - the State Planning Agency recently announced that the economy has slipped back into recession – it was only a matter of time before they stepped in. 

Unfortunately the coup isn’t likely to solve much of the underlying problem as they are too closely aligned with the “Blue Shirt” opposition of the urban elite. Perhaps they would have had more credibility if they had forced Suthep’s supporters NOT to have boycotted the Februa

Half a league, half a league

Last week was not a week to write a blog.

Although the Russian invasion of Crimea was the major event and had the expected and inevitable effect on the markets, it was so overwhelming event that it drowned out any thoughtful discussion. Best to let things settle down a bit first.

As entertaining as all the sturm und drange about the invasion has been, it is actually pretty pointless. Western Nations are not going to do anything dramatic, and token visa sanctions stopping oligarchs and friends of Putin visiting their London mansions just mean they will spend more time on their yachts.

Bloomberg has gone so far as to post “Russia’s Ukraine problem in six stark lines”. All good stuff, but Putin doesn’t care. He’s rich enough and protected enough; he measures his “success” in different ways.

The UK journalist, Jeremy Paxman, recently described how he felt modern society would never support a rerun of World War 1; we are too self obsessed and hedonistic. The days of sending in a gunboat are even the Light Brigade are long gone. That is NOT necessarily a bad thing, but it does make effective sanctions harder. I am sure Paxman is right, and no doubt President Putin feels the same.

What matters to Putin is rebuilding the image of a strong Russia and reversing the humiliations, as he sees them, of Russia since the fall of Communism. If the Western Powers are so pissed off with him that they are holding emergency meetings, discussing sanctions, or moving military hardware strategically, that means he has a result.

I cannot begin to fathom where this particular story will end, and frankly I don’t think anyone else does. Of all the talking heads out there, someone will be right, but we won’t know until the end who that it is.

Russian stocks are cheap. They were cheap before this invasion, and they will remain cheap for a very long time. I would venture to say they will remain cheap until Putin is clearly on the way out (Whether the ensuing rally will be a false dawn or not only time will tell, but it will make for a fun ride). There will still be opportunities there, although many will be “rentals” for a while. I am looking for real businesses that don’t depend on Government connections and that Putin won’t find a “strategic” need to get involved in.

In the mean time, Europe has a serious problem; it is too dependent on Russian gas.

It is particularly vulnerable to further escalation in the Ukraine, but ultimately it is vulnerable to the whims of Russia. Most people would probably say that Russia has too much to lose by cutting off supplies to Europe entirely, and I would agree, but so much can go wrong in a heavy winter; a few production problems in Siberia, a faulty valve in a pumping station, new monitoring equipment not working as planned…

So I can certainly see Germany quietly restarting its nuclear electricity program to give itself more energy choices. Realpolitik will mean that any announcement will try to avoid any linkage, but I would expect confirmation over the summer that the Government has been “running tests” as it slows down the decommissioning process.

Western Oil companies will pour into the Ukraine to exploit their shale gas, Europe’s 3^rd largest reserves. Ukraine needs the money desperately and the West needs the gas; it’s a marriage made in heaven

Chevron and Shell have both signed deals already, but with the ancien regime. I’m sure, given her history, Yulia Tymoshenko will be easily persuaded to allow such contracts to stand and will encourage the newly elected president to take the same approach. Other former Soviet Satellites, such a Lithuania and Poland, will also accelerate development of their shale reserves.

Elsewhere, the most exciting thing to happen was a bond default in China, that some people are calling China’s Bear Sterns moment. Bear Sterns was famously “saved” by JP Morgan, and markets continued to rise for several more months, thinking that the credit crisis had been averted. The bankruptcy of Lehman Brothers a year later showed the folly of that over-confidence. I think the comparison is a little misplaced myself.

As I have mentioned before, China needs bond defaults so that investors start to price risk correctly and they can start to control the runaway credit in the shadow banking system. Allowing such defaults, especially in an environment where they go against vested interests, is always painful. The trick is going to be allowing sufficient defaults to take place to allow the credit cycle to work but without so many happening that a complete credit freeze occurs leading to a complete rout.

The process becomes more complicated in China where a default can very quickly be seen as a punishment of someone who did not have the right connection, reinforcing the graft and influence peddling that the Government is trying so hard to reign in.

Although this default was widely flagged ahead of time, it has set the Rumour Mill into high gear, and the market is now awash with stories of banks calling in large numbers of private loans, steel mills being forced to shut down….

Complicating the picture are some pretty awful Chinese February export numbers, down 18.1% year on year when expectations were for a gain of 7.5%. It is highly likely that these awful numbers are a product of the usual distortions that occur around Chinese New Year, as the numbers for the first two months of the year only show a decline of 1.6%. Given that the Chinese authorities are also working very hard to squeeze out the rampant over and under invoicing that plagues Chinese trade data, that is probably an OK number.

All in all, I’m starting to get encouraged that an awful lot of very bad news is in the market. We haven’t seen one of the big blow offs that usually mark a turning point, and that makes me nervous, but several of the most vulnerable markets have actually rallied in recent weeks. Barring a plague of Frogs, it is hard to imagine what isn’t being discounted at current levels.