“Russia is a riddle wrapped in a mystery inside an enigma.” – Winston Churchill
“The secret of politics? Make a good treaty with Russia.” – Otto von Bismarck, founder and first chancellor (1871–90) of the German Empire
“Sometimes it is necessary to be lonely in order to prove that you are right.” – Vladimir Putin
In 1985, members of Hezbollah, the Sh’ia political party and military group based in Lebanon, kidnapped four Russian diplomats in West Beirut. The terrorists “warned that the four Soviet captives would be executed, one by one, unless Moscow pressured pro-Syrian militiamen to cease shelling positions held by the pro-Iranian fundamentalist militia in Lebanon’s northern port city of Tripoli.” The militants ended up killing Arkady Katkov, a consular attaché and one of the four kidnapped diplomats.
Moscow, upon hearing the news of Mr Latkov’s death, dispatched Spetsgruppa “A” – also known as the Alpha Group.
The Alpha Group was formed in 1974 by Yuri Andropov, the chairman of the KGB at the time, in response to the Black September attacks at the Munich Olympics in 1972. Although founded under the KGB, the unit survived the collapse of the Soviet Union and operates today as a stand-alone counter-terrorism and counterintelligence unit under the auspices of Russia’s Special Forces.
The Alpha Group successfully rescued the three remaining diplomats after being dispatched to Lebanon. How they achieved this feat though is a chilling tale of brutality and effectiveness.
According to one version of how events transpired, the Alpha Group kidnapped twelve Shi’a, one of whom was the relative of a Hezbollah leader. The kidnapped relative was castrated and shot in the head, his testicles stuffed in his mouth, and his body shipped to Hezbollah with a letter promising a similar fate for the eleven other captives if the Russian diplomats were not released. In an alternate retelling of events, the unit is said to have abducted one of the kidnapper’s brothers, and sent two of his fingers home to his family in separate envelopes.
Russia allegedly has a longstanding policy of targeting family members of terrorists. The reports of Alpha Group’s rumoured operation in Lebanon are in keeping with this tradition.
Hezbollah has long since heeded Otto von Bismarck’s advice and made a ‘good treaty’ with Russia. Today, Russia and Hezbollah operate closely as allies in the Syrian civil war and in their support for Bashar Al Assad in the conflict
The recent poisoning of former Russian spy Sergei Skripal in the UK has set-off a wave of diplomatic expulsions. The United Kingdom, accusing Russia as being behind the poisoning, made the first move by expelling twenty three Russian diplomats. In a show of solidarity, twenty six other nations, including the US, followed Britain’s lead and expelled Russian diplomats. Moscow, rejecting the accusations, has announced the closure of the British Council and US consulate in St. Petersburg and the expulsion of British and American diplomats.
While the saga continues to make the headlines, we believe neither the British nor the Americans have the wherewithal to sustain a diplomatic dogfight with the Russians. Britain still has the not-so-small matter of Brexit negotiations to deal with and its economy cannot afford to close itself off from Russian capital or Russian consumers. The Trump Administration, on the other hand, is fighting too many battles on too many fronts and a diplomatic standoff with Russia, as it appears at least, is way down the list of priorities.
While geopolitics will always be a concern when one invests in Russia, we think the political risks are no greater today than they have been in the past. We think both the US and the UK will either make good with Russia over time or there will be little development in solving the murder and the issue will be demoted to background noise. We certainly do not see Russia backing down – Putin after all remains ready to exploit the ‘us against them’ siege mentality to the benefit of his popularity amongst Russians.
For now, we prefer to focus on cyclical tailwinds that Russia is enjoying today and not the geopolitics.
Investment Perspective
The sharp drop in the oil price in late 2014 forced Russia to move the ruble to a floating exchange rate. The move led to a sharp drop in the ruble as the artificially overvalued currency adjusted to the new regime. The inflation that followed was painful and the Central Bank of the Russian Federation responded by hiking interest rates. The combination crippled economic activity.
No sector suffered more in the economic slump than the consumer sector. As inflation ravaged the Russian consumer in 2015 and 2016, consumer spending dropped off a cliff – leading to high levels of consolidation across consumer facing companies. Only the largest were able to withstand the challenging environment. And even then, they too had to adapt and become leaner and more efficient.
The rebound in oil prices last year has lifted the economy out of recession, supported the ruble and allowed the central bank to aggressively cut interest rates – cumulatively the central bank has cut the policy rate by 9.75 per cent since January 2015. The policy rate now stands at 7.25 per cent, well above the central bank’s target inflation rate of 4 per cent.
In response to the economic upturn, we expect Russian consumer demand to recover as increased economic activity translates into higher employment rates and higher wages. This recovery in consumer spending in turn should fuel further improvements in economic activity. The combination of increasing economic activity and significantly lower interest rates will encourage, we think, Russian corporates to increase capital investment.
Based on the Levy-Kalecki profit formula:
Profits – Tax = Gross Investment + Government Deficit + Net Exports – Workers’ Saving
Increasing capital investment and higher consumer spending (lower workers’ savings) both contribute to higher profitability. If Russian consumer spending and capital investment do increase as we suspect they will in 2018, the profitability of Russian companies, too, should be much higher. Specifically, consumer companies that have come out of the slump much leaner and with much larger market shares are well placed to benefit from the cyclical upturn in the Russian economy.
For those of you that have frequented Bond Street in London or Dubai Mall in the United Arab Emirates will be all too aware that Russian consumers have a taste for the finer things in life. Demand for luxury handbags, expensive automobiles, and beachfront properties all goes up when the Russian consumer is spending. For this reason we think that some of the leading European fashion houses will also be amongst the primary beneficiaries of the improvements in the Russian economy.
We have been long Russia since the start of the year and remain long. Next week, we will be adding a number of European fashion houses as long trade ideas as means to play the Russia theme, especially for those of you that cannot directly invest in Russian assets.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.