From Russia with Love

News that gasoline prices dipped below $2.00/gallon at the pump in some local markets is welcome relief for many beleaguered commuters in the US. Come to think of it, it’s also pretty good news for the good folks at Ford Motor Co. who are busy stamping out new fuel efficient aluminum bodied F150 pickups just in time for buyers to replace their old wheezy beaters without feeling too bad about stepping behind the wheel of a full sized truck. For our comrades in Russia however, the prospects of oil selling below $70/bbl for an extended period of time is bleaker than a blast of icy wind blowing in from Siberia. Depending on your perspective, it ultimately may not be such good news for US investors either.

The Russian economy is highly dependent on oil, and according to one former economic adviser to the Kremlin, requires an average price of $100/bbl just to keep Russian GDP from flatlining and the economy falling into recession. When those comments were made to a CNBC reporter less than a month ago in mid November, Brent Sea crude was trading hands around $82/bbl. Today it closed at just under $60/bbl. Sure, the entire Russian economy represents a small percentage of world GDP, but we all said the same thing about Greece in 2013.

The challenge for US investors however, is as much geopolitical as it is economic. In the short-run, a weakened Russian economy presents diminished opportunity for trade and commerce as local attention is understandably focused on basic needs and forestalling the threat of austerity programs. Viewed from the perspective of US investors, it’s hard to sell the latest version of the iPhone when the ruble is in a near free fall and the prospects for a near term recovery are practically nil.

Having one of your trading partners suffering from a stagnant economy is bad enough, but Vladimir Putin also has a pretty well established habit of exciting Russian nationalism at inconvenient times. The probability that Putin’s extra-territorial ambitions conveniently become inflamed at a time when the domestic Russian economic outlook takes a turn for the worse is not a bad bet. It’s not hard to envision any number of scenarios where Putin goes shopping around the regional neighborhood for territorial assets that might (in his view) plausibly be claimed as having historically Russian ties. If those assets throw off hard cash…hey, all the better.

Unsurprisingly, global markets generally take a pretty dim view of military adventures as the solution to economic woes…especially when the guys behind the tanks also happen to have a potent nuclear arsenal sitting around in cold storage. And while this is not a prediction, let’s be honest here, it’s not like these adventures haven’t happened before. It’s the kind of intrigue even James Bond would appreciate.

If the prospects of a more strident Russian military aren’t frightening enough, what really has traders sitting on the edge of their seats is the growing risk of a Russian sovereign default. Unlike the threat of military action that can be dismissed as a mild form of paranoia, the probability of sovereign default can be directly observed in the credit default swap (CDS) market. It’s not pretty.

Credit default swaps are contracts that essentially act as insurance policies against the risk (not the certainty) of a country defaulting on its debt obligations. And the price of those contracts on Russian bonds (in other words the insurance premiums) has gone up. Way up. It’s enough to send a small shiver down the spine of even the most stoic Wall Street veteran.

Even in the midst of a raging bull market it’s been said that no one is truly content. Perhaps that’s because we all harbor a secret fear that whatever success we’ve experienced is too good to last and that ultimately we’re all doomed. How very Russian. While the distant thunder echoing from Eastern Europe is too important to simply ignore, maybe, just maybe, it’s overreacting to the imaginary SPECTRE coming from Russia (with love) we need fear the most.

Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management. While he has not yet purchased a shiny new Ford F150, he watches gas prices closely while driving around town in his wheezy old beater. He has seen way too many James Bond movies. The opinions expressed in this article are his own.