WHAT TO MAKE OF RUSSIA’S DOWNGRADE

In light of the ongoing tensions in Ukraine as well as the downgrade of Russia by Standard &

Poor’s (S&P) last week we would like to provide an update on the situation.

Firstly, with regards to Russia’s credit rating and its downgrade, it should be noted that the rating actually

appears to be rather odd based on the country’s financial numbers: For the purpose of comparison, Japan has

got a debt/GDP ratio of 227% and a S&P credit rating of AA-, the United States has got a debt/GDP ratio of

102% and a rating of AA+, and Hong Kong a debt/GDP ratio of 33% and a credit rating of AAA. We can see

that normally the lower a country’s debt the higher its credit rating. Yet Russia, at a negligible debt/GDP ratio of

9%, is blessed with a rating of BBB-, which raises the question of a potential political bias.

CAN YOU SPOT THE ODD ONE OUT?

Sure, it can be argued that credit ratings should not be solely based on debt/GDP ratios, but that other factors

come into play also, for example the strength of an independent legal system, corruption and many other

things.

So let us consider for further reference as well the sovereign credit ratings of another US based ratings agency

named Weiss Ratings which appears to be much more independent as it prouds itself on removing political bias

from the analysis process. Interestingly Weiss rates both Japan and the United States ‘C-‘, while Hong Kong still

gets the highest rating ‘A’, and Russia comes in at ‘C+’. So it is noteworthy here that although Russia’s rating is

again lower than that of Hong Kong despite the more favorable debt/GDP ratio (partly due to Hong Kong’s

governance advantages), Russia does rank two levels above what is considered to be the ultimate safe haven

debt of Japan and the United States.

28 April 2014

In any case, whether or not Russia’s low credit rating by S&P is justified or not, what is important to understand

here is that it does not matter too much to the country, since it’s extremely low debt also means that there is

little if any risk of a debt crisis: Russia basically does not need investors to buy its debt as its financial position is

strong.

Besides, investing in Russian equities is different from investing in Russian sovereign debt. Russian corporates

generally have strong financial positions as even the major rating agencies admit.

On this occasion we should also be reminded of the present valuation of Russian equities. Not only do they trade

at an approximate 70% discount to the global average, but also at a 110% discount to Russia’s own historical

valuations average. Such prices tend to be typical of market bottoms.

EMERGING MARKET P/E RATIOS VS. THEIR RELATIVE HISTORICAL AVERAGES

Yes, further sanctions are be a potential risk and threat, but since Europe actually happens to export more goods

to Russia than the other way around, and since natural gas exports from Russia to the EU will be harder to

replace (at least anytime soon) than the export of manufactured goods from the EU to Russia (most of these

could be imported from China instead), it seems that the EU is just as dependent on Russia as Russia is on the

EU.

Moreover, Russia can turn towards the east. China’s worsening pollution problem may result in a mega energy

deal between the two countries signed in the near future, as China is actively seeking to reduce coal use in favor

of cleaner burning natural gas.

Expanded oil and natural gas supplies (via shipped LNG) to India are also being discussed at present, and

although Japan talks a bit tougher (presumably with some US prompting), at the end of the day the country is

highly energy import dependent too, as is South Korea, and both of these countries have been seeking to

expand energy imports from Russia as well.

In this regard you may also want to see our recently published article in the Hong Kong Standard (as separately

attached to this email) and a Bloomberg interview on the topic of our chief economist.

In summary, while risks are clearly present and volatility of the Russian stock market tends to be high especially

given the ongoing geo-political uncertainties, taking all factors into account we maintain our positive outlook on

the market and recommend a degree of exposure as part of a diversified portfolio for medium to long term

investors.

Regards The Investment Committee The Henley Group 28 April 2014