Hedging Putin

For most of 2014, the man of the hour has been Vladimir V. Putin of Russia

From the spotlight of the Winter Games at Sochi to game, set and match in the Crimea, every move by Putin has been both dramatic and dangerous and certain to move markets. Getting into the mind of the Russians has not been so critical to investors for twenty-five years, but it remains as difficult as ever. "I cannot forecast to you the action of Russia,” Churchill famously said in 1939.

Russian President Vladimir Putin Frederic Legrand / Shutterstock.com

“It is a riddle, wrapped in a mystery, inside an enigma.”

So what’s an investor to do?  Fortunately, the insanely frothy credit markets and the blithe conventional wisdom regarding Russian intentions – or lack thereof – may have conspired to provide a cheap hedge against Russian imperialism, an asymmetric insurance policy against a sudden and unexpected gambit from Mr. Putin.  A short position in the sovereign debt – and related credit default swaps – of Latvia, the little Baltic republic that sits on the doorstep of Russia, offers a ratio of risk to reward that is, as we say on Wall Street, compelling.  The cost of carry, at less than two percent per annum on ten year paper and at just over 110 basis points of spread on five year credit default swaps, seems a small premium to pay.  To be clear, we don’t actually think Mr. Putin will invade Latvia. But you can be sure that if he does, these bonds will make money when most everything else is going down hard.

Latvia is a small country of two million people, which together with Estonia, its neighbor to the north, and Lithuania, its neighbor to the south, are commonly known as the Baltics.  For centuries, these three little countries were part of the Russian empire before breaking free briefly after the First World War. Following their re-annexation by Stalin during World War II, they remained a part of the same Soviet Union that Mr. Putin is so nostalgic for until 1991, when they received their independence. Learning the tough lesson of proximity to Russia, Latvia and its Baltic brethren seized the opportunity over the last two decades to join both NATO and the European Union and integrate with the West as much as possible.  As of January, Latvia has joined the Eurozone as well.

At first blush, there is a lot to recommend Latvia.  While it is a tiny country with a $33 billion economy whose main export product is timber, it is the fastest growing country in Europe, expecting to clock in at five percent next year.  Inflation is under control, there is a fairly stable democracy, and the country is wide open as a hub of commerce and trade.  Its balance sheet seems rock solid, with a debt to GDP ratio of just forty percent, a number that is itself historically high and the vestige of bank bailouts and other emergency measures taken during the financial crisis.  In a world of low growth and high debt, a fast growing, dynamic, European country with little currency risk, decent rule of law, and a current account surplus seems quite attractive and has earned Latvia an investment grade rating.  Indeed, as recently as the end of April the Republic of Latvia issued €1 billion of ten year bonds with a 2.875% coupon, which bonds now trade well over par to yield around 1.8%.

There are, however, some emergent headwinds.  To begin with, Latvia’s largest trading partner is Russia, which is currently seeing a sharp slowdown and decreased trade flows due to sanctions and instability in the wake of the Crimea crisis.  Indeed, the entire neighborhood is being affected and Latvia will surely catch cold if Eastern Europe sneezes.  While debt to GDP looks okay now, there is always the tricky issue of the denominator, which shrunk by twenty-five percent in 2009, the most massive contraction in Europe.  And there is the fact that one hundred percent of Latvian energy and power comes from Russian gas supply.

Of course, the real risk in Latvia is Putin risk, and for now that seems to be contained.  In rapid response to the annexation of the Ukraine, NATO has scrambled to increase its air and ground military presence in the Baltics in a show of support, staging rotating public exercises and putting together a rapid response force to provide urgent defense.  But “the society has fear,” as the Latvian defense minister recently announced, and this fear is largely focused on the fact that twenty-five percent of the population are the same type of Russian-speaking minorities whose protection by the mother country was at the heart of the Ukrainian intervention.  And in Latvia, the same issues of language and culture are sources of tension, with some fifteen percent of the population (all Russian) denied citizenship because of a refusal to adopt language proficiency.   As anyone who has made it to the end of Anna Karenina knows, Russia has gone to war many times to protect fellow Slavs. The current pro-European government’s new ruling coalition entirely excludes the Russian Concord Party, which was the largest single winner in this fall’s parliamentary elections but was locked out of any negotiations to join the government. The embers of resentment could be simmering for the Russian-speaking minority Russian Concord represents, two thirds of whom supported Putin’s Ukrainian strategy.

The real difference from the Ukraine, of course, is that the Baltics are members of NATO.  The reason why seventy-five percent of the troops stationed there are American is Article 5 of the North Atlantic Treaty, which states that an attack on any NATO member shall be taken as an attack on all other members.  In September, President Obama stopped by Estonia to declare, “We will defend our NATO Allies…. Article 5 is crystal clear: An attack on one is an attack on all.  So if, in such a moment, you ever ask again, ‘who will come to help,’ you’ll know the answer – the NATO Alliance, including the Armed Forces of the United States of America.” This is why no one thinks that Putin would cross what is clearly a red line and precipitate a crisis that would dwarf the current one.  In fact, Putin himself has said he has no designs on the Baltics.  There may be little to gain from the tiny Baltics with their population of six million, and indeed the only military stronghold there is already owned by Russia, the enclave of Kaliningrad.  That it would make no sense for Putin to do anything is also certainly the current view of the market for Latvian debt.