Russia Sanctions and U.S. Investment: A Silver Lining?

With Russia's annexation of Crimea prompting worrisome forecasts regarding Eastern Ukraine and the eventual effects of sanctions, what do these developments mean for U.S. investment in Russia?

Russian markets reacted almost joyously to the announcement of the limited Western sanctions targeting a handful of top Russian officials (with more to come), with the Micex stock exchange rallying 3.7% on March 18. This came after the index fell 5% to a five-year low on March 14 due to fears of far tougher sanctions than those that have so far been unveiled.

Still, according to Deputy Economy Minister Sergei Belyakov, the Russian economy is in crisis. And assuming Russian markets will remain volatile while the politics plays out amid weakening growth, should investors wait out the crisis, or could there be a silver lining to the risks?

Black clouds
The Russian market has generally been slow to react to political developments in this crisis, considering their magnitude and the scale of confrontation between Russia and the West. Risk perceptions will, however, markedly deteriorate as the crisis drags on, suggesting a dire long-term investment climate. Standard & Poor's cut Russia's credit rating from stable to poor ("BBB," the second-lowest investment grade) on March 20. If sanctions are intensified, they could deal even more serious blows to the Russian credit score.

The Russian economy was already in dire straits prior to the beginnings of the Ukrainian crisis last October due to deep-seated structural problems. It is now teetering on recession. If credit markets were to close further, it would become far more expensive for Russian banks and corporations to finance themselves -- and they already have roughly $150 billion worth of debt rollover for 2014. According to former Finance Minister Alexei Kudrin, there could be a capital flight of up to $200 billion in 2014, meaning considerable pressure on currency reserves.

The Russian central bank had, until the first sanctions, kept rates on hold, waiting to evaluate developments -- e.g., the extent of the sanctions, the amount of capital flight, and the impact on the reserve level. If the situation deteriorates further, the central bank will probably raise interest rates in order to defend the exchange rate, which would mean lower growth and perhaps even recession. In any case, it will attempt to anchor the exchange rate for political reasons.

The real Western leverage is through oil prices. The U.S. acted in the second week of March to release funds and oil from its strategic energy stockpiles. Even though Russia's oil markets are generally considered stable in the face of securities sell-offs, a deep fall in oil prices would probably hit Russia the hardest by simultaneously sparking even broader market sell-offs. Vladimir Putin may bet that immediate Western sanctions will be inconsequential, but the West may hold the better card in the long term: If the EU manages to compensate for a reduction of energy imports from Russia, trade would drop considerably, and Russia would find itself virtually isolated (though part of Putin's strategy is to pivot Russia's energy industry toward Asia). Meanwhile, given its small manufacturing base, Russia would also be extremely vulnerable to cancellations from U.S. and European customers.

U.S. companies that could take a hit
How much will sanctions hurt U.S. investors and businesses? Sanctions could inadvertently punish U.S. interests and invite Russian retaliation against U.S. companies. Companies with sizable investments in Russia, such as General Electric (NYSE: GE  ) and Boeing (NYSE: BA  ) , are jittery.

General Electric's Capital Aviation Services (GECAS), the world's largest aircraft-leasing company, has 54 aircraft in Russia. GECAS CEO Norm Liu called the standoff situation "unique" and voiced concern that the conflict could cross beyond diplomatic circles, adding to existing fears about GE's lagging stock performance this past year.

Meanwhile, aircraft manufacturer Boeing sources a large amount of steel, titanium, and aircraft parts from Russian companies. In late 2013, the company estimated that over the next few decades it will spend about $27 billion on Russian materials and services. Boeing also delivered $2.1 billion in aircraft to Russian carriers in 2013. The company could see its Russian joint venture with Lockheed Martin (NYSE: LMT  ) , United Launch Alliance, threatened by sanctions, and its plans to expand its joint manufacturing venture with Rostec are at risk.

In this climate of mutually assured economic punishment, who blinks first?

Silver lining?
Putin's course appears set, regardless of Western actions and the state of the Russian economy. The crisis is likely to continue for a long period of time, because his agenda stretches beyond Crimea, and the Ukrainian dilemma cannot move forward without some form of agreement with Russia. The question is whether to take the short-term or long-term view on investment in Russia.

Given forecasts of recession in Q2 and Q3, the overall state of the Russian economy, and the weakness of the ruble -- down 11% against the dollar this year -- what is the takeaway for investors at this point? Though it may be a while coming, and short-term risks are high, any hints of easing political tensions could provide longer-term buying opportunities because of the cheap valuations of Russian stocks. Sell-offs have taken valuations to their lowest levels since 2008. This means there's little chance of immediate returns, but there could be a payoff in the longer run if the situation stabilizes.

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