Three half full glasses
(As you will see below, there was a lot to discuss for a Sunday. We have chopped this longer-than-usual blotter in two, and will publish the second and final half tomorrow.)
The extraordinary events in Turkey over the course of the last couple of days have hijacked the global narrative and with it, made my task of picking a title for this Sunday’s blotter, troublesome. I thought about “Another August Surprise”, a reference to the fact that time and time again, a quiet summer gets upended by an unexpected event roiling financial assets. I thought about calling it “Contagion is dead”, a comment about the fact that global investors have become much more sophisticated and discerning about the idiosyncratic factors that drive the economic outlook of emerging market economies. A poor Turkish viewpoint isn’t going to upend Indonesia or India. The third title was “Chill”, a statement that the panic amongst the financial punditry that this is it for global assets and the world economy is nothing more than the alarmist propaganda from perma-bears. I couldn’t decide so I will give you all three.
The August Surprise
For most of my career, August has been a month when something, from somewhere, pops up and, at a minimum, forces investors to leave the poolside, run to the concierge desk and ask, “Excuse me, can you tell me where the Business Center is?” From Hurricane Katrina to the evolution of the Global Financial Crisis through the summer of 2008, quiet, holiday markets have seen volatility spikes in August due events unforeseen. They are not all negative. Italian / Spanish bonds spreads peaked after Mario Draghi’s “Whatever it takes” speech in late July 2012 as the August surprise was a strong rally in European assets. That said, most shocks are negative and exacerbated by less liquid markets. Who could forget the weakness in the Yuan in August 2015 as the Chinese moved to appease the IMF to gain entry into the Special Drawing Rights Basket (SDR)?
Is this a way for the investing Gods to ruin our summers or are we victims of a search for a theme during quiet times? The answer is neither. Markets do not get upended for no reason and market shocks are certainly justified. While Friday’s collapse in the Turkish Lira was historic in its scale, it is hardly a surprise to anyone with half an eye on events that the economic outlook is a dire one. The Lira’s slide has been going on for a while with the currency having lost over 35% of its value so far this year. Are we surprised that the combination of skyrocketing inflation, a structural current account deficit, underhedged corporates and a Central Bank unable to respond due to political interference is pushing Turkey towards the capital controls, the IMF or probably both? These are not surprises at all, yet the market often picks unusual times to respond. Small scale sanctions from the United States on Turkey are not going to have much of an overall economic impact but they do appear to be the straw that breaks the camels back.
With Turkish corporates yet to feel the true impact of the recent 20% decline in the value of the Lira, bank / corporate bailouts will be required. Please note that this is not a sovereign issue. As our good friend Michael Nicoletos of Appletree Capital relayed to me on Thursday, Turkey’s sovereign position is ok. For example, foreign currency sovereign bonds are only $60bn out of an economy at close to $900bn. The issue is corporate debt that is getting trashed due to a currency that has no near-term floor. 45% of non-financial listed companies have negative free cash flow and even though the ROEs look solid, debt has been increasing rapidly. With a 50% depreciation in the value of the Lira over the past several years, the damage to corporate balance sheets is already done. Again, nothing new here.
IMF involvement is needed, and I would believe, inevitable, but the key question is when. The Trump administration is clearly using Turkey’s economic malaise to extract a political price regarding the jailing of an American Pastor. Will there be US pressure on the IMF not to give Turkey a bailout which will see the currency plummet even further? This could prove disastrous for Turkey and problematic for certain European banks but is any of this a surprise? The damage is already done and while it could get worse due to delays, the IMF will eventually step in.
As Michael outlines in our discussion, IMF involvement would require the Central Bank to raise rates by 300bps – 400bps to stabilize the currency. This is vital for several reasons. Firstly, corporate deterioration will not stop until the currency stops weakening. While the economic consequences of jacking up rates would be to push an economy forecasted to grow at 4% to one close to, or in recession, it is the lesser of two evils. Secondly, and much more importantly, rate hikes would show the world that Central Bank independence has been reestablished and that President Erdogan has come to his senses regarding how a modern economy should be run. Central Bank independence is a precondition to ending the Lira’s slide and while we cannot truly know what is going on behind the scenes, interest rate increases would be a sign that economic sanity has returned.
Friday was certainly an August surprise. However, despite some risk asset selling, USD buying and lower developed market yields, will Turkey be a true shock to risk assets going forward? In a compliment to the calmness and rationality of many investors, I have argued to a while now that….
Contagion is Dead
The reasons why I remain extremely constructive about the long-term outlook for emerging markets revolves around a belief that the risk premia for emerging market assets, in the aggregate remain too high versus the long-term outlook for economic growth and profitability. Simply put, with a couple of glaring exceptions, aka Turkey and to a lesser extent South Africa, the economic stewards who are in charge of emerging markets are simply getting better at their jobs and the checks and balances that are in place have done wonders for economic stability. Central Bank independence is established in the vast majority of countries and its absence in Turkey has exposed just how important it is. Strong finance ministers hold office in many countries, ensuring higher degrees of confidence in places that previously had little. FX reserves are better managed, as is foreign corporate debt and the push towards domestic consumption as the drivers of growth have led many EM economies to be much less prone to the cyclical gyrations of the global cycle. Structurally, emerging markets are just in better shape.
I think that the relative performance of emerging market bonds and equities shows this. China has had a rough few quarters, post last November’s Party Congress where President Xi Jinping was appointed as leader for life. Slowing growth, greater regulation regarding off balance sheet / shadow banking lending and an escalating trade dispute with the United States has led to significant equity and trade weight currency weakness. Now I will argue that Yuan weakness is being orchestrated from Beijing as a policy tool to stimulate activity and make exports more competitive, but it is undeniable that holders of Chinese assets, both local and foreign are having a tough time. Yet, for all of China’s struggles, the much of the rest of EM has been immune or more specifically, the contagion impacts from troubles in major EM markets like China and Turkey, simply haven’t been reflected in asset markets elsewhere. Taiwanese equities are positive on the year, as is the Mexican Peso and that’s with the election of a new President whose market credentials are dubious. The facts are that woes of some countries have not spread elsewhere, and even with Turkey’s precipitous deterioration, something that has been well telegraphed, it is difficult to see why now is the time for the EM to panic over factors are idiosyncratic to Turkey.
Does Indian growth get effected by Turkey’s political shift to Iran and Russia? Does Indonesia’s current account become more difficult to fund because of the nationalist policies of President Erdogan? I say no, and this gets me to the crux of the issue regarding Turkey and that is that is just time to ….
Which we'll publish tomorrow