PAUL KRAKE: Three half full glasses (part 2)

The extraordinary events in Turkey over the course of the last couple of days have hijacked the global narrative.

Three half full glasses - Chill

(There was a lot to discuss in our weekly blotter. Below is part 2, please find part 1 here.)

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Does Indian growth get affected 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 ….

Chill

A statement of fact. Just because you predict dire consequences for global financial markets in every report you produce, doesn’t mean that you are correct when negative things happen. Timing is everything to investors of all time frames, and consistently saying that the world is screwed doesn’t permit you a victory lap when EuroStoxx banks fall a few percent on the back of a Turkish upheaval. Turkey’s woes are not the beginning of something more dire for global financial assets and those predicting a USD breakout, balance sheet destruction for Eurozone banks and EM contagion are missing the point.

Turkey’s idiosyncratic woes will not be enough to derail a solid global growth environment that is generating continued strong corporate profitability. Yes, the odds heavily favor Turkey going into recession, but should you be focusing on this, or a Chinese economy that is clearly providing a three-pronged stimulus involving monetary, targeted fiscal and a trade weighted weakening of the RMB. US growth is still on a fiscally induced sugar high, yet long dated yields remain well and truly capped and the path of Fed rate increases is in alignment with market expectations. The Fed will raise rates every quarter for at least the next nine months and this is pretty much priced. Despite US Core inflation running at its highest level in a decade, Fed Chair Powell has outlined a calm orderly scenario and the chances of him raising rates at a quicker pace than being currently priced is remote indeed.

Chill is a word you will not hear from the Fed, but it could often be used to describe the FOMC’s attitude towards emerging market problems. The notion that the Fed alters the trajectory of interest rate policy based in events abroad is a fallacy in my opinion. We have multiple examples from Greenspan to Bernanke and Mrs. Yellen where the Fed has chosen to ignore events abroad because the economic impact on the US has yet to be determined. The Fed is not in the business of pre-empting the economic impacts of shocks from abroad. Asia was going bankrupt because of the 1997-98 crisis yet it wasn’t until the Russian default and the bearing that this had on Long Term Capital Management and the prime brokerage units of Bear Sterns and Lehman Brothers that forced the Fed to cut rates by 75bps. The taper tantrum in 2013 didn’t stop the Fed from discussing tapering and in fact, Chairman Bernanke made it clear that he conducted US monetary policy and that emerging markets are in charge of their own fortunes. While Mrs. Yellen surprised asset markets by not tightening policy in September 2015, she did so in December, even though China’s instability remained. The point is, those expecting help from the Fed if the Turkish situation gets worse are missing the point because until data deteriorates in the US, the Fed will maintain its policy trajectory. The Fed will, as always, be chilled about overseas events.

Conclusion

You should never lose sight of the following statement of fact:

More money gets made by buying distressed / beaten down assets than selling expensive ones.

Turkey’s issues are not going to derail the economies of Asia, Latin America and definitely not the developed world. While liquidity issues for emerging market bonds could be a little tricky over the balance of the summer (and structurally for all the regulatory reasons that we know about), the opportunities being created because of heightened volatility are buying not selling. Eventually, there will be opportunities in Turkish sovereign debt. Capital controls and the IMF will eventually stabilize the currency, so local currency sovereign bonds will be an outstanding opportunity for local investors brave enough to step in. While the corporate sector is a mess, USD sovereign bonds will get interesting at some stage. Not yet, but soon.

The opportunities exist in other markets, especially in high yielding Asia, where economic contagion is not going to be an issue. India and Indonesian two-year note are compelling at roughly 7.50 and 7.00% respectively. Any further currency weakness next week will see the thematic model portfolio a keen buyer of both.

As for Europe, while UniCredit, BBVA and others have exposure, it isn’t enough for a systemic shock to European banks and despite concerns about Italy’s budget, I am prone to use weakness to tactically buy Italian banks as European activity rebounds after H1 weakness.

The USD’s move higher has discredited some of my thinking about a range bound USD, but I am convinced this will prove temporary. As stated above, the Fed and the markets are in alignment about the course of fed tightening which says to me that an interest rate shock is unlikely. Can the USD rally sustainably without a further recalibration of interest rate expectations? I don’t see it. That said, the Fed’s path is established so long dated yields wont fall significantly below 2.80% (10’s) and therefore the boring 20bps range will be maintained.

So, what to do?

  • Sell US 10’s at 2.80%
  • Buying high yielding Asian fixed income (India and Indonesia) into weakness
  • Cover all EM hedges upon the announcement of Turkish capital controls.
  • Buy US Equities (SPX) at 2775
  • Buy European banks (SX7E) at 108

While the investor world will be fixated on Turkey, The Norges Bank meets on Thursday. On Monday Singapore GDP. Tuesday, Japanese Industrial Production, German CPI and GDP, EU GDP, and UK Employment data. Wednesday, UK CPI, and US Industrial Production. On Thursday Australian Employment. Friday, EU and Canadian CPI, and the University of Michigan sentiment report.

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