Turkish turmoil: Are things as bad as they sound?

August 20, 2018 Ian Taylor

 

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Unsurprisingly, geopolitics have made headlines once again as Turkey’s Lira hit record lows (US$0.1425).  As part of our ongoing analysis of global economic conditions, we’ve been watching Turkey’s predicament unfold. Let’s take a look at what’s happening and what it means for you.  

The Turkish government has lost economic credibility

The lira has plunged as a result, losing 40% of its value this year alone. We believe that the drop is likely the result of several issues combined: 

●      Keeping interest rates low allowing inflation (currently at 15%) to run hot,

●      The persistent running of current account and budget deficits,

●      The recent snap election that cemented Executive President Erdogan’s control,

●      Concerns about the appointment of the Executive President’s son-in-law as the Minister of Finance,

●      And a worsening relationship with the U.S., capped by the approval to double tariffs on Turkish steel and aluminum.

 

Keeping an eye on emerging market sentiment and European banks

To put this in perspective, Turkey, by itself, is a small component in the global economy. Our research suggests that Turkey’s problems are largely contained to the domestic economy and should not be a major cause for concern.

However, fears of contagion, primarily across other emerging markets and Eurozone banks is something we continue to assess.

Separately, we’ve seen investor sentiment weaken for emerging markets because of ongoing concerns, some of which we expect to persist:

●      A stronger U.S. dollar and higher American bond yields fueling emerging market volatility and currency weakness,

●      Capital flowing back to developed economies such as the U.S.,

●      American anti-trade rhetoric, including the trade spat between China and the U.S.,

●      Geopolitical events in Argentina, North Korea, and Iran,

●      And pressure on oil prices.

 

The European banking sector, particularly Spanish and French banks, is most exposed to Turkey’ situation and we’ve seen prices decline as a result. We are only a few years removed from the European Sovereign Debt Crisis, so we are closely monitoring credit markets for any signs of concerns to the broader Eurozone economy given its relative importance to the global economy.   

Fallout from Turkey should be limited

At this point in time, we remain neutral on emerging markets. Relatively attractive growth potential is roughly balanced out by the risks outlined above as well as the change in sentiment and earnings expectations over the last 6 months.

We do have some exposure in Turkey via the MD PIM Emerging Markets Equity Pool, but these positions are small overall. Given the depressed prices due to the heightened geopolitical risk, our value-style manager GMO & Co. took a modest contrarian overweight to some positions. The weakness in the Turkish Lira has been a modest negative contributor to the pool.

Overall, we’re overweight European equities but underweight European banks. At this time, we still expect above trend growth from the region and the banks are much better capitalized than they were during the 2009 through 2014 period of uncertainty, which has limited any spillover effect. We have been short the Euro and this has worked in our favour.

I’ll admit, being underweight European banks was not a call against Turkey but rather because there are better growth opportunities elsewhere, despite their lower prices. Furthermore, the banks continue to deleverage, which when combined with lower interest rates and lower economic growth, hasn’t provided a compelling investment opportunity. What exposure we do have tends to be more focused on faster growing regions in Asia, as opposed to Europe (or Japan).

At this time, global credit markets remain stable and incoming economic data and surveys remain strong despite the recent difficulties in Turkey and the broader uncertainties facing emerging markets in general. We remain convinced that markets will be supportive of equites and we continue to be overweight equities overall. Moreover, we continue to see a low probability of a recession over the next 12 months.

The headlines will come and they will go. We’ve already seen the Lira rebound somewhat as Finance Minister Albayrak turns his attention to rein in inflation and the country’s deficits. We will continue to monitor the situation as it develops.

 If you have any additional questions about the situation in Turkey, how it may impact the global economy or your portfolios, please reach out to your MD Advisor. 

 

About the Author

Ian Taylor

Ian Taylor, CFA, CIM, is an Assistant Vice President with the Investment Management and Strategy team at MD Financial Management. He oversees strategic and tactical asset allocation mandates, alternative investment mutual funds and is a member of MD’s Tactical and Risk Allocation Committee.

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