Turkey Contagion and Opportunity
Turkish assets led by the lira have come under severe pressure in August.  The spark came from an escalation of the political confrontation with the United States over Turkey’s detention of an American pastor accused of espionage. In early August, the United States imposed sanctions on two Turkish cabinet ministers, followed by President Trump doubling tariffs on Turkish steel and aluminum on August 10. Since the imposition of U.S. tariffs, the Turkish lira initially dropped more than 40%.

Due to recent events in Turkey and the potential for financial market contagion, emerging market (EM) assets have decreased in value as the market recalibrates risk and/or liquidates positions.  In the fixed income and currency markets, the JP Morgan Government Bond Index-Emerging Markets (GBI-EM) index has declined by 4.7% year-to-date through August 22.

We believe the current contagion presents an opportunity to buy assets at discounted prices, particularly if the underlying global growth fundamentals do not change materially.

How Did We Get Here?

Macro imbalances, or how the aggregate economy behaves based on a variety of economy-wide phenomena, have been building up as the country has focused on unbalanced growth, resulting in high inflation. Turkey has run large current-account deficits for an extended period, with externally borrowed money fueling growth needed for the current administration to fulfill its political ambitions. This has led to deterioration in the institutional framework and governance.

While the government did not build up excess borrowing, the corporate sector did, and this is best illustrated by Turkey’s extremely net negative international investment position (IIP). This large IIP position can quickly worsen with a weaker currency and looming slowdown/recession, making it more challenging to service foreign debt.

Given these imbalances have been building up for some time, it was inevitable that the currency and interest rates would come under severe pressure.  As the new government increased its hostility towards the U.S. and its traditional western allies, the pushback from those allies created conditions that resulted in the financial market sell-off, which is also a direct reflection of the lack of confidence in the administration and its policies.

As the Turkish economy adjusts to the new reality of the high cost of the past debt build up, a hard landing and large recession are becoming a reality.  The ensuing downgrades by the credit rating agencies will increase the cost of debt, further limiting chances of a near-term recovery. 

We have been generally underweight Turkey in our global debt portfolios because of weak economic fundamentals for approximately three years. However, once the economy adjusts to the new reality, we believe there will be a significant opportunity to buy cheap Turkish assets that could provide a rate of return commensurate with the risk.

Contagion:  Likelihood and Channels

The spread of financial market contagion is quite common when there is a large downward move in a country.  Examples include the Chinese currency devaluation in 2015, the Greece debt crisis in 2015, and the collapse of the Russian ruble and Brazil’s deep recession in 2014.  In most of these cases the contagion was limited to financial markets and then dissipated over a short period of time.  Those willing to invest at times of stress were usually rewarded with excess returns, as we have seen in Greece.

There have been three occasions in the recent past when financial contagion affected the real economy and spread broadly:

  • The European peripheral crisis, which resulted in a global slowdown from 2011 to 2014,
  • The global financial crisis of 2008, which started in the housing market and U.S. banks and spread globally, and
  • The Asian market crisis in 1997.

In 1997, there were many countries in Asia that had engaged in behavior similar to Turkey’s, unlike today when it is largely two countries, Turkey and Argentina. 

One channel through which Turkey may affect the world more broadly is the European banking channel, which has some exposure to Turkey. Several European banks own subsidiaries or have operations in Turkey, and could incur losses on Turkish lira depreciation and non-performing loans. Spain’s BBVA and Italy’s UniCredit have relatively larger exposures to Turkey, compared with their European bank peers.  However, the banks potentially affected by exposure to Turkey are well-capitalized and, in our view, will be able to withstand even the highly unlikely scenario of full write-downs without jeopardizing their capital ratios. While we expect some losses, we believe these liabilities would be manageable. 

While we consider the risks of broad market contagion to be limited, we believe the Turkish crisis will have near-term implications for markets in countries that have sanctions-related issues such as Russia, or with high levels of external debt ownership such as Indonesia, or similar economic vulnerabilities such as South Africa.

In the case of Russia, while we expect increased market volatility resulting from uncertainty around U.S. sanctions, external vulnerabilities are relatively low, as President Vladimir Putin’s government has actively worked to reduce the effect of sanctions. Further, we believe currency intervention to smooth market volatility is likely.

In Indonesia, the central bank has been making appropriate adjustments to its monetary policy, and we expect it to continue implementing policy measures that would reduce currency depreciation. Similarly, if the South African rand depreciates materially, we would expect the South African Reserve Bank to adjust its policy rates upward due to inflation concerns. Overall, we believe the near-term implications of the Turkish crisis will be limited to idiosyncratic countries, with limited spillover effects.

Opportunity

The depreciation in EM currencies, rates and credit has created a significant market opportunity despite improved fundamentals and monetary/fiscal policy across many emerging market economies. EM currencies are now back down to their lowest levels versus the U.S. dollar in the past three years, during which time EM foreign exchange (FX) rallied, but they are now also close to the lowest levels in over a decade, which included the global financial crisis. Exhibit 1

Exhibit 1: Emerging Market Foreign Exchange Almost Back to Pre-Global Financial Crisis Levels

Emerging markets, on average, offer a significant pick-up in real yields compared to developed market yields. The EM-DM (developed market) real yield spread is approximately 4%, which is also near a 10-year high. Exhibit 2

Exhibit 2: Emerging Market Real Yields Significantly Higher Than Developed Market Real Yields

EM credit also shows compelling value with EM ‘BB’ rated sovereign debt trading at wider spreads than U.S. high-yield debt (these levels are close to decade wides). Sovereign debt typically has the full faith and credit of the issuing sovereign without the idiosyncratic risk of a corporate credit. Looking at valuations, EM currencies, rates, and credit are all close to or near the most attractive entry points in more than 10 years. Exhibit 3

Exhibit 3: Emerging Market BB Rated Soverign Debt vs. U.S. High Yield BB Rated Bonds

Given our views, we expect to slowly increase the weight of EM FX exposure along with select EM country rate exposure in our portfolios. Countries with larger representation of rates in our portfolios currently include Mexico, India, and South Africa.  In FX, our current exposure to EM currencies includes the Polish zloty, Indonesian rupiah, Indian rupee, and South African rand.