14th August 2018

Rathbones: Burnt Turkey

Every now and then financial markets lay a beating on a nation with a severity that seems completely unjustified.

Hot money flows can send an economy to ruin as international traders create a wave of momentum that breaks upon it. Turkey has its problems, for sure. Worryingly it’s circling despotism as Mr Erdogan centralises power in himself and jails a good number of people who disagree with him. The country’s house prices have more than doubled over the past five years as an overheated construction boom rolls on. The nation’s companies have levered up substantially using foreign cash, too. And Turkey has one of the worst current account deficits of emerging nations at 5%, no doubt exacerbated by Turkey’s need to import oil which has risen by half again over the past year. In fact, Turkey’s current account deficit is now even worse than the UK’s. Last year, Britain’s deficit fell below 5% for the first time since 2012. Some people can greater rely on the kindness of strangers than others …

It doesn’t help that Turkey has overstepped itself by holding an American pastor on espionage and terrorism charges. Of course they’ve held Andrew Brunson for about two years now, but President Trump took the chance to jump on the weakness last week and announce doubled tariffs for Turkish steel and aluminium. That sent Turkey’s vital signs on another leg down.

Currency traders have been aggressively selling the Turkish lira for months and after a few recent capitulations it has slumped 45% year to date. Financial markets can be a great way to encourage governments and companies to manage their affairs prudently. But they can also become self-fulfilling: the 2-year yield on Turkish debt was almost 22% this morning, while the 10-year’s was 20.6%. It could have refinanced itself at 12% in March, but it certainly can’t at 22% today. The central bank has tried to cushion the blow and ensure the nation’s financial system doesn’t seize up by reducing the amount of lira reserves banks have to hold. 

An interest rate hike doesn’t appear forthcoming, which suggests that the central bank is under the thumb of Mr Erdogan. But then the benchmark rate did rocket from 8% to 17.75% just a few months ago and the currency just fell even faster. For much of 2018 Erdogan has argued that interest rates shouldn’t be raised – instead they should be cut to dampen inflation. Not exactly economics 101 when the currency had fallen more than 40% year to date and inflation is knocking on 16%. The President can’t escape blame for the position his country is in. While financial markets have characteristically overblown the whole situation, he has caused much damage to the economy and the nation’s international reputation. Typically, Mr Erdogan has responded to the crisis by rounding up Turkish journalists who don’t share his warped perception of reality and blaming foreign powers. 

We think the troubles in Turkey won’t snowball into a wider emerging markets crisis, such as the one that hit Asia in the 1990s. Most other developing nations have much healthier fundamentals. Many investors sold European banks, sending their shares down between 4% and 6%. The European Central Bank says it has been monitoring Continental banks’ exposure to Turkey, putting more fright into the mix. Spanish banks in particular appear to be holding a lot of Turkish debt – roughly a quarter of bank capital and reserves. French and Dutch banks also hold a solid amount of Turkish debt. If they take heavy losses on these loans it may lead to another European banking crisis through the backdoor. For now, investors will be scrambling to determine whether these loans were made to well-capitalised Turkish banks and blue chips or to entities of a much lower calibre …

Source: FE Analytics, data sterling total return to 10 August 

The flip side

One aggravating factor for the Turkish lira is here to stay for the foreseeable future: the dollar is still riding high.

The greenback is up 3% since the beginning of the year and has gained more than 7% since its 2018 low in February. The US Federal Reserve (Fed) is almost definitely going to add another 25 basis points to the Fed Funds Rate next month. That would take the benchmark rate range to 2.00-2.25%. Inflation came in flat at 2.9%, but core inflation – the Fed’s favoured measure – rose 10bps to 2.4%.

American economic figures look rosy indeed and the S&P 500’s first-quarter earnings were exceptional. The NFIB Small Business Optimism Index is forecast to report another strong reading on Tuesday. That’s followed by retail sales growth, housing data and industrial production on Wednesday. The University of Michigan Consumer Confidence Survey comes out on Friday. It’s expected to remain pretty much flat at 97.9 – down from recent highs but still very high historically speaking.

This seems to be helping the US place new debt. Treasury bond issuance stepped up last week in response to the dramatically larger shortfall in state spending. Mr Trump’s extraordinary tax cut has pushed the budget deficit to 3.5% of GDP on its projected path to 5% by 2022. Investors gobbled up all of the $26bn of debt without a hitch. It was the largest ever Treasury auction, easily eclipsing the $25bn auctions used to finance the US’s response to the global financial crisis in 2010. 

This is a tremendous amount of debt to be piped into global markets, especially when the Fed is raising interest rates and buying fewer bonds (reducing support for Treasury prices). Still, at a yield approaching 3% yield investors are more than happy to hold these debts.

Bonds

UK 10-Year yield @ 1.24%
US 10-Year yield @ 2.87%
Germany 10-Year yield @ 0.32%
Italy 10-Year yield @ 2.99% 
Spain 10-Year yield @ 1.40%

Investments, Investment Commentary