Cold Turkey: economic trouble created a spike in risk aversion

In recent days, headline risk in Emerging Markets increased as a result of the US proposing sanctions against Russia, escalating tensions between the US and Turkey amidst an overall deterioration in market confidence in Turkish policymakers.

For years, Turkey has been one of the most vulnerable emerging economies. There are several reasons for this, including the fact that its current account deficit exceeds 5%, its banks are heavily dependent on foreign funding, the Erdogan government’s aggressive growth maximisation strategy via subsidised lending schemes, a widening fiscal deficit, the rapid increase in FX debt in the energy sector, structural double-digit inflation rates and the continuous pressure on the central bank and other economic institutions. We knew that at some point, pressure on the country would increase to levels high enough to push the lira down substantially and interest rates up. This has now happened this year, starting in a relatively orderly manner in Q2 due to the rising oil price and the appreciating dollar. Turkey is now experiencing a loss in market confidence, following unorthodox policy statements and President Erdogan’s removal of key members of the economic team within his government following the June 2018 elections.

After his re-election, Erdogan further consolidated his power by appointing his son-in-law as Minister of Treasury and Finance. The removal of other key cabinet members was perceived as a sign of the risk of a potentially worsening policy mix. This was further exacerbated by comments from Erdogan on his desire for rates to go lower.

In reaction to Turkey’s cabinet change, Fitch downgraded Turkey further, noting political pressure on the monetary policy authority as well as uncertainty over the commitment to macro stability, high external financing needs and a low international liquidity ratio.  The market’s fears seemed to be confirmed at the July MPC meeting when the central bank failed to deliver a meaningful rate hike in response to a weakening currency and rising inflation expectations. The Central Bank of the Republic of Turkey (CBRT) instead chose to ‘wait and see’. It will assess the disinflationary impact of the anticipated sharp slowdown and tightening domestic financial conditions before delivering further rate hikes.

At the same time, concerns about the health of the banking system have risen. This is due to the depreciation of the lira in combination with large foreign currency liabilities as well as the overall rise in funding costs amidst a weakening economic environment. Separately, tensions with the US picked up over Pastor Brunson, when a Turkish court ruled out his release and moved him from jail to house arrest. The US did not accept the Turkish court’s ruling and imposed sanctions on two Turkish top officials. Turkey then issued counter sanctions on two US ministers.

At this moment, the market is looking for a return of credible policymakers and an improved macro-economic policy mix, which would include a tightening of both fiscal and monetary policy. We see scope for the economic situation to deteriorate further in the absence of a credible policy anchor, which at this point remains elusive. With the lira having depreciated by 45% since the beginning of the year, a deep recession has become inevitable and the risk of a system-wide banking crisis has increased sharply. The government needs external support and a credible economic policy package to regain confidence. For now, this looks unlikely. Still, there is some positive news: we could see a release of the American pastor and an easing of US sanctions. We could also see a sharp interest rate hike by the Turkish central bank, possibly leading to a pull-back of the lira. At the same time, the authorities might feel forced to install capital controls to stop the outflow of foreign capital.

Last Friday, we witnessed some contagion to broader markets as the ECB mentioned the high exposure of several banks to Turkey. As usual, the impact runs through several channels. The first is a rise in global risk aversion. This has led to a textbook reaction by financial markets. The USD and the JPY enjoyed their status as a safe haven and appreciated, whereas risky assets declined and fixed income spreads rose. Safe treasury yields also declined but by less than 10bp. The second channel runs through the banking sector. However, the exposure to Turkey remains limited to a few banks in Spain, Italy and France, and is manageable. We do not expect banks to walk away and expect they will support their Turkish operations by participating partly in roll-over of funding. However, the unpredictability of the outcome, partly in light of the political dimensions, is making investors cautious on the space. Beyond Turkey, we also note some divergence in spreads across the EU (widening in peripheral spreads), which affect EU bank valuations. The price weakness of the banking sector is also linked to the decline in government bond yields.

Looking forward we will continue to monitor developments. We believe that for the time being, there are no clear signs that other Emerging Markets are becoming infected and impacting the global growth outlook. Nor do we see a tightening of financial conditions for now.

Equity exposure reduced to neutral

In our asset allocation we decided to reduce risk by downgrading equities from a medium overweight to neutral. Of course, this is not only linked to Turkey. Over the past period equity markets were supported by the better-than-expected second quarter results, particularly in the US and Japan. With the earnings season behind us, this tailwind is fading. At the same time, a number of other (geo)political risks are still present, including budget discussions in Italy, escalation of a trade war, Iran sanctions and Brexit. Finally, the positive impulse from macro data has faded recently as the global economy has moved from an acceleration to a consolidation phase. Nevertheless, the absolute level of the data remains at a healthy level.

Within equities, we reduced our exposure to Eurozone equities from neutral to a small underweight. Compared to other developed markets, the relative earnings and macro data are on the weak side and political risks in Italy may continue to weigh on the region even if a compromise acceptable to the EU is eventually found. The euro depreciation may counterbalance this, but the impact will only be felt over the medium term. Another point to take into account is the low investor positioning in the Eurozone. Both elements could act as a buffer.

We hold on to our small overweight in Emerging Market equities. The balance of payment and credibility problems Turkey is facing are not widespread in the rest of the emerging world. Argentina is the only country that also has large external imbalances but its government has a good reputation and has stepped up its macro adjustment efforts with the backing of the IMF. And while South Africa has a 3%-4% current account deficit, progress has been made in the past years to reduce it. Even more important is that the new South African government has a reasonable reputation in the market. There are expectations of positive reforms in the coming years. Indonesia has a 2% current account deficit and a 2% fiscal deficit as well. So the starting point is not that bad. The problem in Indonesia is that the change is negative, and the government has become less orthodox in recent quarters. With elections coming in 2019, Indonesian policymakers might not deliver the policy mix that markets demand.

The rest of the emerging world is in relatively good shape and not necessarily vulnerable to serious contagion from Turkey. Particularly relevant here is China, which has managed to reduce its financial system risk in the past years and has just started to ease economic policies. Also, the depreciation of the renminbi, which caused some market nervousness in the past months, seems to have stopped. This eliminates a negative factor for EM FX and could help all EM assets to recover in the coming months. Investor positioning in EM has also fallen back.

Finally, we have cut our exposure to EMD HC sovereigns to a small overweight as a result of the Turkey-related weakness in EMD. We have not closed the overweight altogether, given decent fundamentals in EM overall and because we have seen a sizeable positioning adjustment in EMD over the past months.