Let’s talk Turkey…because at this point it seems that everyone else has! The old quote from Hemingway is applicable here. In the novel The Sun Also Rises, there is an exchange where it is asked “How did you go bankrupt?” to which the reply is “Two ways. Gradually, then suddenly.” Now the fiscal situation in Turkey is not as extreme as bankruptcy (though it is in a very difficult spot), but there are enough parallels to previously traumatic market episodes to give the much broader market jitters. Let’s start with its “external financing needs” which in plain-speak is how much capital they need to pay their bills when they spend more than they take in. Turkey has a roughly $50bln current account deficit (which is the economic term of income less spending). Many countries including the US have current account deficits that they finance through the issuance of debt. One of the key issues with Turkey is much of that debt is capital raised from outside the country and, importantly, most often denominated in a currency other than the Turkish lira. In fact, they have about $180bln in external debt that will be coming due soon and unfortunately they do not have enough in reserves (a country’s “rainy day fund”) to bridge the gap. Couple that with a massive decline in the value of the lira (it fell 20% in the last week alone) which is being undercut by the Turkish finance minister (who happens to be the President’s son-in-law) saying that he is against higher interest rates. All of this brings to mind for investors the Asian crisis in 1997 triggered by the Thai baht that then circled the globe with problems. Second, much of the investment in the recent growth of Turkey are European banks, in particular the Spanish. This of course brought to mind the European banking crisis stemming from the Global Financial Crisis of 2008. The excesses and actions which led to Turkey’s circumstances occurred over years, but it is triggered now by a tariff action by the US against Turkey in response to detention of a US citizen (a pastor) that the country claims had ties to a failed coup attempt in 2016. In Hemingway’s word, “Gradually, then suddenly.”
With such situational parallels to historic poster-children of market turmoil, it is not surprising that global equity markets reeled, US Treasury yields fell, and the US dollar strengthened in a flight to safety. But stepping back, we must remember that the world has changed quite a bit from the market’s traumatic past. The emerging market currency crises (the Thai baht was followed just after by the Russian ruble) occurred in the late 1990s. That was a time when most emerging market countries had currencies that were pegged, were dependent on USD-denominated debt issuance, and there were little if any reserves. Twenty years later, due to the good fortune and great growth, most emerging market countries are in much better situations. Currencies float with market factors more often than not, capital markets in these countries have deepened and debt is often denominated in local currency, and reserves have been built. There are absolutely exceptions. Turkey has long been on the list as has been Argentina (which has also been in the news for its troubles) along with Indonesia. But by and large, they are notable as the exceptions instead of the rule.
European banks have taken the time since the financial crisis to do a better job containing risk by offsetting local currency loans with local currency deposits to reduce the risk of such a dramatic currency value swing. Estimated at roughly $220bln, the degree of exposure is large in absolute terms but more modest when thought in the context of the support that has been used to protect the banks until this point. And all of this concern emanating from a country that is about 1% of global GDP. That is not to make light of the economic difficulties which exist and can amplify elsewhere, but there is an ability to manage the situation better today than what 1997 or 2008 would imply just by invoking the past.
Understandably, the broad equity market index most impacted in this news flow is the emerging markets. The MSCI Emerging Markets equity index remains down about 20% from its January 2018 high. The good news is that despite this week index-level performance (which is made worse when translated to USD) there are fewer individual emerging market stocks that are making new lows suggesting that it is in the process of settling down. While the next 5 months will likely remain difficult for EM stocks as emotions win out in the short-term, looking out 5 years we believe that they deserve an allocation in global equity portfolios. The index trade at just over an 11x P/E multiple which is about one-third less than the P/E of the S&P 500 and represents a large portion of the global economic future. In a world where many assets have high valuations, that is something to talk about.