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emerging markets lira Markets turkey

‘This Is Not Going To End Well’: Turkey Isn’t EM’s Bellwether, But Brace For Impact Nonetheless

"...markets need to be prepared for a hard landing in the economy, corporate defaults on foreign currency debt, and possible bank failures."

As the lira collapse accelerated on Friday, a defiant Recep Tayyip Erdogan took the stage in a series of rallies and delivered the usual talking points.

He described Turkey as “my nation”, he blamed nefarious foreign actors for “waging an economic war” against the country’s people, he tilted at the “interest rate lobby” windmill, he branded currency instability “artificial”, and he called on Turkish citizens to trade in their dollars, euros and gold for liras as part of a “resistance” movement.

What’s happening in markets, Erdogan declared, is the result of “economic hitmen”.

Because irony and satire are dead, Donald Trump made Erdogan’s otherwise absurd claims partially true by taking to Twitter to inform the world that the U.S. is prepared to double metals tariffs on Turkey in response to Erdogan’s refusal to budge when it comes to releasing North Carolina Christian pastor Andrew Brunson, who stands accused of conspiring with the Turkish autocrat’s arch nemesis Fethullah Gulen.

All of this came hot on the heels of a Financial Times article that suggested the ECB is concerned about some European banks’ exposure to Turkey. That report sent the euro careening to a one-year low as traders pondered a possible policy response and were reminded that the political situation in Italy has populist parallels to Turkey.

As global markets stumble amid the lira slide, I want to remind you about something I said on Thursday. To wit, from “‘Don’t Be Afraid At All’: In Turkey, Desperation As Currency Crisis Spirals“:

I’ve spent an inordinate amount of time documenting this over the past several weeks, although upon reflection, I’m not sure “inordinate” is the right word. This is important. Irrespective of the impact Turkey “should” have (mechanically speaking) on emerging market assets as a group, the collapse of the currency and the country’s plunge into one-man rule is a curse on risk sentiment – an albatross around the neck of a market that’s already laboring under a laundry list of geopolitical concerns.

For months, analysts and asset managers variously suggested that the situation in Turkey likely wouldn’t deteriorate meaningfully. The lira and Turkish assets rallied when Erdogan announced the date for early elections and they rallied again when he prevailed. Political scientists traders are apparently not.

It was abundantly clear what was likely to happen to the lira after Erdogan consolidated power and this is one of the few times I’m keen on saying “I told you so.” Our Turkey archive is a veritable museum of bearish lira calls and one of the many themes that permeates those posts is that you cannot simply look at what the mechanical effect of a collapse in Turkish assets “should” mean for EM as an asset class and declare that everything should be fine. Especially not in an environment where the new Fed chair said the following in May about assumed EM resilience in the face of DM policy normalization:

Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

The backdrop for developing market assets is not sanguine and as such, idiosyncratic flareups are magnified in the minds of market participants. Yes, they are country-specific and yes, country-specific risk is part and parcel of investing in emerging markets, but when external conditions take a turn for the restrictive (i.e., Fed tightening), these idiosyncratic stories serve as a preview of what can happen if the Fed isn’t careful in managing the hiking cycle.

Sure, the fundamentals may be decidedly more favorable for countries other than Turkey, but as we saw with Russia in April (full recap of that episode here) and as we’re about to see with Russia again thanks to a renewed sanctions push, decent fundamentals will not carry the day if access to dollars is curtailed either by sanctions or simply because the Fed is contributing to a global dollar funding crunch.

Doom and gloom aside, there are decent arguments when it comes to the whole “Turkey is not EM” narrative. Here, for instance, is an excerpt and visual out from Goldman on Friday:

We refresh our external funding requirement analysis to highlight vulnerabilities in EM over time (see Exhibit 1). This metric, which measures reserve cover relative to near-term USD funding needs (short-term external debt and the current account balance), has been a helpful measure to monitor in previous EM crises. On average, EM funding needs are completely covered by reserves (meaning the likelihood of USD debt crises is extremely limited), but Turkey’s funding needs are more like Frontier Markets, and in the same ballpark as the needs of Latin America economies in the 1980s and Asia in the 1990s. Floating vs. fixed exchange rates are an important difference compared with the EM crises of yesteryear, but the starting point for Turkey’s recent volatility is that these USD funding needs are extremely significant, much more so than other EMs.

TurkeyGS

So Turkey is basically a frontier market when it comes to relying on external funding. Got it.

Goldman goes to explain that optically “cheap” does not a good investment thesis make. “Turkish assets screen as inexpensive vs. history, but we do not expect valuation to be a catalyst for a reversal in local markets”, the bank writes.

GSTurkey2

(Goldman)

Goldman goes on to deliver something of a caveat by suggesting local rates may be cheap (actually, they just say that local rates are more oversold than USD-denominated debt), but as far as the lira goes, the bank notes that “there have only been three ‘tradable rallies’ from a total return perspective” since 2014.

“Unless Turkey benefits from a sudden positive external impulse in the form of strong global growth but a dovish Fed, an unlikely outcome, we think local policymakers will need to respond with credible change to stabilize local assets”, the bank concludes.

Right. But “local policymakers” and “credible change” are no longer terms that can be used in the same sentence. Because when it comes to the economy, the only “local policymakers” that matter are Erdogan and his son-in-law Berat Albayrak, who was installed as economic czar shortly after the election, much to the chagrin of markets.

Just read the following assessment from Brown Brothers Harriman’s Win Thin:

The way things are going, markets need to be prepared for a hard landing in the economy, corporate defaults on foreign currency debt, and possible bank failures. This is not going to end well. This is a textbook currency crisis that’s morphing into a debt and liquidity crisis due to policy mistakes.To state the obvious, Turkey’s economic czar is in over his head. Market-friendly types in the cabinet have been marginalized or outright ejected and so there’s very little experience or orthodoxy for Turkey to draw upon. Erdogan once knew better way back when (he actually entered into an IMF program after first taking office), but he is a different person now and I can’t imagine him submitting to IMF conditionality unless as a very last resort.

Now that’s a guy who gets it, apparently.

Nothing further.

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