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One Bank Warns: ‘Forget Turkey, Asia Is The Elephant In This Room’

"As the tide of excess liquidity recedes, EMs like South Africa will begin to pay the heavy price of this misallocation of credit."

Emerging markets got something of a reprieve on Tuesday amid a (likely temporary) stabilization in the lira, but if a Reuters story out late in the U.S. session is any indication, meaningful progress on resolving the diplomatic dispute at the heart of the Turkish currency’s most recent leg lower remains elusive.

A day after John Bolton reportedly told Serdar Kilic that negotiations will not resume until Andrew Brunson is released, an unnamed U.S. official told Reuters the following about the situation:

The administration is going to stay extremely firm on this. The president is 100 percent committed to bringing Pastor Brunson home and if we do not see actions in the next few days or a week there could be further actions taken.

The pressure is going to keep up if we’re not seeing results.

The official didn’t specify what Trump is prepared to do, but did indicate that further economic sanctions are likely in the cards.

MSCI

(And MSCI gauge of emerging market currencies has suffered grievous losses since the dollar began to rise in earnest in April, and declines have accelerated in August)

On Monday, as the lira careened lower after a weekend that saw President Recep Tayyip Erdogan give a series of defiant speeches, other emerging market currencies including, notably, the South African rand, fell sharply in sympathy.

The overarching message in our Monday morning post documenting the contagion was simple: the rampant misallocation of capital catalyzed by years of easy monetary policy in developed market economies was unwinding. We reiterated that in “‘Perhaps – Finally – Realistic’: Five Years Later, One Man’s Carry Trade Prophecy Comes True“, writing the following:

The tsunami of liquidity unleashed by developed market central banks in the wake of the financial crisis is in large part responsible for facilitating the kinds of imbalances that are now unraveling as that stimulus is rolled back. The mad scramble for yield catalyzed by post-crisis monetary policy sent investors scurrying down the quality ladder, leaving everything priced to perfection. Spreads on risky debt were (and in most cases still are) an illusion. Now that the Fed is tightening and dollar liquidity is disappearing, the carry trade is unwinding and the first casualties are showing up. Turkey is the first domino.

For those interested, there’s a ton of color on this in “Dollar Liquidity Dynamics: An Epochal Shift Is Coming, One Bank Warns“.

In the dollar liquidity post linked at the end of that excerpt, we highlighted some commentary from Nedbank’s Neel Heyenke and Mehul Daya who have been pounding the table on dollar liquidity and the likely ramifications for various carry trades all year long. On Tuesday, they’re out with a new piece.

“For EMs over the past couple of years we’ve seen fundamentals drift back to close to where they were in 2009/10, as reflected in their aggregate sovereign ratings [and] yet, investors have allocated large amounts of their portfolio allocations to EM’s relative to DM markets”, the Nedbank strategists write, attributing this propensity to the global hunt for yield.

Nedbank1

(Nedbank)

“As the tide of excess liquidity recedes, EMs like South Africa will begin to pay the heavy price of this misallocation of credit”, Heyenke and Daya warn, before delivering the following rather sobering assessment of where the real danger lies:

Forget about Turkey’s woes, Asia is the elephant in the room. South East Asia stands out again as in 1997/8, with a large amount of USD denominated debt outstanding. The only difference is then Asia had fixed exchange rates and now they are floating! We believe Asia will be the next source of downside systemic risk for financial markets.

Nedbank2

Asia’s USD debt, relative to international FX reserves and exports, has risen significantly since 2009. This leaves these nations susceptible to a shortage in USDs. Notably, the Asian nations that have amassed record amounts of USD debt are also home to the largest technology companies i.e. Tencent (China), Alibab (China), TSNC (Taiwan), Samsung (S.Korea). The tech sector is now 28% of the MSCI EM index.

Nedbank3

Needless to say, this situation is exacerbated by what BofAML last week called “a trifecta of dollar-positive macro policies”. To wit, from a note by the bank’s Ethan Harris:

[It’s] an oversimplification to ignore how exchange rates respond to policy changes. The US is running a trifecta of dollar-positive macro policies.

  1. Easy fiscal policy pushes up the dollar by boosting interest rates and stimulating imports. The new tax laws also create incentives to repatriate cash to the US and if these monies are not already in dollar assets, this could strength the dollar as well.
  2. Fed tightening also pushes up interest rates, boosting the dollar.
  3. And actual and threatened US tariffs strengthen the dollar as well. Tariffs tend to weaken imports, reducing US demand for foreign currency, and threatened tariffs add to global uncertainty, pushing up safe-haven currencies like the dollar.

In the week through last Tuesday, speculative length in the dollar rose for a seventh week in eight, with the net overall long position now sitting at nearly $23 billion, the highest since January 20, 2017:

dollar

(Goldman)

This all seems precarious, especially given that late-cycle fiscal stimulus and tariffs are inflationary in the short-term, which means the Fed is effectively pigeonholed into hiking.

Last Friday, the latest CPI data showed core prices rising at their fastest pace since 2008 and if Trump moves ahead with tariffs on an additional $200 billion in Chinese goods, it will only make things worse.

Draw your own conclusions.

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