No Turkish Delight For Emerging Markets?

Jim O'Neill, a former chairman of Goldman Sachs Asset Management and a former UK Treasury Minister who is Chairman of Chatham House, wrote a comment for Project Syndicate, The Turkish Emerging Market Timebomb:

Turkey’s falling currency and deteriorating financial conditions lend credence, at least for some people, to the notion that “a crisis is a terrible thing to waste.” I suspect that many Western policymakers, in particular, are not entirely unhappy about Turkey’s plight.

To veteran economic observers, Turkey’s troubles are almost a textbook case of an emerging-market flop. It is August, after all, and back in the 1990s, one could barely go a single year without some kind of financial crisis striking in the dog days of summer.

But more to the point, Turkey has a large, persistent current-account deficit, and a belligerent leader who does not realize – or refuses to acknowledge – that his populist economic policies are unsustainable. Moreover, Turkey has become increasingly dependent on overseas investors (and probably some wealthy domestic investors, too).

Given these slowly gestating factors, markets have long assumed that Turkey was headed for a currency crisis. In fact, such worries were widespread as far back as the fall of 2013, when I was in Istanbul interviewing business and financial leaders for a BBC Radio series on emerging economies. At that time, markets were beginning to fear that monetary-policy normalization and an end to quantitative easing in the United States would have dire consequences globally. The Turkish lira has been flirting with disaster ever since.

Now that the crisis has finally come to pass, it is Turkey’s population that will bear the brunt of it. The country must drastically tighten its domestic monetary policy, curtail foreign borrowing, and prepare for the likelihood of a full-blown economic recession, during which time domestic saving will slowly have to be rebuilt.

Turkish President Recep Tayyip Erdoğan’s leadership will both complicate matters and give Turkey some leverage. Erdoğan has steadily been seizing constitutional powers, reducing those of the parliament, and undercutting the independence of monetary and fiscal policymaking. And to top it off, he seems to be reveling in an escalating feud with US President Donald Trump’s administration over Turkey’s imprisonment of an American pastor and purchase of a Russian S-400 missile-defense system.

This is a dangerous brew for the leader of an emerging economy to imbibe, particularly when the United States itself has embarked on a Ronald Reagan-style fiscal expansion that has pushed the US Federal Reserve to raise interest rates faster than it would have otherwise. Given the unlikelihood of some external source of funding emerging, Erdoğan will eventually have to back down on some of his unorthodox policies. My guess is that we’ll see a return to a more conventional monetary policy, and possibly a new fiscal-policy framework.

As for Turkey’s leverage in the current crisis, it is worth remembering that the country has a large and youthful population, and thus the potential to grow into a much larger economy in the future. It also enjoys a privileged geographic position at the crossroads of Europe, the Middle East, and Central Asia, which means that many major players have a stake in ensuring its stability. Indeed, many Europeans still hold out hope that Turkey will embrace Western-style capitalism, despite the damage that Erdoğan has done to the country’s European Union accession bid.

Among the regional powers, Russia is sometimes mentioned as a potential savior for Turkey. There is no doubt that Russian President Vladimir Putin would love to use Turkey’s crisis to pull it even further away from its NATO allies. But Erdoğan and his advisers would be deeply mistaken to think that Russia can fill Turkey’s financial void. A Kremlin intervention would do little for Turkey, and would likely exacerbate Russia’s own financial and economic challenges.

The other two potential patrons are Qatar and, of course, China. But while Qatar, one of Turkey’s closest Gulf allies, could provide financial aid, it does not ultimately have the wherewithal to pull Turkey out of its crisis singlehandedly.

As for China, though it will not want to waste the opportunity to increase its influence vis-à-vis Turkey, it is not the country’s style to step into such a volatile situation, much less assume responsibility for solving the problem. The more likely outcome – as we are seeing in Greece – is that China will unleash its companies to pursue investment opportunities after the dust settles.

That means that Turkey’s economic salvation lies with its conventional Western allies: the US and the EU (particularly France and Germany). On August 13, a White House spokesperson confirmed that the Trump administration is watching the financial-market response to Turkey’s crisis “very closely.” The last thing that Trump wants is a crumbling world economy and a massive dollar rally, which could derail his domestic economic ambitions. So a classic Trump “trade” is probably there for Erdoğan, if he is willing to come to the negotiating table.

Likewise, some of Europe’s biggest and most fragile banks have significant exposure to Turkey. Combine that with the ongoing political crisis over migration, and you have a recipe for deeper destabilization within the EU. I, for one, cannot imagine that European leaders will sit by and do nothing while Turkey implodes on their border.

Despite his escalating rhetoric, Erdoğan may soon find that he has little choice but to abandon his isolationist and antagonistic policies of the last few years. If he does, many investors may look back next year and wish that they had snapped up a few lira when they had the chance.

I miss Jim O'Neill, he always wrote so well on global macro issues and this comment on Turkey is excellent.

I personally feel cooler heads will prevail and Erdoğan and Trump will strike a deal to save face and stop this from becoming a full-blown crisis that will spill over to the US.

Markets are equally optimistic. Today the Turkish lira rallied as Qatar invested $15 billion and at market close, the iShares MSCI Turkey ETF (TUR) rallied for a second straight day after taking a beating on Monday, hitting a new 52-week low (click on image):

This was actually a great short at $44 but when I saw the action on Monday, I knew shorts were covering.

Still, as I stated on Stocktwits, I wouldn't rush to buy Turkish shares here, it's still a high-risk trade, and the contagion effect to other emerging markets is what worries me most now:

As you see from the chart above, emerging market shares (EEM) plunged below their 100-week moving average today and are likely going to test the 200-week moving average if these markets continue to get hit.

If for any reason that doesn't hold, all hell will break loose and the US Dollar Index (DXY) will surge even higher:

And a higher US dollar will just exacerbate any crisis in emerging markets because a lot of emerging market debt is denominated in US dollars. This is especially worrisome since Trump will continue imposing tariffs on China, Turkey and elsewhere.

Interestingly, the US dollar has been strengthening so much that some market pros are wondering when the White House will start tweeting about it.

We shall see, I'm actually surprised the greenback has rallied so hard and emerging markets are getting clobbered so hard because I expected some sort of a relief rally this summer.

Still, I remain short emerging markets and long the US dollar, so I'm not complaining but from a trading perspective, things are a little overdone here.

Can emerging markets overshoot to the downside? You bet which is why I remain cautious here even if I think a relief rally is long overdue.

It's also worth noting there are some emerging market bulls out there who think the tantrum should eventually subside.

Last week, Mehran Nakhjavani of MRB Partners published a comment on LinkedIn asking, EM's Trade Tantrum: Over Already?:

The fear of trade wars is one of three narratives that has been responsible for blunting risk appetites recently. While it is difficult to handicap these risks, one thing seems certain: at least part of President Trump’s motivation for ratcheting tensions higher has something to do with the domestic electoral timetable, so we can be certain that tensions will simmer until at least the November mid-terms. In other words, more turbulence lies ahead. Now, when facing an air pocket or two, it matters a great deal whether one is flying at 30,000 feet or at 3,000 feet. And we can observe that the starting conditions for global trade are relatively robust: both in dollar and in volume terms, global trade momentum offers a constructive backdrop for risk assets such as EM currencies.

A second narrative that has heightened investor anxiety with respect to EM currencies has been the U.S. dollar itself. It is telling that, after its Q2 rally, once the dollar settled into a sideways churn, EM currencies have mounted a modest comeback. This suggests that for all the trade war talk, the floor boards under EM currencies remain sound.

A third narrative that has gripped investor attention is the notion that tightening liquidity is triggering a retreat of global portfolio capital, which will inevitably cause an EM crisis. This narrative can be questioned on two grounds:

• First, the retreat of hot money from EM assets is par for the course during periods of global economic expansion and tightening monetary settings. Only when there has been a legitimate threat to growth does the capital outflow trigger EM crises.
• Secondly, the current episode of capital flight has been rather modest, when compared with the Taper Tantrum of 2013 and the commodity price meltdown of 2014.

One corollary arising from these observations is that as soon as the initial EM-negative signal from tighter liquidity failed to be validated by data, hot money swung into positive momentum and EM currencies outperformed in carry-adjusted terms.

A second corollary is that for all the turbulence and uncertainty of the past 5 or 6 years, holding EM currencies has not damaged long-term investors. In other words, in carry-adjusted terms, EM currencies have kept pace with the U.S. dollar on a buy and hold basis (click on image).

Mehran is a sharp cookie, he used to manage a portfolio of emerging market stocks at UBS and knows that he's talking about.

But while I respect Mehran, I respect my macro calls too. Right now, I'm not bullish on cyclical stocks or emerging markets even if I've been waiting for a relief rally this summer so I can short them some more.

I've told my readers to beware of the flattening yield curve and the corollary from that is Risk-off markets will dominate and we will see a return to stability.

Also, not everyone is as sanguine on developments in Turkey. On Monday, Alpine Macro published an Investment Alert titled: “Assessing The Lira Crisis”. 

David Abramson, Senior Strategist at Alpine Macro, shared this on LinkedIN:

The Turkish lira crisis has been intensifying for weeks. Although the lira seems stabilizing today on reports that the U.S. and Turkey are talking to each other, conditions remain highly volatile, uncertain and extremely risky. The report provides our independent perspective on the ongoing crisis, and answers the 3 crucial questions facing global investors: 1. How serious will the market contagion will be? 2. What does the crisis mean for the world economy? 3. What should investors do in the current environment? If you are interested in a copy, please email Cecilia@AlpineMacro.com.

Below, Byron Wien, Blackstone vice chair of private wealth solutions, discusses the sell-off and what he sees for equity markets in the wake of the Turkey currency crisis.