The last week’s market highlights:
Quote of the week:
“No enemies is a sign that fortune has forgotten you.” – Turkish proverb
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Midyear Outlook:
- U.S. economy: Running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Central banks aren’t all on the same wavelength.
- Fixed income: Starting to prefer higher-quality assets.
- Equities: Earnings are supporting prices, but expect plenty more volatility.
- Asset allocation: Remain risk on, but focus on quality.
Global economy: Talkin’ turkey about Turkey
Over his 16-year tenure, Turkish President Recep Tayyip Erdogan has consolidated power and now holds significant control over Turkey’s fiscal and monetary policy. Wearing both hats, Erdogan has run economic policy to allow Turkey to live above its means, directly resulting in the current currency crisis.
Year-over-year GDP growth soared from -0.81% in 2016 to 11.3% in the third quarter of 2017, before “slowing” to 7.4% during the first quarter of 2018. Although such rapid expansion made Turkey one of the world’s fastest-growing economies, these gains were fueled by vast amounts of dollar-denominated debt. Another signal “flashing red” was inflation, which reached double digits for six consecutive quarters, accelerating to 15.4% as of June 30, 2018.
Responsible governments faced with an overheating economy generally pass budget cuts to limit spending. At the same time, central bankers tend to hike interest rates to fend off inflation. While causing short-term pain by raising borrowing costs for businesses and consumers, such a move would represent typical monetary policy to cool off the economy. In addition, higher interest rates tend to attract foreign capital, strengthening the currency and lowering inflation.
Erdogan, though, has eschewed these traditional measures. He once described (high) interest rates as “the mother and father of all evil.” And in order to boost an already red-hot economy prior to June’s presidential election, he enacted fiscal stimulus to fund infrastructure and construction projects.
The Turkish lira has borne the brunt of Erdogan’s unusual policy decisions. Even after gaining 7% last week, the currency has fallen 19% in August to date and 37% since the beginning of the year. A prohibition on short selling, a strategy that seeks to profit from falling asset prices, helped support last week’s lira rally. So did a late-week conference call held by Treasury Minister Berat Albayrak (Erdogan’s son-in-law)—on which the dominant theme was that the country would rely largely on fiscal measures to slow the economy and reduce inflation.
In terms of monetary policy, while Turkey has taken steps to ensure liquidity in the banking system by lowering reserve requirements for commercial lenders and easing other rules, the central bank hasn’t raised interest rates since early June, nor has it provided forward guidance—a crucial element for comforting investors during times of crisis.
This downcast backdrop aside, our base case is that the Turkish government will eventually deliver a comprehensive program to help rein in inflation and promote more sustainable growth. We believe this would lead to a notable recovery in asset prices.
At the same time, we’ll be continually monitoring a number of factors, including the stability of key macroeconomic indicators; the overall direction of U.S./Turkish relations; and the ability of Turkey’s “Medium-Term Program” to improve economic growth, employment and income distribution. We’re aware that the longer the government takes to address economic imbalances, the greater the risk that it will be forced to choose an alternative path—such as capital controls—that may exacerbate those imbalances.
Global economy: Don’t throw the baby out with the (Turkish) bath water
We’re still constructive on the broad emerging markets (EM) space in spite of the recent barrage of sentiment-dampening headlines about Turkey. Our reasons include:
- Few EM economies share Turkey’s concerning combination of a drift toward authoritarian populism, large external (USD) debt, and inadequate foreign reserve coverage of that debt.
- The majority of EM countries have sound policy frameworks, and policymakers have responded rapidly and forcefully when faced with a crisis (or potential crisis).
- While a member of NATO and therefore geo-strategically important, Turkey’s economy is relatively small, with a GDP ranked #17 in the world.
Regarding EM debt markets, Mexico and Indonesia may be better positioned to weather the fallout from country-specific developments. The same is true for Brazil, despite some uncertainty about the upcoming presidential elections this fall. Overall, sovereign and corporate credits appear attractively valued, especially compared to U.S. high-yield and investment-grade corporate debt. Specific opportunities in local currency bonds may be compelling, too, although we expect currency volatility to persist.
Currency caution also applies to EM equities. Turkish stocks in particular may remain under pressure (even in local terms) as import prices have skyrocketed and the country’s consumers have seen their disposable income decimated by inflation. Broadly speaking, EM corporate earnings are being revised down for 2018 and 2019, but expected profits growth has stayed relatively solid (around 10%).
Meanwhile, EM equity valuations are the lowest they’ve been in absolute terms since November 2015, and relative to U.S. shares since February 2014. Some “bounce” is possible as the Turkish government addresses the country’s economic imbalances (or as Turkey’s woes recede from the headlines). Also on our radar are escalating global trade disputes, which remain a key risk that could prevent EM shares from recapturing their early 2018 highs anytime soon.