Finance is hugely interconnected and its history is full of seemingly distinct events that end up having unforeseen consequences for economies far removed. Historically, these interconnections have typically been made via the banking system, with a default in one place leading to a banking failure elsewhere and hence consequential impacts for the bank’s other customers. This is the reason there is such an emphasis on banking regulation and banking capital adequacy as an attempt to reduce the risk of extreme contagion, particularly post GFC (global financial crisis).
The current meltdown in Turkey appears to be playing out similarly to the emerging market crises of the past. A country with a high dependency on foreign borrowing mismanages its economy leading to high deficits (government and trade), the currency weakens making foreign borrowing more expensive and the government blames the market. In Turkey’s case, a bump on the road (the US sanctions) was the proximate cause that turned a progressive deterioration into a crisis. The obvious impact of this crisis has been on the European banks where in some cases there are material exposures and these have sold off in reaction. The last thing the European financial system needs is another bad debt black hole and so there is no doubt a desire in Europe to see the situation stabilise.
Some other emerging market currencies and bond markets have also sold off during this period, particularly South Africa which also suffers from an external deficit and relatively high levels of foreign debt. The difference here is that government borrowing is all in local currency. The sell-off is widely attributed to knee jerk selling of liquid emerging market assets rather than any real deterioration in South Africa’s financial situation as a consequence of Turkey’s problems. This appears to be a feature of modern financial markets, driven as they are by risk models and ETFs. Important events in one part of the system can impact elsewhere, not via the mechanism of the banking system or economic fundamentals, but simply because they are in the same index or have a high correlation in a risk model. A similar impact could be seen on Mexican assets in the period with even less justification.
While Turkey may stabilise in the short-term, its ongoing transition from potential EU member to radical dictatorship is disturbing on a number of levels, particularly because of its geographic position as a buffer between the Middle East and Europe and its status as a NATO member. The EU has been notably silent while Turkey has been moving in a very uncomfortable direction, most likely because they have relied on Turkey as a buffer during the Syrian crisis and ally in the Middle East. We do not see Turkey as an investable market in the long-term for the same reasons we have avoided some other emerging markets such as Russia, as governance is too poor and the leadership potentially hostile to foreign debt holders.
A bigger picture way of looking at the current crisis may simply be that as the US economy continues to strengthen and US yields continue to rise, opportunities for investors in the US are more plentiful and therefore the desire to chase yield in Emerging Markets is greatly reduced, particularly in the context of a strong US dollar. We think capital will be much less plentiful in the future than the past as the global savings glut reduces and therefore it will pay to be more selective when looking at both equity and bond markets. We have been trying to avoid assets that we consider paper tigers, driven largely by weight of money rather than real investment merit led by strong fundamentals. In many cases these paper tigers, merely because they have a high weight in an index or ETF, have achieved a valuation quite out of line with fundamentals. Turkey is proving a good example of this but we expect many more to arise as time goes on, perhaps in the Eurozone bond markets and certain parts of high yield generally. As we continue to transition from the era of ultra-low interest rates we expect more events such as this.
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Source for information: Miton as at 15/08/2018 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
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