Since July 31st, Turkey’s national currency, the Turkish Lira, has fallen as much as 23% on threats of a trade war and declining confidence in Turkey’s government. Turkey clearly faces some daunting economic challenges. More broadly, investors are wondering if Turkey’s predicament could spread to other emerging markets and even spark global recession.
Why is Turkey under pressure? Does it portend broader problems for emerging markets and the global economy? What role should emerging markets play in your portfolio?
To summarize our messages:
- Emerging markets as a group are likely to remain under pressure as the US Dollar gains strength and if the US raises rates faster than expected. The MSCI Emerging Markets Index is down 12% this year (at 8/17/18)—one of the worst performing asset groups—after performing among the best in 2017.
- We believe these macro headwinds are amplifying the specific political and economic weaknesses for Turkey, and perhaps a handful of other emerging market countries. They face serious challenges, but the global banking system appears stable. We do not expect their particular crises to spread throughout all emerging economies.
- Despite the headwinds, we believe emerging markets currently offer some of the best opportunity for investors with long horizons. We maintain a moderate allocation in our standard balanced portfolios (typically 3-5% of a strategy), whereby we seek broad exposure without making disproportionate allocations to any particular country.
Context: What is an Emerging Market?
By way of background, emerging markets are different than developed markets. They consist of about 40 countries—China and India being the largest—at various stages of economic and political development. These countries can have some of the highest economic growth (and therefore investment returns) but also tend to be more volatile (politically, economically, financially) than developed countries like Germany, Japan, Australia or Switzerland. Their economies tend to be less diverse and banking systems less mature. Currency swings or commodity prices can have a dramatic impact on their stability. Yet, they are important contributors to global growth, and are playing a larger and larger role in the world economy.
As an emerging market, Turkey is not a significant force economically (its economy is 17th largest, around 1% of global GDP). Moreover, in our client portfolios, it has a negligible presence on its own. Nevertheless, the country carries major significance politically. Despite growing tensions with the US over Russia and Syria, Turkey remains a key ally in NATO as a host of land command and radar systems, and it plays a vital role in the war on terror vs. Islamic State. Due to its strategic role, Turkey matters to the world order.
A View from the Currency Markets
The value of a country’s currency can be a barometer of that country’s health, so let’s have a look at what the currency markets are telling us.
The Turkish Lira received a lot of attention on August 10th when the Trump Administration threatened to double steel tariffs on Turkey, but in reality the Turkish currency has been weakening for some time.
As Exhibit 1 highlights, we can trace the current problems back to July 2016, when a failed coup in Turkey sparked repressive actions by President Erdogan, including potential corruption and purges. Since that time, the Turkish Lira is down as much as 55% as confidence in Erdogan has waned, independence of its central bank appears to be compromised, and its economic plight has darkened.
To summarize, then, the markets are showing real concern over the political and economic stability of Turkey.
Exhibit 1: The Path of the Turkish Lira
Source: CapIQ and CornerCap Research
Are currency markets showing similar concern with other countries? Exhibit 2 shows year-to-date currency trends for selected major emerging markets, along with two key indicators of economic health.
While most emerging markets currencies are down this year, those of Turkey and Argentina are down by far the most, around 38%, more than double that of other major currencies. We believe currency markets are drawing a distinction between emerging market economies. Countries facing what we might call the “triple whammy” of 1) high external debt; 2) high current account deficits; and 3) low currency reserves are being penalized the most. Many of the major emerging markets may have one or two of those characteristics, but few have all three.
Exhibit 2: Comparative Currency Returns by Major Market
Sources: IMF, World Bank, OECD, CornerCap
Why We Believe Turkey is among the Isolated Cases
In our view, a stable emerging market economy tends to have the following profile:
- A responsible ruling authority that honors judicial and legislative branches
- An independent and experienced central bank to govern monetary policy
- A clear source of economic strength (the more diversified, the better)
- Sufficient capital reserves and robust banking system to cushion economic cycles.
We believe Turkey is showing weakening trends in most of these areas:
- President Erdoğan has amassed outsized personal influence in most key areas of government through constitutional referendum and resignation of some key finance ministers and cabinet officials.
- The independence of its central bank is in question after constitutional reform. Erdoğan has recently called for lower rates at a time when monetary policy might require higher rates to counter double-digit inflation and encourage foreign investors.
- Turkey has one of the largest current account deficits (over 6% of GDP), which means it is heavily reliant on foreign investment to drive economic growth… at a time when foreign investors are losing confidence.
- Turkey has some of the highest external debt levels—defined as debt payable to foreign entities such as the US—with signs that its banking system may be facing increasing strain from nonperforming loans. Reports show that a third of Turkey’s debt is due next year, and 40% of its external debt is floating rate. This condition will put higher demand on its currency reserves to cover any gaps on payments and servicing.
These issues are compounded by a stronger US Dollar (which makes Turkey’s dollar-denominated debt and imports more expensive) and the threat of a trade war on steel (which could reduce a vital export to fuel economic growth). These macro issues can create a vicious spiral, whereby the current account deficit increases, putting further pressure on reserves, currency, and the banking system.
Turkey is at risk of this vicious cycle.
Contagion: Possible but Less Likely
At this point, we believe the market is successfully concluding that contagion is not likely. The strength of the US dollar and threat of trade wars are negatives for most emerging markets, but those with weak government institutions, high levels of debt denominated in US dollars, and a challenging combination of deficits and currency reserves pose the greatest risk.
Contagion tends to occur when the collapse of a handful of countries affects the economic stability of neighboring countries with significant trading or financial relationships, or if the global banking system stops lending or providing liquidity. Turkey’s economy itself is not large enough to affect many countries. We do not suspect the global banking system would destabilize if Turkey’s debt (along with a handful of debt of other countries) went into default. Argentina’s economy is about the same size as Turkey’s, and Argentina recently won support from the IMF for a $50 billion loan package to help close budget gaps, which helps maintain confidence within the banking system.
Our view is that markets are proceeding rationally, focused on particular countries and not expressing alarm across the broader spectrum.
A Word on Valuation in Emerging Markets
For long-term investors, we believe a moderate allocation to emerging markets is appropriate because it offers a return stream that is diversified away from the US economy and plays a different risk-reward role. It can offer some of the highest returns, although it is a volatile asset class.
By our analysis, emerging markets currently carry some of the better valuations available to investors. Current P/E multiple for the MSCI Emerging Markets index is 13-times, well below that of the S&P 500’s 20-times and the MSCI Developed Markets’ 16-times. Dividend yield is also attractive at 2.8%, vs. 1.9% for the S&P 500 and competitive with larger developed markets.
We believe Turkey faces difficult choices and suspect that a handful of other emerging markets countries will also struggle. Nevertheless, as long as the global banking system remains rational, we do not expect the struggles of these countries alone to destabilize global economic relationships and capital flows.
We would become more concerned if the global economy were to slow materially, affecting larger players in the global order and exposing greater problems in the banking system. Threats of trade war are certainly a wild card, which is why we build diversified portfolios to strive to accommodate unpredictable events.
Disclosure: Past performance is no guarantee of future results, and all investments are subject to risk of loss.
 Turkey represents 0.8% of the Vanguard FTSE Emerging Markets ETF (VWO), for example.
 According to Investopedia, a Current Account Deficit is defined as: “… a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the goods and services it exports. The current account includes net income, such as interest and dividends, and transfers, such as foreign aid… A current account deficit represents negative net sales abroad. Developed countries, such as the United States, often run current account deficits, while emerging economies often run current account surpluses. Extremely poor countries tend to run current account deficits.”
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