Turkey has long been the beneficiary of substantial US dollar funding. However the Erdogan administration is now on the receiving end of US sanctions, having failed to agree to the release of a US pastor held under house arrest in Turkey. A 28% fall in the Turkish Lira last week has highlighted the risks to a corporate sector highly reliant on dollar borrowing. In addition, solutions now appear down to geopolitics rather than domestic economic policy. Given the already entrenched positions of both the US and Turkey, resolution in the short-term appears unlikely in our view. For investors not exposed to Turkey, the lessons are twofold. First, economic fundamentals do now “matter” as the era of cheap and plentiful US dollars draws to close. Second, the rise of populism on both sides of the Atlantic continues to translate elevated political risk into actual investment outcomes.
Over the weekend, Turkey’s President Erdogan has clearly laid out a policy of zero compromise in respect of US sanctions and the house arrest of US pastor Andrew Brunson on charges related to the failed military coup of 2016. While deft diplomacy cannot at this stage be ruled out to defuse the crisis, the US and Turkey remain on a collision course at present. Erdogan is keen to play the possibility of support from other allies – perhaps Russia, China and Iran. This is therefore more than a domestic economic or political crisis but potentially a key geopolitical turning point in respect of NATO and Turkey’s relationship with the EU.
For Turkey, the key fragility is the 7% current account deficit and the $300bn of dollar-denominated corporate debt which may severely impact unhedged borrowers. Furthermore, a devaluation of the currency of this magnitude is likely to create another surge in inflation which is already running at close to 20%. While the Turkish Lira is now at its lowest level since 1998 on a real, effective basis, Exhibit 1, Turkish residents would appear to have little incentive to exchange hoarded gold and hard currency for exposure to both the Lira and potential default risk within the banking system.
We would note however that Turkish equities are on Thomson Reuters calculations trading at a meaningful discount to long-term averages on both a price/book and dividend yield basis. This is unsurprising in the circumstances. Investors would have be comfortable with the potential risks of further sanctions, capital controls, bank sector risks and declining profits if this currency crisis is followed by a recession. Given the entrenched position of the US and Turkey it is in our view too early to speculate on a political resolution to the crisis. Therefore, investors attracted by the yields on offer would have be prepared to invest for the long-term as valuations in such emerging market situations can remain highly depressed for a significant period of time. Furthermore, exchange controls and other unconventional policy measures which may impact portfolio investors are risks which cannot be ruled out.
Outside Turkey the key risk is in our view is a greater degree of spill-over to other relatively fragile regions of the world economy. Fortunately in terms of direct exposures, the amounts appear to be relatively modest. Press reports indicate the ECB believes there is approximately $100bn of exposure to Turkey within the Eurozone banking system, which on the face of it is a manageable figure. However, the impact on investor sentiment could be a much more significant factor. In this regard we note that Italian bond yields have been moving steadily higher since mid-July and moved sharply higher on Friday 10th August as the Turkish Lira fell. Headlines in respect of Italy’s budget for 2018 suggest differing views within the Italian government as to the acceptable level of government spending.
While the budgetary risks in Italy given the populist agenda for the current administration are well-known to investors, the experience of the past 20 years is that financial stress often spills over to other sectors as investors become more risk averse. With the world’s central banks continuing to tighten monetary policy, it seems counter-intuitive to us to be aggressively pursuing yield by adding risk to portfolios at this point in the cycle. We would be watching the evolution of the spread between Italian and German bond yields carefully over coming weeks as a measure of contagion from events in Turkey.
Turkey is in our view an example of the effects of tighter US dollar funding conditions in combination with adverse geopolitical developments. Separated from the political angle, a Western-style refinancing and restructuring to resolve the excessively large inflation and current account deficit problems would appear to be a rational response to the problem. However, the antagonism between the Turkish administration and the US makes this scenario look far-fetched at present. We expect therefore the sense of crisis to persist until either the pressure on the economy forces concessions from Turkey or details of President Erdogan’s new alliances are forthcoming.