Canary in the coal-mine – Emerging market contagion

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Macro Letter – No 100 – 13-07-2018

Canary in the coal-mine – Emerging market contagion

  • Emerging market currencies, bonds and stocks have weakened
  • Fears about the impact of US tariffs have been felt here most clearly
  • The risk to Europe and Japan is significant
  • Turkey may be the key market to watch

As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?

To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.

In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –

EM Debt and GDP

Source: Trading Economics, Investing.com, IMF, World Bank

For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.

Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.

Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.

Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.

This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –

EM Markets and Inflation

Source: Trading Economics, Investing.com, IMF, World Bank

In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.

India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.

Is Turkey the canary?

The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.

Conclusion and investment opportunities

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –

…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.

If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.

 

 

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Should we buy Turkey for Thanksgiving?

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Macro Letter – No 46 – 20-11-2015

Should we buy Turkey for Thanksgiving?

  • Erdogan’s AKP won an unexpected majority in this month’s election
  • The Turkish Lira (TRY) has fallen by 60% against the USD since 2008
  • Turkish stocks look inexpensive by several measures
  • Economic reform appears unlikely

Back in June the AKP failed to achieve a majority in this year’s first general election. Second time around they achieved a resounding victory – though not the “supermajority” required for constitutional reform. The main reason for the loss of confidence earlier in the year was the state of the Turkish economy. Now the AKP has an opportunity to embark on economic reform – this may be easier said than done.

They need to deal with rising unemployment which, having dipped to 9.3% in May, is on the rise again – August 10.1%. Labour participation has been steadily rising – from 43.6 in 2006 to 51.2 today, however it is still low by international standards and female participation is a rather dismal 29%. Youth unemployment has fallen from 28% in 2009 to 18.3% in August, but this does not bode well for their relatively young nation. Of the 77mln population, 67% are notionally working age – 15 to 64. Only 6% are over 64 years. Turks make up 75% of the population whilst Kurds already account for 18%; as this 2012 article from the IB Times – A Kurdish Majority In Turkey Within One Generation? makes clear, substantial cultural challenges lie ahead.

High unemployment has impacted consumer confidence which plunged to 58.52 in September – its lowest level since the global recession of 2009. October saw a rebound to 62.78.

Core inflation remains stubbornly high despite the fall in oil prices. During the summer it dipped below 8% but by October it was 9.3%. The chart below shows the core inflation rate over the last decade:-

turkey-core-inflation-rate

Source: Tradingeconomics and Eurostat

High inflation is primarily due to the weakness of the TRY; the next chart shows USDTRY, but the BIS Effective exchange rate also declined from 100 in 2010 to 70.6 at the end of 2014. The last big TRY devaluation occurred between February and October 2001, the move since 2008 has been of a similar magnitude, albeit with less precipitous haste:-

turkey-currency

Source: Tradingeconomics

Inflation might have been even higher had imports not fallen:-

turkey-imports

Source: Tradingeconomics and Turk Stat

The decline in imports, principally from Russia (10.4%) China (10.3%) and Germany (9.2%) helped reduce the current account deficit to some extent but at -6% of GDP it remains, unhealthy:-

turkey-current-account-to-gdp

Source: Tradingeconomics and Central Bank of Turkey

Turkey is a big energy importer – for a more detailed discussion on energy security for Turkey (and the EU) this working paper from Bruegel – Designing a new Eu-Turkey Gas Partnership is worth perusal.

The current account deficit is matched by the government budget balance, this has remained negative for most of the decade, although the debt to GDP ratio is an undemanding 33%:-

turkey-government-budget

Source: Tradingeconomics and Turkish Ministry of Economics

Meanwhile Turkey’s external debt continues to grow, it now equates to more than half of GDP:-

turkey-external-debt

Source: Tradingeconomics and Turkish Treasury

Much of the external borrowing has been short-term and the private sector accounts for more than two thirds of the total. Since 2002 GDP has increased from $233bln to $800bln – during the same period external debt has tripled. Short-term debt to central bank reserves have doubled. The table below investigates this and other aspects of Turkey’s external debt:-

Turkish Debt

Source: Central Bank of Turkey and Turk Stat

In 2013 Morgan Stanley dubbed Turkey one of the “fragile five”, the others being Brazil, India, Indonesia and South Africa. These countries had high external debt, twin deficits, structurally high inflation and slowing growth. Turkish GDP has been recovering somewhat this year – 3.8% in Q2 2015 – but it remains below its 2002-2011 average of 5.2%:-

turkey-gdp-growth-annual

Source: Tradingeconomics and Turk Stat

Given the weakness of the currency it is surprising that economic recovery has not been more pronounced. This may be due to the parlous state in Turkey’s principal export markets, Germany (9.6%) has seen slow growth and Iraq (6.9%) has been in recession:-

turkey-exports

Source: Tradingeconomics and Turk Stat

In March Morgan Stanley announced that India and Indonesia had made sufficient reforms to be removed from the “Fragile” category. Turkey remains, unreformed, especially in terms of its labour laws – a focal point if they are to reduce structural unemployment.

Turkey has demographic trends on its side but its productivity has been stagnant since the financial crisis. The OECD estimated GDP per hour for 2014 at 29.3 hours – in 2007 it was 28.9 hours.

Financial Markets

Short-term interest rates, which touched 10% last year, have fallen to 7.5%, despite inflation and TRY weakness, but the independence of the central bank has been questioned since Erdogan openly criticised their interest rate policy in March – with the AKP majority restored the problem of inflation may be deferred:-

turkey-interest-rate

Source: Tradingeconomics and Central Bank of Turkey

Reflecting market sentiment better, 10yr Turkish Government bonds, reached 10.78% in October, although they have recovered, in the wake of the election, to yield 9.72% today (Wednesday 18th) here is a five year chart:-

turkey-government-bond-yield 5yr

Source: Tradingeconomics and Turkish Treasury

From a technical perspective bond yields appear to have backed away from the 2014 highs, but considered in conjunction with the continued trend of the TRY, I lack the confidence to buy ahead of real economic reform package. Meanwhile, the US Federal Reserve look set to raise interest rates next month, putting further downward pressure on the TRY and driving short-term US$ financing costs higher.

The Turkish XU100 stock index rallied from 77,776 to 83,692 after the election – today (Wednesday 18th) it stands at 81,274. It has been buoyed by currency weakness:-

turkey-stock-market

Source: Tradingeconomics and Istanbul Stock Exchange

The market valuation is relatively undemanding. A CAPE of 10.3 is higher than its emerging European neighbours, but on a straight PE basis (11 times) and dividend yield (3.4%) it is comparable. On a price to cost, price to book or price to sales basis, however, it is more expensive than Emerging Europe.

The largest stocks in the index are:-

Company Ticker Sector
Garanti Bankası GARAN Banking
Akbank AKBNK Banking
Turkcell TCELL Telecommunications
Koç Holding KCHOL Conglomerate
Türkiye İş Bankası ISATR Banking
Türk Telekom TTKOM Telecommunications
Enka İnşaat ENKAI Construction
Sabancı Holding SAHOL Conglomerate
Halk Bankası HALKB Banking
Efes Beverage Group AEFES Beverage
Vakıfbank VAKBN Banking
Turkish Airlines THYAO Transportation

Source: Istanbul Stock Exchange

Whilst the economy is 25% Agriculture, 26% Industry and 49% Services, the stock market is dominated by banks. At the end of 2013 the weights for the XU100 were 36% Banks, 17% Beverages and 8% Conglomerates – although the fragmented (30 companies) cement industry should be mentioned. It is the largest in Europe and fifth largest globally. Rising bond yields, even though they have fallen since the election, and the weakness of the TRY increase the risk of bank losses. Technically, one should remain long, but I’m not inclined to add aggressively at this stage.

An additional concern is Turkey’s political relations with the EU. According to a 3rd September article from Brookings – Why 100,000s of Syrian refugees are fleeing to Europe:-

Turkey’s is being deeply affected too, in spite of having the largest economy in the region and a strong state tradition. Its resources and public patience are wearing thin. The Syrian refugee issue certainly plays a role in the current political instability in the country. According to UNHCR, Turkey became the world’s largest recipient of refugees (total, including those from Iraq) in 2014. 

The EU’s inability to act on concert to address the migrant crisis, along with the imminent collapse of the Schengen Agreement, is likely to further strain relations. It may not stop existing trade but it is likely to slow new business developments.

Security remains a major issue for the new Turkish government as CFR – What Turkey’s Election Surprise Says About the Troubled Country explains:-

…Turkey now confronts simultaneous conflicts with the PKK and the Islamic State. After a year of intensive American diplomacy, Ankara’s decision last July to provide the United States and coalition forces access to air bases close to the Islamic State’s territory has made Turkey a target.

On a more positive note. The new government is likely to make good on its election promises by increasing fiscal stimulus. That 33% debt to GDP ratio must be burning a hole in Erdogan’s pocket. Stimulus is expected to be directed at infrastructure – the “three R’s”, roads, railways and real-estate. “Grand projects” include a third Airport and a mountaintop mosque for Istanbul, a third bridge and a tunnel across the Bosporus, a canal linking the Black Sea to the Sea of Marmara and a gigantic presidential palace in Ankara.

Conclusion – the currency is key

On balance I think it is too soon to buy Turkish bonds or stocks. The new government seems reluctant to embrace the economic reforms needed to drive productivity growth. External debt will have to be repaid, inflation, subdued and jobs created. Turkish stocks look relatively inexpensive and her bonds may be tempting to the carry trader, but an appreciating TRY is key – should the currency recover, stocks and bonds will follow.