Quite Foreboding

In this, the eighth month of the year
The market’s succumbing to fear
With Turkey imploding
It feels quite foreboding
And folks, it can get more severe!

On Friday I discussed the Turkey situation as one beginning to spiral out of control. Well, this morning it has lived up to that billing with the lira falling an additional 7.5% as I type, although that includes a substantial recovery from its worst levels today. Now, the central bank there has finally reacted by loosening reserve requirements and offering foreign currency loans to local banks in unlimited size, but those moves have had only a limited positive impact on the currency. And since President Erdogan refuses to countenance higher interest rates, it seems that the next move is going to be capital controls, and it is likely to come pretty soon. In fact, if the recent pace of the lira’s decline continues unchecked, and I see no reason for it to stop yet, I expect that we will see capital controls before the week is out, and maybe as soon as tomorrow.

Here’s the thing. Turkey’s growth over the past decade has largely been debt driven (after all, who’s hasn’t?) but the Turks have been one of the most aggressive in using USD funding such that dollar debt represents >50% of the total debt in the economy. When the Fed turned from ultra easy monetary policy to begin tightening, it really began to hurt them. And as Chairman Powell has not only continued the process begun under Yellen, but increased the pace, the pain has become unbearable for Turkey’s economy. So it is fair to say that Turkey’s problems are self-inflicted (had they taken a more local and gradual path toward growth they arguably wouldn’t be in this bind), but those problems are not unique within the emerging markets, and at a certain point to investors, it doesn’t matter.

As I mentioned Friday, herd behavior amongst investors is the rule, not the exception. And as liquidity in Turkish asset markets dries up, and it has, investment managers will be looking to sell other risky assets in order to manage their overall portfolios. That is a key reason why ZAR has fallen by 2.5% this morning. Too, the Mexican peso has fallen 2% and even the Korean won, which is nobody’s idea of an emerging market (per capita GDP ranks ahead of Spain, Italy and New Zealand according to the CIA) has fallen 1.0%. The point is, if an asset manager cannot sell what he wants to sell to reduce risk, then he will sell what he can sell in order to limit portfolio damage. And this is how contagion starts!

So does Turkey really matter? In the FX markets, prior to the recent situation, the Turkish lira was a favored carry trade component, with investors seeking to earn what had been very high yields with a relatively stable currency. But that trade is over, and by all appearances, Turkey is going to be facing a recession pretty soon, which means that real trade flows are likely to diminish as well. In that sense, Turkey doesn’t matter too much.

But when you put this situation in the context of what else is happening in the world, this could well be the proverbial last straw. We have already been dealing with escalating trade tensions that show no sign of ebbing; a seeming stalemate in the Brexit talks opening the door to the UK crashing out of the EU with no deal; a populist government in Italy threatening to challenge Eurozone fiscal rules; and not least, a Federal Reserve that, despite everything else going on, is hell-bent and determined to continue raising interest rates. It should be no surprise that a number of equity markets around the world have struggled so far this year, but there is still a lot more green than red on screens. However, market sentiment can only take so much stress before investors decide that the risk is no longer worth the reward. I fear that we may be approaching that point. Market sentiment can be fleeting, and right now, we seem to be watching it flee!

With that in mind, a look at the G10 currency space confirms everything we have seen for the past several sessions. The dollar is broadly higher, with the euro -0.3% and the pound -0.2% although the yen, as is its wont in a crisis, has rallied 0.5%. Equity markets around the world are bathed in red, with the Nikkei falling 2% overnight and European shares, on average, down about 0.5%. US equity futures are pointing to a -0.3% opening in New York as well. Treasuries and Bunds have continued their modest rally, with yields falling another 1-2bps, and commodity prices are under pressure again. In other words, this is a classic risk off performance.

What can stop this? Historically, it has been the IMF that would step in and help support a country and its currency when stressed in this manner (remember Argentina a few months ago getting a $50 billion line of credit), but I am skeptical of that happening this time around. There are two things likely to prevent the IMF from getting involved: first, President Erdogan has been extremely vocal in his disdain for orthodox economic policies like raising interest rates in to help combat rising inflation, but the IMF will demand tighter monetary and tighter fiscal policy, neither of which Erdogan is likely to embrace; and second, for the IMF to act, the US has to be on sides, and the current situation has been partly aggravated by the diplomatic row between the US and Turkey. It seems hard to believe that President Trump will give the IMF the leeway to extend help. Unfortunately, I fear that there is more turmoil in our future.

Turning to the data review this week, there is a modest uptick in the volume of data, but it is not clear any of it will be critical to the Fed’s view of the world.

Tuesday NFIB Small Business 106.9
Wednesday Nonfarm Productivity 2.3%
  Unit Labor Costs 0.3%
  Empire State Mfg 20
  Retail Sales 0.1%
  -ex Autos 0.3%
  IP 0.3%
  Capacity Utilization 78.2%
Thursday Housing Starts 1.26M
  Building Permits 1.31M
  Initial Claims 215K
  Philly Fed 22
Friday Michigan Sentiment 98

Arguably, Retail Sales will be the most watched number, but everything we have heard from Fed speakers of late has been full speed ahead, so we will need to see much weaker data to change that perspective. Either that or a total collapse in the emerging market space, with the latter situation seemingly far more likely than the former. In the end, I see no reason to change my views on the dollar’s broad trajectory, which remains higher for the foreseeable future.

Good luck