“From the Desk of Michael Sheldon”
Over the past several weeks, Turkey’s stock market has been weak, their currency has been under pressure and interest rates in that country have risen sharply. The situation appears to have stabilized a bit over the past few days but over the medium term, risks remain. These events have not come out of the blue and have been years in the making. President Tayyip Erdogan is trying to stem the recent rise in volatility (for example by stating that Turkey will avoid capital controls) but he has his hands full. An important question is whether events in Turkey are likely to spread to other emerging market countries and impact global financial markets.
Right now, we believe that the risk of contagion to U.S. markets appears on the low side and is unlikely to bump the U.S. expansion off course near term. Overall, most emerging market countries appear in better shape to handle a financial crisis than they were a decade or two ago (for example when most foreign exchange rates were fixed versus the U.S. dollar). However, weakness in a few emerging markets like Argentina, Russia, South Africa etc…could lead to some additional volatility in global financial markets over the next few months.
How did Turkey arrive in its current situation? The main issue is that over the past several years, Turkey has borrowed too much money (to help stimulate economic growth) with a large portion in foreign currencies like the Euro and the U.S. Dollar. Thus, when things go wrong, this puts Turkey in a difficult position. For example, according to Barron’s Magazine (August 18, 2018), at the start of 2010, Turkish external debt (owed by the private sector and banks) totaled $175 billion.
However, as of the first quarter of this year that figure totaled $375 billion. Using original currency rates from 2010 the country’s debt totaled 44% of GDP. Based on current exchange rates, the country’s debt to GDP now stands at close to 80%.
Over the past several quarters, a combination of rising Turkish debt levels, rising U.S. interest rates, higher oil prices (which have led to a pickup in inflation) and a strong dollar / weaker Turkish Lira have led to a rise in volatility in Turkey’s financial markets. This month President Trump has also threatened to raise tariffs on Turkish steel and aluminum, putting more pressure on the country’s economy and financial markets. According to J.P. Morgan, Turkey represents just 0.6% of the MSCI Emerging Markets index and according to the International Monetary Fund (IMF), Turkey represents just 1.5% of global GDP.
The bigger contagion risk, near term, is more likely in Europe due to European bank exposure to Turkey. Research indicates that Spanish, French and Italian banks have the most exposure to the Turkish financial system with Spain having the most at 4.5% of total balance sheet exposure to Turkey. Importantly, tier 1 capital ratios (which represent a level of liquidity and equity cushion) for European banks have risen from around 10% in 2012 to over 15% in 2018. Thus, European banks appear more able to handle Turkish financial problems, should they get worse.
While events in Turkey are fluid and the situation may deteriorate further, for now it appears that the risk of contagion (from Turkey’s banks to other financial institutions around the world) appears fairly limited. In other words, based on current events, it does not appear that we are likely to see a major impact on the global banking system (which is how a larger and more serious financial problem might develop).
Right now, Turkey has its hands full. Among their various choices, they could raise interest rates (to attract capital and stabilize their currency), they could ask for help from the IMF (which would come with restrictions the country will likely not want to deal with) or they could write off some of their debt (which would have major negative implications for Turkey and its creditors).
Importantly, the economic problems that Turkey is facing appear largely unique to Turkey. There are other emerging market countries that face a number of financial market issues including a large current account deficit, rising debt levels (much of it with external debt), high inflation and interest rates along with currency instability. However, few countries appear to face all of these issues at the same time the way Turkey does today.
Based on recent data, the U.S. economic expansion appears on track. For example, labor markets look healthy, retail sales continue to grow, the NFIB Small Business Survey increased to its second highest rate ever this past month (dating back to 1973) and the Conference board’s Monthly Leading Economic Index (LEI) continues to rise. While GDP growth of 4.1% last quarter could represent a cycle high, GDP is currently forecast to grow a solid 3% this quarter. Housing appears to be the one area of the economy that has experienced some softness in recent months. Volatility in financial markets could remain elevated if events in Turkey get worse from here. However, at least for now, the majority of data points to the fact that weakness in Turkey is likely to remain mostly localized without having a major impact on the U.S. economy.
In the RDM Market Summer Update that we shared with you a few weeks ago, we highlighted some of our longer-term economic and market concerns that we will keep an eye on over the next several quarters. One additional topic to add to the list is the economy in China, where recent economic data has missed expectations (possibly due to growing fears over a trade war with the U.S.). On a more positive note (although expectations are currently pretty low), there is news that a new round of trade talks between the U.S. and China are set to take place this week, possibly leading to higher level talks between the leaders of China and the United States later this Fall. Looking ahead, the potential for a wider and more protracted trade war between the U.S., China and other countries likely represents the single largest threat to global financial markets in coming months.
As always, we welcome any comments you may have and hope you enjoy the rest of the summer.
S & P 500 – The S&P 500 Index is widely followed gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
MSCI ACWI – The MSCI ACWI Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is comprised of stocks from both developed and emerging markets.
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