Emerging markets seen weathering Turkey storm

Market Update , Multi Asset 8/13/2018
Reading time: 4 minute(s)
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  • The current turbulence in Turkey is rather unlikely to lead to a wider crisis in emerging markets (EM)
  • The reasons for EM underperformance so far this year are weaker economic momentum and increasing external headwinds such as a surge in the U.S. dollar and U.S. yields
  • We are currently neutrally positioned in EM local debt and equities, and underweight EM hard-currency debt
  • External headwinds should calm down later this year, which may open buying opportunities in EM assets

Emerging-market currencies, bonds and equities have performed poorly so far this year (see chart 1). Turkish assets suffered even more with the Turkish lira depreciating 45 percent year-to-date (see chart 2). The sell-off at the end of last week was partly owing to investors' concerns about contagion risks after a European Central Bank (ECB) report had highlighted significant exposure of European banks, particularly Spanish ones, to Turkey. We believe that the fears are overstated, as these banks don't have capitalization issues, in our opinion.

We have reduced our emerging-market local-debt exposure to neutral in April and May 2018 as we expected headwinds for emerging markets to rise.

Chart 1: Emerging-market assets are down in 2018

Total Return of benchmark indices (January 2018 = 100) in USD

Source: Thomson Reuters Datastream, Vontobel

Turkey is a special case

When global liquidity decreases or becomes more expensive, as is the case now, emerging economies are particularly vulnerable if their short-term external debt ratios and current- account deficits are high. Turkey is a case in point. The ongoing slump in the Turkish lira reflects the country's negative trend of vulnerability indicators, including a current-account deficit of 6.7 percent of GDP. Other, country-specific factors have added to the asset price downturn. High inflation (presently at 15.9 percent year-on-year) has always been an issue in Turkey. As inflation is a key variable in determining a country's competitiveness, high-inflation economies need to depreciate their currency to remain competitive. With the new (old) government now apparently ready to undermine the Turkish central bank's independence, the prospects of stabilizing inflation and the currency have decreased.

Chart 2: The Turkish lira is selling off

TRY per USD

Source: Thomson Reuters Datastream, Vontobel

Moreover, Turkey seems less well positioned if it comes to reserve adequacy ratios (see the table below), which may limit the country's willingness to defend the currency via interventions on foreign-exchange markets. A (foreign currency) reserves-to-short-term-debt ratio below 1, for instance, is a particularly worrying fact (see right-hand column in the table). The authorities may, therefore, resort to capital-account controls instead. If implemented correctly, these are an effective measure to limit currency depreciation. However, this also means that Turkey may fail to attract capital for necessary investments, which heightens the risk of Turkey entering a recession.

Therefore, without reforms that would bring Turkish inflation down to sustainable levels, the currency is likely to remain on a downward path over time. Capital controls may limit the downside, but this would probably result in much lower growth and a recession risk in the shorter term.

Is there contagion risk?

We believe the risk of the Turkish crisis spreading to other emerging markets is rather limited because the country does relatively little trade with other major emerging markets. Moreover, economic fundamentals (foreign-exchange reserves, current-account balances, real interest rates and growth) have improved over the past few years in many emerging markets. The worst-case development we currently see is the possibility of European banks becoming jittery over Turkey and pulling out of other emerging economies. Yet this looks like a distant prospect as the European banks with significant exposure to Turkey appear to be well capitalized.

Fundamentals have improved in many emerging markets

Moreover, the fundamental picture in emerging markets has generally improved, as we highlighted in our May 29 Market Update Our view on emerging markets. In many countries, current-account balance deficits have decreased, currency reserves increased, and economic growth has stabilized. In addition, the valuations of all asset classes (bonds, equities and currencies) are fair or even cheap. Naturally, weaknesses remain. The International Monetary Fund (IMF) has voiced concern over emerging-market corporate debt in energy-related sectors, and generally in China.

External factors still weigh on markets

We share the IMF's view that debt levels in most countries are manageable. However, the combination of high debt ratios or leverage, and deteriorating external financing conditions, makes it difficult for emerging markets to outperform, particularly if domestic growth is sluggish. This seems to be the case now in some countries as July PMIs haven't yet indicated an imminent growth acceleration.

So, we are most likely left with external factors deciding about EM asset class performance. As during many EM downturns, tighter global monetary policy plays a key role. Today, it is the U.S. Federal Reserve that is tightening monetary policy via its balance-sheet reduction and base-rate increases. Any sign that Fed could halt its tightening cycle would be welcome, and may open buying opportunities in EM assets. We expect the Fed to raise its key interest rate to as much as 3.25 percent by the end of 2019. As the market is currently pricing in only 2.80-2.90 percent, we're not there yet, but getting closer.

What impact on markets?

A contagion via the euro zone bank channel seems overblown to us. However, in the context of a further escalation of the China-U.S. trade war, the upcoming Italian budget discussion and the implementation of U.S. sanctions against Iran, the Turkish crisis adds to uncertainties related to the outlook for growth and inflation. We maintain a moderate underweight equity stance and still hold put options on equity indices. We retain our significant overweight exposure to the U.S. dollar as it is likely to provide effective portfolio diversification in the period ahead.

The turbulence in Turkey adds downside pressure on emerging-market assets (both equity and debt), which have already sold off substantially since peaking in the first quarter. Valuations look attractive now and any cooling of the China-U.S. stand-off would present, everything else being equal, a buying opportunity.

Table: Reserve adequacy ratios of EM central banks

Source: Thomson Reuters Datastream, Vontobel