Turkey has been on a downward path for some time. Its soaring inflation and rising debt-to-GDP of about 70% under President Recep Erdogan's regime has been a growing problem. As central banks pumped money into the system over the past decade, nations like Turkey and other emerging market economies used the opportunity to raise more and more "cheap" debt to boost their productivity. Erdogan has been leading the country in an economically unsound and reckless path for some time. In a quarrel over releasing a U.S. citizen, Pastor Amdrew Brunson, held by Turkey on terrorism charges, President Trump imposed additional sanctions last Friday, doubling the tariffs on imported steel and aluminium from Turkey. The lira fell 20%. Turkey 5-year credit default swaps traded at 535, +105bps. Now it's crunch time. Turkey is on verge of a default and it needs some help.
The problem is that Erdogan refuses to raise rates to stem the decline of the currency and constrain capital outflows. (He should learn a bit from Argentina!) Nor is he prepared to ask the IMF for help and cede control of his country and face strict austerity measures. Leaving this reckless leadership aside, the problem now lies in contagion. The concern is that EU banks have exposure to both external Turkish debt and local operations. With close to $250 billion of dollar and euro denominated debt, every 1% move lower in the Turkish currency brings a nasty 5 billion lira interest coverage problem. According to a report by Goldman Sachs, a lira move near 7 to the dollar wipes out most of the equity in Turkey's banking system, and that's on a $1 trillion economy. That is where the problem can become a big one; default risk is rising.
Investors may be forgiven for drawing parallels to Asian currency crisis in 1997 as we have seen near collapse in currencies like the Argentinian peso, Brazilian real, Indian rupee, South African rand and the Russian ruble. Turkey does not have massive foreign exchange reserves to stem any capital outflows. As of the first quarter of 2018 Spanish bank exposure to Turkey was $82.3 billion. France's exposure was $38.4 billion, the UK's $19.2 billion, the U.S.'s $18 billion, Germany's $17.1 billion, Italy's $16.9 billion and Japan's $14 billion. The European Central Bank must be watching closely to see how these headlines develop. If the next move is to instil capital controls, that could be a grave threat. Contagion can spread when investors are forced to take money out of other emerging markets to make up for this. We are not there yet, however.
On a day like Monday, when the Turkish lira flirted with 7 to the dollar and the Brazilian real with 4 to the dollar, could one imagine seeing copper up on the day? Yet mining stocks opened down 2% only to close the day up 1.5%. In addition, Chinese stocks moved higher. What gives? Some of us old enough to remember the vicious moves of the 1997 currency crisis or the unwind of the financial system in '08, would be forgiven for expecting the worst in coming weeks. However, it is important to consider some key differences between the current situation and those earlier ones.
China is stimulating its economy via its medium-term lending facility and boosting infrastructure investment to be seen in the second half of 2018 . Economic data Tuesday showed a slowdown in China's fixed asset investment, retail sales and industrial production, yet physical commodity market prices are trading according to their fundamentals causing a discrepancy between asset classes. Either the commodity is wrong or the equity, but this gap cannot last for too long. Copper stockpiles in SHFE warehouses contracted for sixth week to their lowest level since January. Copper inventories are down 21,710 tons, or 11%, to 171,107 tons, the steepest decline since Sept. 2017. Strike action looms among the key mines, raising risks of more supply disruptions. Every day the price averages this level, the top line of the equity mining companies is higher, not lower. These stocks are cheap.
We all knew 2018 would be a year of excess stimulus unwind. With the Fed being the only central bank raising rates gradually, and the dollar appreciating amongst most G7 and G10 countries, this creates problem for economies that borrowed cheap debt in dollars, but which now face rising interest costs as the dollar appreciates. There is a secular case to be made for this emerging market unwind. But not all markets are the same. China cannot be placed in same category as Argentina or Turkey.
It is impotent to separate the forest from the trees. Fundamentals are strong in copper, iron ore, and steel (just look at the commodity prices!). Investors need to make a distinction between counties and sectors. But they are too focused on deflation and recession. Perhaps that is Trump's real plan. Strangely enough, the 5-year U.S. breakeven inflation rate has fallen back below 2% (below the Fed's target). Hint hint, could we be at a point where Fed has ammunition to hold off on raising rates? They couldn't justify it before, but perhaps now there is macro economic evidence to do so.
It is easy to blanket sell quality as one experiences pain in the portfolio. Rest assured the strongest parts of the market will always rally back first as the fundamentals are the strongest, no matter how much they have outperformed. Look at Amazon! The copper market is in deficit this year with risks of supply falling more. Once we move past these negative headlines on Turkey, as well as the U.S. and China tariff games, to a quieter tape, these stocks can make their way higher without anyone noticing.
