Head of Fixed Interest Research
We met up with Richard Carter, Head of Fixed Interest Research, to understand how the problems in Turkey and other events might affect investors.
The immediate trigger for the sell-off in Turkey was a dispute with the US over an imprisoned American pastor, Andrew Brunson (since released), who was caught up in the aborted coup of 2016. Turkey’s failure to release him led to the US imposing sanctions on two Turkish ministers as well as tariffs on some of their goods. In August alone, the Turkish lira lost around 25% of its value against the US dollar while yields on Turkish bonds have skyrocketed.
However, there have been wider concerns beyond the spat with the US. Investors have become increasingly worried about President Erdogan’s autocratic rule while the economy is vulnerable because of high inflation, unorthodox interest rate policy, and a dependence on foreign investors for lending to companies.
Emerging markets (EMs) in general have had a difficult year and there have certainly been problems beyond Turkey. Argentina, Brazil, Russia and South Africa have all seen sharp falls in their currencies this year due to a mix of economic and political issues.
There is also an underlying concern for EM investors that the global backdrop is becoming much less supportive. Low interest rates in developed markets, alongside the electronic creation of money in the US and UK, have helped to drive money into emerging markets in a search for a return. However, the US Federal Reserve is now raising interest rates and reducing the amount of money in circulation. Europe and Japan are expected to follow suit next year. The hostile rhetoric emanating from Donald Trump on international trade is also extremely unhelpful.
The US dollar is the world’s global reserve currency, i.e. the preferred currency to use in international trade and one that central banks hold as part of their foreign currency reserves. The direction of the US dollar therefore has a big impact on EM economies and their growth prospects.
The US dollar has been strengthening since around February this year, on the back of higher interest rates. This is bad news for EM countries, given that a lot of their governments and companies borrow from investors in US dollars. For example, Turkey has around $500bn in external debt, roughly half the size of its economy. If the value of the US dollar goes up, this debt burden becomes harder to pay.
There may be some relief on the horizon if the US Federal Reserve starts to slow its pace of interest rate rises. Inflation remains well-behaved and markets do not expect many rate hikes next year, something that would reduce upward pressure on the dollar.
Several times – sharp bouts of volatility are a regular hazard for investors in emerging markets. Previous examples include the taper tantrum of 2013 when the Fed’s announcement that it would be scaling back quantitative easing sent US Treasury yields sharply higher. In the end, the Fed did not act as aggressively as some expected.
Also, the Asian crisis of 1997 saw a wave of currency devaluations following a period of US dollar strength. Most emerging market countries are in relatively good shape today though, and should be able to cope with the vicissitudes of the market. However, there are always exceptions to the rule or a risk that investors over-react.
There are things governments and central banks can do over the medium to long term, such as reducing their reliance on overseas investment and building up currency reserves in case of emergency.
In the short term though, there is relatively little the authorities can do. Central banks can raise interest rates to try to tame inflation and protect the currency, but this can have a very negative impact on the local economy. Argentina’s central bank, for example, raised interest rates to more than 60% in the summer.
Governments can also appeal to the International Monetary Fund to help tide them over in difficult times. This can be politically difficult, however, as it often comes with significant spending reforms or other changes. The IMF is not always a silver bullet either – Argentina has continued to come under pressure in recent months for example, despite already having a credit line in place.
A sell-off in Turkey or Argentina is a concern but it is not going to de-rail the global economy. A wider bout of weakness in emerging markets could cause problems in general but is unlikely to slow the global economy by that much if previous episodes are anything to go by. However, emerging markets have become an increasingly important part of the global economy, representing around 60% of global GDP versus around 40% back in 2000. A large part of that weight is made up by India and China though, with neither of these countries particularly vulnerable to rising interest rates.
Arguably, some of the concerns that EM investors have could be applied to developed markets too, especially a strong US dollar, rising interest rates and deteriorating international trade relations. We would see those issues as more likely to cause a global slowdown rather than an EM crisis alone.
The sell-off in Turkey and Argentina has certainly led to some contagion in other areas of the emerging market assets – both stock and bond markets – despite strong fundamentals in these markets. This is probably inevitable but it does also create opportunities for truly active managers to increase exposure to the markets and assets that they favour.
Overall, we can see some value in the emerging markets, especially at a time when global growth remains buoyant. Currencies have already weakened significantly and equity valuations have also retraced to more attractive levels. Government bonds now look quite compelling with yields currently at five year highs of almost 7% in local currency terms. Like most investments though, we believe it is important to be in it for the long term and we also favour truly active managers in what can be quite an inefficient and illiquid asset class.
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