This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Jason Herried, SVP, Director of Equity Strategies.
While U.S. stocks approached all‐time highs last week, having recovered from the 10% correction experienced earlier this year, other global markets did not fare as well. Last week in particular, Turkey was in the spotlight as its stock market fell 20% on the week and 50% for the year, expressed in U.S. dollars. Global markets followed Turkey lower to varying degrees as buyers paused to see how this situation developed before returning to stocks.
To oversimplify the situation, Turkey is similar to the person who borrowed more than he could afford and eventually lost the confidence of creditors. Looking deeper, Turkey's situation is quite interesting and could be the next plot for political drama. The starring role is played by Turkey's President Recep Tayyip Erdogan. Erdogan has gone to great efforts to foster strong economic growth, with expectations for approximately 5% growth in 2018 and 2019 according to the Organisation for Economic Cooperation and Development (OECD).
To finance its export‐led growth, the country has borrowed aggressively, pushing the current‐account deficit to 6.5% of the economy, which is equal to Greece's deficit when its debt crisis hit in 2012. Investors have had concerns about the situation in Turkey for some time. The Turkish lira has been depreciating at a similar rate as the Turkish stock market, resulting in investors' lack of confidence. The depreciating currency has pushed up the cost of imports, with the July inflation reading up to 16% compared to the central bank's target of 5%. Accordingly, interest rates have increased with the 10‐year bond near 20% at points last week. Because a large part of the debt is denominated in dollars, this means that the cost of debt has tripled as a result of the decline in the value of the lira. The normal course of action would be to raise interest rates to dampen inflation and support the currency. But remember, Erdogan wants growth, so he has pressured the central bank to limit rate hikes. Thus the virtuous cycle of lower lira, lower stock prices and higher interest rates has continued to what now may be a breaking point.
While this financial drama is interesting for an investment professional, to make it more broadly appealing we need political intrigue—enter none other than President Donald Trump as the antagonist. Trump and Erdogan have been negotiating for the release of political prisoners, namely North Carolina Pastor Andrew Brunson who is being held by Turkey as a spy. Knowing that Erdogan has his back against the wall, Trump ramped up the rhetoric on Friday, threatening to double tariffs on Turkish aluminum and steel imports to 20% and 50%, respectively. As a result, the lira and the stock market fell precipitously. I'll leave it there, but there is plenty of information on the internet for those interested in learning more.
While Turkey will certainly have many weeks, months or years of challenges as a result of its current situation, global investors are considering whether Turkey is the proverbial canary in a coal mine. In the short run the answer is probably yes, and stock markets are unlikely to make much progress until the situation stabilizes. Given the pain suffered as a result of the Great Financial Crisis just 10 years ago, investors and regulators are likely to be cautious in their assessment of risk. As the situation in Turkey has progressed, investors have been selling the currencies and stocks of other ‘weak’ countries like Argentina and South America. In addition, European regulators announced last Friday that they are looking closely at specific European banks that have above‐average exposure to Turkey.
Looking past the next few weeks, however, Turkey is unlikely to be the cause of the next global recession. The country represents about 1% of global GDP, and the contagion risk appears isolated to a handful of European banks. Furthermore, we now have the European Central Bank as a more organized lender of last resort in Europe, which was not the case during the great financial crisis. Global growth, while slowing of late, remains above trend, giving the global economy room to absorb a small shock like this. Corporate earnings growth remains strong, with year over year growth for U.S. companies greater than 20%, and European and Japanese companies about 10%. Finally, central banks are certain to be monitoring financial conditions to stem contagion and provide liquidity as needed.
While I'm not sure if the events unfolding in Turkey will make the cut for the next television drama, I do know that we have experienced episodes like this before, and economies and markets have been able to absorb the negative shocks. The situation reinforces why we build diversified portfolios that focus on our clients' financial goals and risk tolerance. By doing so, we are not forced to sell at inopportune times.
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