Economics

EMD Relative weekly notes

Week Ending August 10, 2018

10/08/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

President Erdogan's refusal to raise interest rates has deepened a crisis in Turkey that is likely to spill over into Europe and other EM assets. Some of the contagion will be fundamental, but some will likely be via asset prices that is likely to create opportunities for investors.

Turkey's refusal to address market concerns about its excessive growth rate and burgeoning current account deficit will be a costly exercise for its citizens, and with a roughly 50% nominal depreciation of the currency and plummeting bond prices, local bondholders have effectively experienced a default. Banking stresses and perhaps bond restructurings are quite likely to follow, as will a boost to inflation while growth slows. One consolation for investors is that the current account deficit—the largest among big EM countries—should shrink, although in the most painful way possible. Foreign exchange reserves have been declining well before this most recent policy intransigence (see chart below).

Source: Central Bank of the Republic of Turkey, as of July 27, 2018.

In our view, likely options available without raising interest rates will be capital controls or loans from China or Russia. A traditional embrace of the IMF in a crisis scenario seems unlikely with Erdogan's intransigence towards the West. None of these seem imminent, and in their absence contagion risks that could nick growth in the rest of Europe and European assets are high.

Additional contagion to the rest of EM is more solely focused on asset price movement. Lower-rated credits are likely to be most affected but these have already under-performed significantly in recent months, and could represent good value with further price falls relative to the rest of EM.

The Turkish debacle comes at a time when EM sentiment is fragile, and much of that is an artifact of a stronger US dollar as the Fed hiking cycle marches on. If Turkish fallout changes perceptions of the Fed's willingness to hike further, an EM relief rally would likely emerge. The probability of that—however low it might seem today—would help provide a floor to some of the worst contagion that we think is simply asset-based, rather than fundamental.