Risk of a Turkish default.

Principal Global Investors’ Chief Global Economist, Bob Baur, takes a look at how Trump’s sanctions and a threat of tariffs on Turkish exports to the US are propelling the downdraft 17 August 2018 Trade, Turkey, Tariffs, Trump and turmoil “The currency had already been weakening this year, along with emerging economies in general, on account of accelerating headwinds.

Those obstacles include a decelerating Chinese economy, broad relative U.S. dollar strength, rising yields on long-term U.S. Treasury bonds, and falling commodity prices. Challenges like these always hit the most vulnerable currencies first, like Argentina, Brazil, Turkey, and Russia.

“Turkey is especially vulnerable with a high level of debt from foreign lenders denominated in U.S. dollars. And, as the lira weakens, loan repayments become increasingly difficult. So, bond prices tumbled, pushing yields on Turkish 10-year bonds over 20%.”

The search for yield brought foreign investors to Turkey in droves…

“Foreign funds flowed into emerging countries fast and furiously in recent years as investors feasted on the higher yields offered on that debt. World growth peaked around the end of last year even as the U.S. economy continued to gain momentum. That brought relative U.S. dollar strength and higher long-yields, while decelerating world growth put the pinch on commodity prices.”

Will President Erdogan instigate controls to stem the currency collapse?

“Turkey faces a myriad of problems: double-digit inflation, an enormous current account deficit, which requires even more foreign capital to finance, slowing growth, low productivity gains, and too much debt. After many years in office, President Erdogan was newly elected again; he sought and was given expanded powers. The fear is that he will institute controls to prevent foreign investors from taking their funds out of Turkey, whether loan payments or investment returns. The President’s hope is that controls would stem the currency’s collapse and lessen the need to raise official interest rates.”

Risk of a negative contagion effect from a Turkish default

“European financial institutions were big lenders to Turkish borrowers and are the most vulnerable to any potential default. Investors also have significant exposure to Turkish defaults through emerging market debt funds. U.S banks have limited exposure to Turkey. The International Monetary Fund would be a likely backstop as has happened in past emerging market crises.” “The biggest concern is the negative contagion that a Turkish default would bring to emerging market debt and stock funds. Investors might not be able to differentiate among countries and the contagion could tar all with a negative brush.”

Tariffs and the impact on US growth momentum

“So far, there is little hard evidence that President Trump’s unorthodox trade negotiations have put a dent in U.S. growth momentum. Stiff tariffs would raise prices and inflation somewhat, at least temporarily, but, job gains and wage growth might be an offset as global companies manufacture more goods in the United States. The impact of rising short- and long-term interest rates, which impact all of the U.S. economy, would seem a bigger problem than tariffs. Offsetting both would be the large reduction in corporate tax rates that helped bring the surge in U.S. growth momentum and confidence.”

Investment implications

“Over the last few months, markets have shrugged off the impact of rising trade tensions even though they fill the headlines. That may not last; the combination of contagion from Turkish debt issues and more tariff threats may bring a downdraft in world stock markets, so near-term caution is warranted. Emerging economy debt and equity markets have underperformed most of this year; that trend will likely continue. The uptick in U.S. inflation will likely keep the Fed on its path of rate hikes. It could easily promote another move higher in yields on long-term U.S. Treasury bonds.”

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