Trade tensions and a strong dollar mean problems in Turkey may be just the tip of the iceberg
In the middle of August, emerging market equities officially moved into bear market territory, with the MSCI Global Emerging Market futures index falling 20 per cent from its late January peak. The trigger for the most recent selloff was trouble in Turkey, but we expect to see continued pressure on emerging economies as the US tightens monetary policy, withdrawing liquidity from faster-growing parts of the world.
Diplomatic relations between the US and Turkey have been at a low ebb for some time since Andrew Brunson, a US pastor, was arrested and accused of plotting to overthrow the Turkish government as part of the attempted coup in 2016.
High-level pressure to release Brunson has been growing and this month saw the Trump administration double steel and aluminium tariffs on Turkey, a Nato ally.
The Turkish economy has been growing rapidly in recent years but a construction boom, rising trade deficit, 15 per cent inflation and a significant increase in debt are signs of an overheating economy.
Increased tariffs hit investor confidence, causing a full-blown currency crisis, with the lira falling 20 per cent in a single day.
Turkey’s problems have no easy domestic solution as president Erdogan has indicated that overt interest rate rises should be avoided, calling tighter monetary policy the “mother of all evils”.
The task of restoring investor confidence is made harder by the president’s decision to appoint his son-in-law as finance minister, raising concerns about the operational independence of the central bank and contributing to a sovereign credit downgrade from Moody’s.
In theory, Turkey could seek external funding but the US is putting pressure on the IMF and Middle Eastern governments not to step in.
Neither a bailout nor rate increases would be good for Erdogan domestically, making a recession or a further destabilising rise in inflation the most likely outcomes.
Cause or symptom?
Turkey’s problems are there for all to see but we view them as a symptom of a more persistent malaise affecting the emerging markets which are facing an unhappy triumvirate: rising finance costs, slowing Chinese growth and increasing trade tensions.
Many smaller economies like Turkey are reliant on overseas portfolio flows to support their trade and budget deficits.
A gradual tightening in monetary policy in America and a strengthening US dollar increase their finance costs. This explains the very tight inverse correlation between dollar strength and emerging market performance since 1990 (see chart).
Emerging market equities tend to outperform developed markets when the dollar is weak and underperform when the dollar
The US Federal Reserve has been the first major central bank to embark on sustained monetary tightening since the financial crisis and this has led to periodic bouts of dollar strength and emerging market weakness, as we have seen since January.
China also has an important role to play in understanding emerging market performance.
The world’s second-largest economy strengthened in the 2000s as a wave of urbanisation boosted growth and sucked in commodities. Growth surged even more in the immediate aftermath of the financial crisis after the authorities panicked and administered one of the largest and most poorly managed monetary and fiscal stimulus packages in history.
Since 2010, China has been slowing more often than it has been accelerating, putting downward pressure on the price of industrial commodities that form an important part of the exports from countries like Brazil, Russia, South Africa and Indonesia.
Trade war concerns exacerbate the situation. A slowdown in global trade would hurt exports from China and other mercantilist economies like Korea and Taiwan that form a large part of emerging market equity indices.
We are broadly neutral on equities, having reduced exposure early in the summer on concerns over a cooling off in growth and a rising trend in inflation.
Our equity exposure is tilted away from the emerging markets and towards the US market.
We expect Donald Trump’s fiscal stimulus to keep the US economy strong going into 2019. This is good news for investors on Wall Street and we would be willing to buy US equities on dips.
However, a strong US economy and continued Fed rate hikes could also keep the dollar strong, turning other emerging markets into submerging markets.
Trevor Greetham is head of multi-asset at Royal London Asset Management