Why Turkey will define the rest of 2018
Senior Fixed Income Strategist
Scenes from Morgan Spurlock’s 2004 documentary ‘Super Size Me’ are what come to mind as I look at the market selling risky assets on the back of the Turkish story. The weight of debt in emerging markets balloons, their capability to react plummets, and what they are left with are the terrifying side effects.
In this case, however, a diet might not be enough to contain the deterioration (of debt) being witnessed.
We have often discussed the debt-binge seen over the past few years, but until now we have not seen what the word overleveraged really entails. It is no secret that since the financial crisis, governments and corporates worldwide have been issuing large amounts of debt, aided both by central bank policies and regulations that made the cost of borrowing very low while allowing investors to increase their risk appetite to chase that extra yield.
Although we have been expecting this moment for months, we didn’t imagine a meltdown such as the one seen in Turkey.
The selloff in Turkish government bonds was not caused by poor economic conditions. Instead, it was triggered by a barrage of #Trumpolitics aimed at Ankara after the Turkish government jailed a US pastor. After this event, investors finally opened the “Turkey box” and found a handful of surprises including: skyrocketing inflation, an overleveraged financial sector, a weak central bank, lax fiscal policies, and most of all a leader who remains unwilling to fix these things.
No wonder investors dumped Turkish debt!
What I really struggle with, however, is understanding why the market did not act before President Trump pulled the tariffs card on Turkey. It was so clear that Turkey had all the necessary ingredients for disaster, but still investors gladly took the odds and invested in this country and other EMs as they were confident that central banks and regulators had their collective back as part of the greater effort to maintain harmony in the international financial market.
Now that we are at a turning point, we ask investors to be cautious and to think twice before investing in EM credits. Certainly, opportunities are still out there, but as long as Federal Reserve chair Jerome Powell continues to raise interest rates and the USD remains strong, EM will continue to deteriorate and expose investors to higher default risk.
Why Turkey is different
The Turkish story is different from the other volatility episodes that we witnessed this year – Argentina, South Africa, and Bahrain – because for the first time we see risk-off sentiment leaking into the developed world, and particularly into Italy.
Bloomberg is reporting that one of the largest Italian banks, Unicredit, maintains a large Turkish exposure along with Spain’s BBVA and France’s BNP Paribas. Regardless Italian BTPS were far more volatile on Monday than their French and Spanish counterparts. In the short part of the Italian government yield curve, we have seen two-year yields fluctuating 20 basis points, which is a considerable movement for shorter maturities, while on the long end of the curve the 10-year BTPs yield fluctuated by just 7 bps.
This should ring investors’ alarm bells as it is clear that not only is the EM world walking a fine line, but even in Europe, the situation is intensifying as pressure is applied to already weak banking sectors such as Italy’s.
The intersection of high debt levels and weak banks may prove explosive, possibly leading to another crisis in the periphery.
More volatility is expected to come out of Italy as the ruling populist parties discuss the budget for next year. This week, look for volatility affecting the short part of the curve in particular as the Current Account Balance is set for release Friday.
EM are cheaper, but it’s not reason enough to get back in
Now that EM have finally showed their true colours, investors should be extra cautious before entering this space – especially in sovereigns. Although one may feel more comfortable buying EM government debt versus corporate debt, it is important to note that while companies default on their debt when they don’t have money to repay, a good part of governments do not default because they lack funds but rather because they have simply made the decision to do so.
Even looking at the EM corporate space, though, can we really say that there is considerably more value than in non-EM corporates?
On the chart below, we the Bloomberg Barclays EM corporate yield-to-worst in blue, and in black the Bloomberg Barclays Global High Yield YTW excluding EM names. As you can see, while it is true that the EM corporates pay higher yields, the spread between the two remains relatively small at approximately 50 bps.
Another important thing to notice is that while corporate credit spreads (ex-EMs) have been widening gradually since the beginning of the week, yields in EM corporates have been rising much faster, indicating that there is a faster degradation of debt compared to the non-EM world.
We believe that there are plenty of opportunities in developed markets, especially when looking at USD-denominated debt. Conservative investors can find opportunities in investment grade issuances which have been widening progressively since the beginning of the year, while speculative investors can find good opportunities in the short part of the curve, keeping in mind to steer away from industries that may be sensitive to a trade war.
False hopes: the worst seems to have passed
Starting from yesterday, we have seen a partial recovery in EM, however we believe that the risks ahead are still very high and returns still don’t compensate investors accordingly.
The main problem still concerns the large amounts of foreign currency debt in the system which now, with a strong dollar and increasingly high interest rates, make refinancing prohibitive for many EM governments and corporates.
The majority of hard currency bonds issued by EM mature between now and 2023 and we believe that as credit spreads deteriorate, we will most likely start to see defaults in that part of the curve.
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