Macro Digest: It's not Turkey, it's the debt cycle

Steen Jakobsen

Chief Economist & CIO

There is currently a lot of focus on Turkey, and for good reason, but Turkey is really only a second or third derivative of the global macro story.

Turkey represents the catalyst for a new theme, which is “too much debt and current account deficits equals crisis”. In that sense, we have come full cycle from deficits and debt mattering in the 1980s and ‘90s but not in the ‘00s and ‘10s post- the Nasdaq crash and great financial crisis under the biggest monetary experiment of all time.

In our view, the order of sequence for this crisis is as follows:

1. The debt cycle is on pause as first China and now the US have deleveraged and 'normalised'.

2. The stock of credit or the 'credit cake' has collapsed. First it was the 'change of the change of credit', or the credit impulse, which tanked in late 2017 and into 2018. Now it is also the stock of credit. Right now, global M2 over global growth is less than one, meaning the world is trying to achieve 6% global growth with less than 2.5% growth in its monetary base… the exact opposite of the 00’s and ‘10s central bank- and politician-driven model.

3. This smaller credit cake is spilling over to a stronger USD (as US growth increases versus the rest of the world) and a higher marginal cost of funding (as the amount of dollars available in the credit system shrinks), leading to a mini-emerging market crisis.

4. Finally, the Turkish situation was really created by the aforementioned factors but it was made worse by President Erdogan’s autocratic and naive monetary and fiscal response. The reason this mini-crisis is not idiosyncratic is points one through three, but the market is still treating Turkey as the starting point of the current EM mini-crisis.

Where do we go from here? More and more investors seem to believe that we are on the brink of an ‘Asian crisis 2.0’ or a liquidity crisis.

I no longer think that there are really any preordained paths or predestined scenarios for all of this, but my forecast would be:

1. A 25% chance of a Turkish default within 12 months. Erdogan is not following the three standard responses to a funding crisis: an aggressive monetary and fiscal response, seeking help from outside (read: European Union or International Monetary Fund), and/or creating a currency board/closing convertibility of TRY. The present approach contains none of these elements, which could lead to further escalation and an overall EM crisis.

2.  A 25% chance a strong reversal of quantitative tightening from the Federal Reserve, supported by the European Central Bank and major central banks. The timing here could be around the Jackson Hole event at the end of August. Overall, US monetary policy and growth have peaked, and the mini-crisis together with the Trump administration’s trade tariffs is creating a need to first pause and then reverse policy lower. The world is almost coming to a standstill, after all, from the Fed’s extremely hollow tightening.

3. A 25% chance that China comes to the rescue in a fashion similar to 2007/08. China is now asynchronically easing both monetary policy and fiscal policy as growth is not only undershooting targets but doing so significantly. To me, the recent technology sector sell-off is a sign that the lows could be coming in soon. A ‘Chinese rescue’ scenario could also be called another delay, or yet more ‘pretend-and-extend’, but the data and research I am seeing from China (plus the research I have published) points to a country that is acutely aware of the risks posed by growth shortfalls based on too much deleveraging relative to the country’s position in its overall economic transformation (China 2025).

Be aware that the potential potency of Chinese stimulus is now much smaller than it was last time as the country’ debt is higher, productivity remains low, and global transmission is clogged.

4. A 23% chance that global recession, based on points one through three, arrives by Q4’18 or Q1’19. This recession would spring from the enormous underestimation of the damage done to SMEs and MMEs by: tariffs, a rising marginal cost of capital, and a USD that is too strong for the world’s indebted markets.

5. A 2% chance that the world recovers, with this event coming to be seen as a mere blip on the radar. In this scenario, the US economy is strong enough to carry the rest of world, Italy sees 3% growth, and the EU solves Brexit… remember, nothing is impossible.

Market views

US markets are three standard deviations more expensive than the MSCI World index. I repeat: three (based on a 24-month look backwards).

Our recommendations:

Forex: We are long dollar, JPY, CHF, and will buy gold in the next 48 hours. We are extremely alert on our USD long as the main driver of dollar equals US growth minus global growth. We expect US growth to have peaked and for global growth to expand relative to US growth; due to USD’s reserve status... this is the driver on the dollar rate.

Fixed Income: Long 10-year and UST as safe-havens, plus we see improving fundamentals.

Commodities: We like grains in the long term and have a small exposure (mainly wheat for now).

EM: We think China is getting cheap… its multiples are down at half of their peak levels and we see the recent technology rout as an opportunity to dip our feet into Chinese stocks. We bought small EM last month and will be adding in increments over the next six months to an overall exposure of 25% on the potential for a Chinese reversal and a turnover in QT.

Equities: We are adding utilities, we like capital goods for their cheapness, but overall we are slowly switching our US equity exposure EM/China.

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