The Turkish currency crisis is threatening an otherwise favorable EM outlook. Emerging market (EM) equities have experienced significant selling pressure this month amid the ongoing trade dispute between the U.S. and China and the crisis in Turkey, which has sparked contagion fears and threatened to send the country into recession. After last week’s 3.7% decline, the MSCI EM Index has lost 9.9% year to date [Figure 1] on a total return basis and is 19.7% below its January 26, 2018, record high. Meanwhile, the S&P 500 is just 0.8% below its record high on that same date. So what should EM investors do now?
WHY NOT BAIL?
While we think EM contagion fears may be overdone, there has clearly been some fundamental deterioration in the space and heightened uncertainty prevents high conviction. So why not sell now? Here are several reasons:
Turkey likely a one-off. Turkey has one of the worst current account (trade) deficits among EM countries, with heavy reliance on external U.S. dollar funding. Add a political skirmish with the U.S. and what appears to be a series of policy mistakes by Turkish President Recep Tayyip Erdogan, and you have a unique situation that does not appear to have a lot of direct implications for other major developing countries.
The Turkish economy is extremely small. A recession in Turkey would not have a meaningful impact on global growth, given the economy represents slightly over 1% of global gross domestic product (GDP). Skeptics might say Greece’s economy is also small and yet its crisis negatively impacted global markets a few years ago. That’s fair, but the primary concerns during the European debt crisis centered on Italy and Spain, economies and markets that are clearly big enough to impair the global economy. Despite Turkey’s economic challenges, we continue to believe developing economies in aggregate can grow GDP at 4.8% in 2018, in line with Bloomberg consensus forecasts, even as China’s economy slows a bit. Additional descriptions and disclosures are available in our publication Midyear Outlook 2018: The Plot Thickens.
Turkey represents a marginal half-percent weight in the EM index. In fact, despite Turkey’s equity market getting cut in half this year, four countries have contributed more to this year’s drop in the EM Index: Brazil, South Africa, South Korea, and China (those four countries account for 58% of the MSCI EM Index in total). Note that the country’s weight in the JPMorgan Emerging Market Bond Index is higher, at 4-5%. EM debt, an asset class we have not recommended this year, is the topic of tomorrow’s Bond Market Perspectives publication.
Turkey’s external debt load is manageable. About $220 billion in Turkish debt is held by foreign investors, which is very small relative to the size of the European Central Bank’s balance sheet, at over $4 trillion (only about 5%), making the prospect of a bailout—should one be needed—quite manageable.
Trade dispute resolution a potential catalyst. Based on how much China and the U.S. have to lose from a full-blown trade war, we continue to expect a compromise that ends up having little if any negative impact on the two economies. We see eventual resolution—though possibly not before the midterm elections—as a potential positive catalyst for EM. The odds of a deal went up late last week following reports that talks are scheduled for later this week. See our Weekly Market Commentary on June 25, 2018, for our thoughts on global trade tensions.