Let's Talk Turkey And Emerging Markets

by: Michael Chandler

One sneezes and they all catch a cold.

A strong US economy is causing financial turmoil in Emerging Markets.

Problems in Turkey and other emerging markets are contagious for Developed World's banks, causing potential slower economic growth in Europe and Asia.

Fed in a Catch 22 and may be forced to act.

Avoid Emerging Markets and keep investments domestic.

The markets throughout the world have been under significant pressure due to significant currency devaluations in the emerging markets. Turkey was just the first to sneeze. It now appears to be contagious throughout the emerging markets and, to some extent, developed countries as well.

According to the UK's Telegraph, the debt to GDP for most of the emerging markets is greater than 300%. That, of course, is serious enough, but with the world's strongest economy being the United States, the dollar has strengthened significantly relative to most all foreign currencies.

Most of the debt Turkey and the other emerging markets have accumulated is dollar denominated. Ergo the problem, Turkey has 16 billion of dollar denominated debt due in the next eight months. Its currency, the lira, has fallen 46% relative to the US dollar. Without excess dollar reserves, Turkey is forced to pay its debt with lira. Simple math will tell you it will take at least twice as much lira to meet those obligations.

Simply put, the dollar denominated debt is worth less than $0.50 on the dollar when marked to the market. Banks as well as corporations are holding this paper and it could have negative repercussions on balance sheets, as well as reserve requirements required by central banks.

Turkey has increased its margin requirements and for the time being has slowed down any short selling in its currency. This is merely a band-aid to a much bigger problem. With runaway inflation as a product of the devaluation, it is imperative that Turkey raises interest rates to support the lira. Currently there appears to be no government appetite for higher rates.

Furthermore, it appears Turkey is digging in its heels following the doubling of US tariffs on steel and aluminum. It will be interesting to see who blinks first.

This problem has been brewing for some time. The US dollar has been increasing since January of this year creating havoc for Emerging Market currencies.

It is quite clear the escalation of the lira's fall was brought on by political issues. Some believe Pres. Trump's actions involving the release of a missionary provoked the collapse of the Turkish lira. I believe it was due to several other issues.

Turkey is a member of NATO and yet it purchased a missile-defense system from Russia, and at the same time, it ordered several US-made F-35 fighter jets. I'm certain this caused many security issues and certainly brought into question Turkey's solidarity with NATO.

Furthermore, Turkey has been the gateway for massive refugees to enter the EU. Turkey's failure to control its borders has created a security risk to much of the EU and the developed world.

A combination of all these reasons provoked President Trump to double the tariffs on steel and aluminum. Turkey subsequently has retaliated with its own tariffs on automobiles and spirits.

It appears to me the issue with Turkey will be resolved through some method of negotiation with our State Department which will involve a more long-term fix with the international monetary fund (IMF).

I'm sure you recall we went through something similar in Greece several years ago. Escalating debt and lack of austerity measures were the main issues then. The Greek issue today is by no means cured and finds itself in constant negotiation with the EU and the IMF. At best it appears to be stable for the time being.

Turkey will be forced to go through a similar restructuring program.

As I indicated above, Turkey is one of many of the emerging markets faced with very high debt to GDP ratios with most of its debt dollar denominated. Paying off debt with a devalued currency brings many of these countries on the brink of financial collapse.

The effects on the developed world can and are to some extent curtailing global growth. Many of the major banks are holding much of this Emerging Market paper.

The contagion is real and may very well have a significant impact on trade negotiations throughout the world.

There has already been enough said about the increase in tariffs globally. Higher tariffs historically have been used as a tool to combat unfair trade practices.

Currency devaluation is another tool being used to combat higher tariffs. Some would argue it may very well be a more effective tool. By undervaluing a country's currency, you can not only increase your exports but also negate any additional cost due to higher tariffs.

The best example of this is today China's yuan.

US Dollar (USD) To Chinese Yuan Renminbi (CNY) History - Foreign Currency Exchange Rates and Currency Converter Calculator

As you can see in the chart above, since January of this year, the value of the Chinese yuan versus the dollar has practically fallen off a cliff.

To compound the issue of global currency devaluations relative to the dollar, the US economy continues to strengthen. With the US economy growing faster than practically any developed country in the world, imports continue to be cheaper than their US counterparts.

This environment is counterproductive to the Trump economic policy. The fact is a weaker US dollar would increase US exports and create an environment conducive to increasing US manufacturing.

With this backdrop, I would not be surprised to see a slowdown in global economic growth to the extent the Federal Reserve slows down its march to normalcy regarding interest rates. 2019 might very well see minimal rate hikes.

From an investment standpoint, I would stand clear of the emerging markets until the dust has settled.

My best guess is this entire situation will become much clearer 12 months out.

If by chance the dollar should reverse itself and start to weaken, the current trade issues could be resolved in a relatively short order. It would seem to me China and others would be faster in coming to a negotiated solution.

Until then it appears wise money should be invested domestically right here in the US.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investment advisory services offered through World Equity Group, Inc., member FINRA and SIPC, a Registered Investment Adviser. Dogwood Capital Management is not owned or controlled by World Equity Group, Inc.