Over the last few days the depreciation of the Turkish lira accelerated and it dropped to a new record low versus the dollar. The weakening trend was mainly caused by high and rising inflation and the absence of a response from the central bank amid increased pressure from Turkey president Erdogan to prevent any more rate hikes. Erdogan believes higher rates will only hurt domestic economic growth, he has continuously pressed the central bank to lower interest rates.
Turkish lira tumbled
The acceleration of the drop came on Friday after President Trump tweeted that he has authorised a doubling of tariffs on steel and aluminium imports from Turkey. These measures are a result of increasing tensions after Turkey holds an American pastor in prison. The Turkish lira tumbled roughly 20% over the last 2 trading days and depreciated 45% since the start of the year. This week, the Turkish Central Bank announced some measures to increase liquidity for Turkish banks and cut the required reserve ratio for their FX liabilities and now allows the use of euro's to be used for maintenance against lira reserves. These measures have steadied the lira exchange rate for now.
What are the spill over effects?
The fall of the Turkish currency hits Turkish bonds, equities and assets directly, but also has spillover effects on (1) EU banks, (2) other vulnerable EM, (3) risk assets in general. Other EM currencies, such as the South African rand and the Mexican peso, have dropped as well in the last few days, but have managed to contain their losses. Even though there may be little fundamental reasons why the Turkey-related turbulence should negatively affect other EM currencies, the fact that investors often bundle together all Emerging Markets means they may prefer to avoid potential losses in other regions by reducing overall EM exposure.
What are our expectations?
The current crisis in Turkey is driven by a combination of economic and polical factors, and sentiment. The high inflation is unlikely to be solved overnight. Strong central bank actions via rate hikes might help bring some stability in the market, but 1) it is possible that the central bank refrains from doing that due to pressure from Erdogan and 2) on previous occasions rate hikes by the CBRT where not very successful in reversing lira depreciations. Another way to manage the situation is if there is political will from either Erdogan and/or Trump to stop the stand-off.
Both Erdogan and Trump have shown to be headstrong in the past, thus the current situation may very well get worse before it gets better.Iavor Botev
At some point however, we expect the Turkish assets depreciation will make them cheap enough on fundamental values measures and thus will make them attractive for the less risk-averse investors.
What is the impact on portfolios?
The multi asset funds have been running with limited Emerging Markets (EM) exposure in the recent months as we have judged that the late-cycle macroeconomic environment, the Fed hiking interest rates, and the somewhat cautious investor sentiment were not supportive for EM FX to outperform. At the same time we maintain an overweight on hard currency EM sovereign debt, which offers attractive yield pick-up over government bonds. As we expect the spill over effect into the broader EM universe to be contained.
European Government bonds
Interest rates dropped last week as investors looked for safe assets amidst the EM volatility. Spreads on Italian bonds widened further as investors are concerned about the upcoming budget talks between the Italian government and the EU.
European Investment Grade Corporate bonds
Sentiment has been subdued. We have only seen some serious spread widening (20-50 basis point) in pockets of the banking sector with large exposures in Turkey (BBVA, Unicredit, BNP, ING), for other European banks impact has been very limited.
European High Yield
Impact has been limited overall, with the Crossover index moving only a few basis points higher.
Equities have seen some negative impact as uncertainty around the Turkish situation increased, mainly via the banking sector. The VStoxx index, which measures the implied volatility on European equity markets moved to 15, which is still below its 5-year average level. This implies the equity market keeps calm.