August 17, 2018
Can the American economy keep soaring like an eagle
when it flies with Turkeys?
For now, the answer is yes. But the feeling last Friday that was taking hold of investors had many saying no.
You see, Turkey, which had been undergoing a substantial stock market and currency decline all year, blew up in financial news last Friday, the 10
th of August, and sent tremors around the financial world. Why? Because the Turkish Lira's descent vs. the Dollar accelerated due to President Trump's announcement that the U.S. would double tariffs on Turkish steel and aluminum imports; on top of the tariffs already imposed recently. But how does all this work to the point that you have to worry about your IRA Rollover getting clobbered?
When it comes to tariff battles, the country with the trade deficit (the U.S.) typically sees its currency strengthen while the country with the trade surplus (Turkey) sees its currency weaken.
There's more to it. U.S. central bank tightening (commonly known as acronym "Q.T." for Quantitative Tightening), and a strong U.S. economy, have all helped to strengthen the U.S. dollar. (When a country's interest rates rise, its currency also becomes more attractive to investors)
I said it more succinctly when I was asked about this by CNBC:
"Can we finally get rid of the synchronized global growth fantasy? Turkey is really just a symptom of the fact that too many emerging market governments and corporations borrowed massively in dollars and now face increasing cost-of-debt service due to weakening local currency."
The mechanism that touches your 401(k) account is this:
- The Turkish government and Turkish corporations borrowed money in Dollars. Even though they collect taxes and earn money in Lira, they have to convert Lira into Dollars to pay interest on their dollar denominated debts (bonds).
- If the Lira declines in value vs. the Dollar, it simply takes more Lira to compensate for that Lira-to-Dollar conversion.
- Worst of all is that there is no easy way out of this mess because the medicine, increasing short term interest rates in Turkey to strengthen and/or defend the Lira (which would plunge their economy into deep recession or depression), tastes just as bad as getting bailed out by the IMF (International Monetary Fund).
- The longer it waits to raise interest rates, the worse the situation will become, which means the more reliant Turkey could be for a bailout.
We've seen this movie before a bunch of times, but the best example is 1997 when the Thai Baht cratered and set off the infamous "Asian Contagion". Southeastern Asian Governments borrowed heavily in U.S dollars. When their currencies weakened vs. the Dollar, their debt payments skyrocketed to the point that they defaulted on their debts. Economies blew up, causing a slowdown in global growth and needed bailouts via the IMF. It was scary. It also didn't last long as the 1990's bull market not only quickly resumed, but accelerated into late 1999.
Other countries that could be in a similar position to Turkey are South Africa, Brazil, and Mexico, but the list of "other Turkeys" goes on. The telltale sign that a country is having a debt problem typically shows up first in a country's currency, which is why you've been seeing and reading about emerging market currencies so much lately in financial news. With increasing geopolitical instability, central bank tightening, and massive government and corporate debt issuance globally over the last 10 years, the main concern is that another emerging market contagion might not end so quickly like the one from 1997. It would cause global growth to slow down and since a great many American large corporations get their revenue growth from emerging markets, you could just imagine the impact that would have on the American economy and financial markets.
Right now, the American economy can continue to soar like an eagle while it flies with Turkeys. But the answer to the question "how long and how far ?" isn't as far off as investors thought just a week ago.
Does this mean you should abandon emerging markets as an asset class? No, not to me. But it is and has always been a volatile investment, which is why it is typically a small allocation in most investment accounts.
My comments from that same CNBC article:
"Don't throw away exposure to EM equities," Goldberg said. "This isn't the first or last time there will be a shock." But he added that people get caught with too much in emerging markets after a period of time when it has done well. "Don't get out, but make sure to rebalance as it becomes too big a portion of the portfolio."
He said the overriding trend that makes emerging markets a strong long-term play hasn't changed: the billions of people entering middle class for the first time around the world. "If you look at the very long term, EM shocks are barely noticeable," Goldberg said.
Ultimately, my approach to emerging markets is a reasonable one; a little for diversification and potential long term growth.
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