Implications of Turkish Debt and Currency Crisis on South Africa’s Asset Class Returns

By Alexander Forbes Investments on Aug 30, 2018 in Market and Economic Commentary

          • Turkey’s currency and debt crisis has spilled over into emerging markets (EMs), with comparable current account and fiscal deficits and high debt levels.
          •  EM credit default swap (CDS) spreads and bond yields are pushing higher, equities are falling and currencies are weakening. However, we believe this will not be a protracted crisis. 
          • Contrary to the sell-off related to fears about Argentinian debt in May, where South African assets handled the EM pressure relatively well, this time South African assets are underperforming EM peers. 
          • EM sell-off is overdone and we believe asset prices outside of Turkey will reprice.
          • Locally, weak economic data for the second quarter of 2018, combined with a lack of clarity on government’s position on key policy reforms, means that South African assets will remain vulnerable to EM stress. 
          • From a very short-term perspective, South African factors have turned negative from neutral. However, we believe the rand and bond sell-off is overdone and should reverse lost ground.
          • Over the medium to longer term, South Africa’s current account deficit is closer to that of Turkey, Brazil, Argentina and India – all vulnerable countries – and the country will have to show better resolve on key policy reforms and implementation for confidence to translate into faster economic activity, which is needed to correct this imbalance.  
          • The resolution on land reform, the jobs and investment summits, and the medium-term budget policy statement are all key events that are important for building confidence, boosting economic growth, influencing credit rating agencies’ reviews and improving local asset class returns.
          • From an asset allocation perspective, the higher offshore exposures, as well as the allocations to hedge funds and private markets, benefited the accumulation portfolios during this market volatility.
          • Given that we believe both the rand and bonds are oversold, it’s timely to add bonds and reduce rand hedge stocks, to benefit when the rand and bond yields recover.

        Through history, United States (US) monetary policy tightening has typically preceded a financial or debt crisis, with a significant portion being in EMs. While we do not know for sure whether it is the rising US rates that caused these crises, the coincidence is striking.

        Since the taper tantrum in May 2013, when the US Federal Reserve (US Fed) signaled the beginning of unwinding its quantitative easing programme, emerging markets experienced several bouts of equity sell-offs. Over the past three years, the US Fed has hiked rates seven times, to an upper level of 2.0% from 0.25%, and its policy guidance suggests it will hike another five times to 3.25% by the end of 2019.

        The crises in Argentina and Turkey are already future statistics of the impact of US Fed rate hikes, although there is political influence in the case of Turkey. We will continue to closely monitor EM countries for any signs of stress going forward and the consequential contagion channels to South Africa and the global economy.

        Turkey’s macroeconomic imbalances and policy inaction

        After the Argentinian debt crisis in May 2018, which sparked a risk-off trade, Turkey’s debt and currency crisis surfaced at the beginning of August. This was sparked by the US announcing a hike in steel tariffs from 25% to 50%, and restrictions on international institutions providing US dollar loans to Turkey over the imprisonment of an American priest. Like many EMs, the biggest issues in Turkey are macroeconomic imbalances, which are widening current account deficits (6.0% of GDP from 3.8% in 2016), and an increasing debt burden with a significant portion being short-term foreign currency debt to the private sector.

        The Turkish lira weakened 120% against the US dollar since January 2016 and by 80% and 40% year-to-date and since the beginning of August 2018. As a result of the weak currency, Turkish inflation has jumped to 16% in July 2018 from 11.9% at the end of 2017. The central bank of Turkey hiked rates from 8.0% in April to 17.75% currently. However, these measures remain insufficient to stabilise the currency.

        Three policy responses are required to correct the macroeconomic imbalances in Turkey:

        1. interest rates must increase by a minimum of 5.0% (markets are pricing a further 7.0% in rate hikes in three months’ time), to dampen domestic demand, import growth and narrow the current account deficit;

        2. even though the fiscal deficit was not a problem, it would speed up the stabilisation process, if it narrowed;

        3. monetary policy independence and credibility needs to be re-established.

        The spillover to EMs is overdone

        The spillover from Turkey negatively impacted South Africa, Argentina, Russia, Brazil and India the most, with currencies falling by between 2% to 8% against the US dollar, and implied policy rates and default risk – measured by CDS spreads – rising. The main channel of contagion is through European banks, which have a significant exposure to Turkish corporate debt and the euro. Historical episodes of euro weakness have always resulted in EM financial markets stress, and this time is no different.

        Although equity prices for European and Gulf banks came under pressure, it is the fear of contagion from direct and indirect exposure to Turkish banks and through the trade channel that has been a major cause for concern. Our analysis shows that Germany, the UK, France, Spain and Italy are the most exposed, both from a financial and trade perspective. These are also the biggest economies in Europe – accounting for 54% of Turkey’s exports – which means that Turkey’s troubles are also Europe’s problems. Consequently, lack of policy response to stabilise the lira implies that European banks’ stock and the euro will remain vulnerable.

        Direct contagion to EMs is limited. However, the euro and the pound – which are the second and third most used currencies, accounting for 36% of global cross-border transactions – will be the channels through which EMs will be impacted. From a trade perspective, Africa accounts for only 8% of Turkey’s exports, thus its exposure is limited. We believe that the current stress is overdone and will recede.

        Turkey is not entirely alone on macroeconomic imbalances

        A close look at countries that experienced significant financial market stress reveals that all have significant financing needs, and thus remain vulnerable to an EM sell-off. The exception is Russia, which is a net creditor to the rest of the world. However, it remains vulnerable due to sanctions from the US. If the US Fed continues to hike rates and the dollar remains stronger, EM currencies will remain weak and their central banks will eventually need to hike interest rates due to upward inflationary pressures.

        What does this mean for EMs and South Africa?

        First, we believe the sell-off is driven by fear and the market’s realisation that countries with macroeconomic imbalances will find it difficult to adjust as the US Fed continues to hike rates. However, we also believe that the current sell-off is overdone, because from a financing need perspective, all deficit EMs have improved relative to 2015. From a macro perspective, global growth remains strong, with EMs performing better than advanced markets. Risk appetite will recover, but we’re shifting towards the end of the cycle and risk events (like Turkey) should be expected. We expect a reversal of the sell-off in other EMs outside of Turkey. For Turkey itself, without significant increases in interest rates, or some support from the International Monetary Fund (as in the case of Argentina), asset prices will remain weak for some time, and will impact European banking stocks.

        Second, the potential impact on South Africa will be via the euro (financial channel), where a weak euro will imply a weak rand and rising bond yields. However, like other EMs outside of Turkey, we expect a recovery in both the rand and bond yields, especially given the credibility of the South African Reserve Bank (SARB) in controlling inflation. We expect the rand to trade in a range of 13.5 to 14.0 against the US dollar, and the 10-year bond yield to fall to 8.6% from 9.2% by year end. We are likely to see rand hedge stocks give up some of the gains as the rand recovers.

        Given our expectation that the rand will regain some lost ground, we expect inflation to remain within the SARB’s target band of 3.0% to 6.0% over the next 12 months. The SARB will likely hike at least once, likely during the second of 2019.

        Third, EMs that have significant external funding needs (large current account deficits and short-term foreign currency debt) would need to hike interest rates to dampen imports and narrow the current account deficits, which will in turn stabilise currencies. South Africa will need to reduce both the current account and fiscal deficits and possibly hike rates, at least once, to be able to weather any EM stress. The SARB’s quarterly projection model assumes at least one rate hike before the end of 2018, to be followed by at least two more hikes in 2019 and 2020. This is in recognition that there is need to hike rates sooner, rather than later.

        Implications for asset allocation

        The decision to use the full 30% offshore limit within Alexander Forbes Investments’ major accumulation portfolios has paid dividends during the recent EM volatility. The slight overweight to EMs has placed some pressure on performance, but the overweight to US dollar cash served as a good counterweight against the EM volatility. Given our expectations, the EM volatility will subside into year end, where we expect the overweight positioning to add value to portfolios going forward and we will not look to adjust these EM positions yet.

        While we do not manage portfolios, by attempting to predict each market event, we have been expecting a period of higher financial market volatility due to the elevated valuations on traditional asset classes and the tighter monetary policy trajectory followed by the US Fed. It is important to note that the greater exposure to hedge funds and private markets, protected capital during the recent market volatility, as these asset classes can protect on the downside during periods of market stress. Private markets also protect against inflation during periods of depreciating currency.

        Looking ahead, the elevated level of South African bond yields makes them quite attractive for South African clients. With the 10-year bond yield above 9%, investors can expect real interest returns in the region of 3% to 5%, which is attractive in the low-return world we expect over the coming years. Accumulation portfolios have large exposures to local bonds and should benefit from this trend.

        Bottom line

        Contagion from Turkey’s currency and debt crisis will be short lived and will not cause a significantly negative impact on South Africa. The rand, local equities and bonds look oversold and will reprice once calm returns to EMs. However, South Africa will remain vulnerable to EM sell-off. We will continue to monitor development in Turkey, Argentina, India and Brazil, as potential sources of future EM stress.

Alexander Forbes Investments

Alexander Forbes Investments

Alexander Forbes Investments was established in 1997. We are a forward-thinking and trusted global investment provider, with roots in Africa. In pursuit of certainty we set out to understand our retail and institutional clients’ circumstances and risk tolerance to set clear goals. Our adaptive investment approach, called Living*Investing allows us to maximise opportunity and minimise risk at every stage of the investment cycle.

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