Managing risk, as well as long term performance, is the signature element of Ariel’s international and global investment process. We seek to own out-of-favor, misunderstood or ignored companies with strong business models and sustainable growth relative to their overall risk profiles, which is further quantified by connecting industry trends with political and economic vulnerabilities. This proactive risk assessment led us to exit our Turkish holdings in early 2016, as perceived authoritarian domestic policies paired with a confluence of fiscal concerns, including a capital account deficit, high level of foreign currency debt and rising borrowing costs. In recent weeks these troubles culminated in a sharp plunge in Turkish lira as investor confidence in the country’s ability to manage its economy was shaken. The crisis also ignited fear that Turkey’s currency woes could ripple through the global financial markets, notably the nation’s largest lenders in Europe. Since Ariel’s strategies lack exposure to Turkey and European banks, we do not expect to see an adverse impact on our portfolios. The commentary that follows is intended to provide a background on the situation in Turkey and Ariel’s view on implications for the global economy:
Turkish crisis has been brewing
President Recep Tayyip Erdogan’s Islamist rooted Justice and Development Party (AKP) came into power in 2001, in the aftermath of a devastating financial crash and subsequent International Monetary Fund “IMF” bailout. His nationalistic administration consolidated control quickly and more recently has come under fire for alleged human rights violations and curtailed freedom of press. Nonetheless, the economy saw a tremendous recovery under its leadership, largely driven by major infrastructure investments in roads, airports and a high speed train network – all financed by a borrowing binge denominated in euros and dollars. Unfortunately, the incremental income generated by these projects has been insufficient to curb the debt burden.
The country is susceptible to shifts in global capital markets
Meanwhile, back in the United States, the Federal Reserve is raising interest rates to shrink its balance sheet in response to economic strength and warming inflation. Removing this money from the market has yielded a much stronger greenback and placed strain on emerging nations, like Turkey, which use local currencies to pay down their dollar-backed debt. Financing costs have also risen in Europe as the Central Bank continues to taper their asset purchase programs. In addition, Turkey is vulnerable to rising energy prices as it is a large importer of oil, which also happens to be priced in U.S. dollars.
Turkey’s predicament extends beyond foreign-exchange
With Turkey’s soaring foreign currency debt, large deficit, rising borrowing costs and surging inflation, investors have been selling the lira, which has fallen over 40% against the US dollar since the start of 2018.
At the same time, Erdogan has been seizing greater control of the country’s monetary policy – refusing to raise interest rates to cool down the economy and stabilize the currency. After recently winning re-election, Erdogan installed his son-in-law as the finance minister, undercutting the independence and therefore credibility of the central bank.
Further exacerbating the situation is a public spat between Turkey and the United States. Detaining an American pastor on disputed terrorism charges has led to U.S sanctions and double tariffs on imports of Turkish steel and aluminum.
Bailout package is nowhere in sight
The customary response for this type of economic collapse usually entails a financing program with the IMF, in exchange for meaningful changes in domestic policy. However, a return to the IMF would run counter to the political platform of his populist and nationalistic rise to power and likely be viewed as a betrayal to Turkish patriotism. Moreover, with the widening rift between the United States and Turkey, a United States led rescue is likely a non-starter.
There are not many alternatives to the IMF that could materially satisfy Turkey’s funding needs. Not to mention, recent standoffs have fueled concerns of a foreign policy shift that would result in Turkey exiting NATO and forging stronger political ties with Russia, China and Iran. However, these new allies are unlikely to deliver the significant cash flow required. Meanwhile, Turkey did receive a $15 billion lifeline from Qatar, but without a major change in its economic agenda as well as monetary and fiscal policy – it is not enough.
With or without a bailout, the issue is not whether Turkey is heading for a recession, but just how deep the recession will be. While the central bank has eased financing requirements for Turkish banks, we expect to see higher bankruptcies and corporate debt defaults, as well as greater demands for the government to support local banks and businesses, while protecting the most vulnerable segments of the population. Erdogan has insisted that Turkey remains committed to the principles of an open market, but given the situation, it’s quickly becoming clear that imposing capital controls may be the only way to provide some temporary respite.
Emerging market contagion?
Although Turkey’s issues, taken in isolation, should not have a big impact on the global economy, investors are nervously looking for signs of contagion. Emerging markets were already struggling with the prospect of trade wars and a strengthening U.S. dollar. Now elements of the crisis in Turkey reveal how developing economies, such as South Africa, Argentina and Mexico that took advantage of incredibly low interest rates in the United States and other developed markets may struggle to service their foreign-currency denominated debts in weakening local currencies. Even though these nations aren’t all that large relative to global GDP, signs of trouble or significantly weakened monetary reserves would trigger chain reactions in the financial markets that could have global repercussions.
Although we have been negative on companies operating in emerging markets for many years, a major sell-off could provide the entry point we have been patiently waiting for.
This commentary candidly discusses current market conditions. The conditions and our opinions are current as of the date of this commentary but are subject to change.
Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, and foreign currencies and taxes.
