August has a habit of throwing up surprises for investors. Those of a certain age might remember Augusts of 1998 (Russian default), 2007 (first redemption freeze of sub-prime crisis), 2011 (U.S. sovereign downgrade) and 2015 (renminbi devaluation/S&P 500 flash crash). The chart below shows the drawdowns in equities, EM assets, and hedge funds in each August going back to 1997.
This August is giving us another emerging market scare. The currencies of Turkey, Argentina, and South Africa (among others) are under major pressure this week and stocks were hit hard while bond yields increased. We wrote about the situation on Wednesday (see here), but we came across an interesting report in our reading this week.
The story is pretty simple, debt levels are up significantly. And as we have all learned numerous times over the last few decades, nothing good happens when debt charts go parabolic.
And owing debt in someone else’s currency is doubly problematic. All’s fine and well when your currency is appreciating as it reduces your debt payments. But when your currency tanks, your debt service payments can balloon.
This is the problem Turkey is facing – how to pay back dollar loans at the same time the lira is falling through the floor. No easy solutions.
But it isn’t just Turkey that is seeing their currency under pressure. As we have talked about recently, the Chinese yuan has fallen by roughly 10% the last few months.
But where Turkey and China differ is in their holdings of foreign exchange reserves. Turkey holds about $130bn of reserves against roughly $63bn of dollar debt. If we strip out their gold holdings they hold only $75bn of reserves. Not much of a cushion.
On the other hand, China holds $3.1tn against roughly $450bn of debt – an enormous cushion.
The added problem is that Turkey needs to borrow over $200bn a year to keep the lights on assuming no change in policy. That is going to be a tough number to hit this year. Hence, policy will need to change whether the government wants to change things or not. The market will essentially force their hand. The question is whether change is driven by outright panic or not.
Who’s Swimming Naked at Low Tide?
Warren Buffett has said a number of times that you only find out who is swimming naked when the tide goes out. He used the line in reference to the follies of large financial institutions exposed by falling home prices. But it applies equally to Turkey’s problems. But what is the tide composed of?
No one put a gun to Turkey’s head to borrow a ton of money in dollars after all. But borrow they did because U.S. rates were very very low. However, this trend is reversing, and critically, dollar liquidity is getting tighter every week. At the end of 2017 the Fed started their quantitative tightening program whereby they aim to reduce the size of their massive balance sheet each month. By the end of July their balance sheet has shrunk by about $200bn, as you can see below.
Essentially, the Fed is draining dollar liquidity from the system, and this is making things tougher on the marginal borrowers. This cycle it is countries like Turkey. Last cycle it was subprime home owners.
What would bring relief to countries such as Turkey? A more dovish fed wouldn’t hurt. But how likely is that over the short-term when we could see 3rd quarter growth at over 4%.
Or when the underlying inflation gauge (blue line below) is pointing towards a core CPI approaching 3% in the months to come.
The only hint of possible economic weakness comes from the Citi Economic Surprise Index (chart below) which has fallen below zero).
But all this means is that the recent economic releases have fallen short of expectations, not that there has been any slowdown in growth. A thin read to hang your hat on if you are betting on relief from the Fed this year.
Have a good weekend.
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