Talking Turkey: the eye of the storm and contagion

We wrote in May about the challenges facing Turkey, and in July about how these threats have the potential to produce extreme outcomes.

Last week saw the manifestation of these challenges. The Turkish Lira decline on Friday was among the largest one-day currency moves of the last ten years, comparable to the decline in the Ruble at the end of 2014, the capping of the Swiss Franc, the Brexit vote, and some of the worst days of 2008.

The recent moves look extreme, even in the context of a decade of devaluation versus the US Dollar:

The dramatic nature of the moves has been reflected in market commentary. Turkey has dominated headlines in a way usually reserved for developed market policy changes, US technology stocks, or Brexit. It has even made mainstream news coverage. It seems that everyone has become an expert on Turkey.

How important are tariffs?

Much of the media attention has focused on how Friday’s move was intensified with the announcement (via Twitter) of a doubling of US tariffs on steel and aluminium out of Turkey.

The direct impact of these tariffs seems likely to be limited. Turkey is relatively diversified in terms of exports with only around 5% of exports going to the US and only 18% of that being made up by non-precious metals. Moreover, as this Bloomberg article has argued, the Turkish steel industry could prove resilient because it should be easy to find new buyers in other parts of the world.

It therefore seems likely that the tariff announcement is somewhat of a red herring, or at least a small part of an ongoing story.

What is really going on?

Last week Eric wrote about the real challenges faced by Turkey, and what characterises an emerging market. A key feature of emerging markets is that when the currency weakens, it presages a tightening of economic policy. This is for two main reasons:

  1. The government or domestic companies have borrowed in foreign currencies, meaning that debt repayments increase as the domestic currency weakens. In the case of Turkey, it is the corporate sector, rather than the government or households, which is most vulnerable in this respect.
  2. Domestic wages are closely tied to the rise in goods prices (‘indexation’) and expectations reflect this. When this is the case, even the temporary impact of a currency decline can set in motion a classic ‘wage-price spiral.’

These features explain why emerging market assets can become highly correlated; with equity and fixed income assets declining alongside the currency weakening. They may also suggest why those in Turkey may not be keen to sell holdings of gold and foreign currencies as President Erdogan has urged.

To deal with these problems emerging market policy makers in recent times have typically responded to a weakening currency by increasing policy rates. This can serve to reduce inflationary pressure in the economy, and potentially attract foreign capital to support the currency.

Turkey did indeed increase their one-week repo rate (the main policy rate) from 8% to 17.75% in June.

However, since then there have been increasing signs that the Central Bank is losing its independence to a President who is opposed to increasing interest rates. First, after his recent re-election, President Erdogan appointed his son-in-law as finance minister, and then the Central Bank chose not to increase rates in July.

In a world of open capital flows, a failure to tighten via policy will often mean that the market will tighten for you, As Eric wrote in June:

“…the main constraint on Erdogan’s growing power is the free movement of domestic and international capital. He can wrestle with his central bank for control of interest rates, but he can’t stop his currency from collapsing at the same time.”

It is this dynamic that has taken hold in August. And not because investors are seeking to attack the Turkish economy, but because they are asking for a greater compensation for risks that appear to have just increased. Such a dynamic also introduces a new risk: that a nationalistic government will seek to impose capital controls (akin to Malaysia in 1998).

Capital flows: What is sentiment and what is fundamental?

We generally try to avoid thinking about market dynamics in terms of flows. Phrases like ‘money on the sidelines’ or ‘more buyers than sellers’ often reveal confusion rather than being useful explanations of what is going on. Flows are merely a reflection of changing beliefs and it is these beliefs we should worry about.

In particular, active investors are typically looking for instances where changes in belief are not true reflections of changing fundamentals but being driven too much by sentiment. If anything, signs of high levels of transactions may be an indicator that market participants are in a rush, and disregarding fundamentals as a result.

However, analysis of capital flows often forms an important part of understanding emerging markets. It arguably represents a point where sentiment and fundamentals meet, because the impact that changing sentiment can have on prices such as currencies, in turn influence the fundamental backdrop. This idea is arguably a version of George Soros’ concept of reflexivity.

This makes analysis of the Turkish situation a challenge. It may seem that Lira moves on Friday were more about sentiment than genuine likely impact of tariffs. However, are the currency moves themselves sufficient to have a far greater fundamental impact and become self-fulfilling? This dynamic can become extremely challenging, particularly when price action is stressful. As in all such situations it is assessing how much compensation you are being offered for the wide variety of outcomes that can emerge.


Of course, one way to improve your chances of capturing investment opportunities that are about investor sentiment and not fundamentals is to try to avoid the ‘eye of the storm.’ Other assets may be caught up in panic, but should be less directly associated from a fundamental standpoint.

This is the type of contagion that should be interesting to investors. Unlike the type of direct fundamental contagion that has been discussed over the last couple of days (e.g. ‘how much exposure to Turkey do banks have?’), there may be cases where the scary nature of Turkish price action is itself sufficient to influence other assets. For example, does the very nature of recent moves cause investors to worry more about short-term loss? Do investors begin to treat all emerging markets the same way? Do Italian government bonds weaken, just because that is our recent experience of what happens in a ‘risk off’ phase?

So far, there are some signs of this type of behaviour. It is certainly the case that Turkey is being used to explain a whole host of other price moves:

Despite this, valuation shifts in most assets so far have been relatively modest (it is perhaps notable that developed market government bond yields have seen only limited declines). However, with such singular focus on Turkey influencing views across so many markets at present, it could well be the case that more profound ‘contagion-led’ opportunities are created from here.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.