Risk-off is on

Renewed political tensions between the US and Turkey and Russia increased uncertainty and led to a currency sell-off in both countries. Traditional safe-haven assets, such as US Treasuries and the yen, rose. Are these crises telling us anything about the state of the global economy?

What is happening and why?

The Turkish lira and the Russian ruble plunged recently, following an escalation of diplomatic tensions between the two countries and the US. In the case of Turkey, problems escalated after a deadline for Turkey to release a US pastor lapsed earlier this week. And on Friday, US President Trump authorised the doubling of some metals tariffs on Turkey. In Russia’s case, the US has proposed new sanctions amid the country’s alleged involvement in US elections. The Turkish lira fell to an all-time low against the US dollar, while the ruble reached its lowest level since March 2016. The tension around Turkey escalated on Friday after Turkish President Recep Tayyip Erdogan said his country wouldn’t bow to economic warfare.

Which assets were more reactive?

Markets turned into a risk-off mode, with investors flocking to traditional safe-haven assets: the world benchmark 10-year US Treasury yield fell to 2.87%, after surpassing 3% only last week, and even despite core inflation posted its biggest gain since 2008. The US dollar and the yen rallied. Most European sovereign yields also fell – except those of Spain, Italy, Portugal and Greece. Emerging Markets (EMs) and their currencies dropped, especially those with a fragile political or economic situation: the argentine peso fell 3.3% against the dollar on Friday, while the South African rand lost 2.5%. European lenders to Turkey were also hit, as a lower currency hinders the payment capacity of Turkish borrowers. Spreads of Italian and Spanish banks’ contingent convertible bonds widened.

What could happen now?

Investors expect Turkey to act quickly to contain the currency drop, as the depreciation makes Turkey’s foreign bill more expensive, especially as the country imports most of its oil needs. Turkey seems to have two ways forward:

• Orthodox: Rate hikes to contain the lira’s fall. Other measures could include Fiscal consolidation and an improvement of the country’s relations with the West in order to ease the US sanctions. This could potentially facilitate an aid programme from the International Monetary Fund (IMF). In this scenario, Turkish banks and companies would suffer, but the pain could be spread over two years. Under a recession, Turkey may see its spending and debt increasing, but assuming its sovereign debt were to increase from 30 to 50% of GDP, this might not be disastrous. Money would have to be spent on bailouts for corporates and banks. Turkish corporate debt is 70% of GDP, of which 35% is in hard currency. Of this 35%, around half is loaned from Turkish banks – which might have to be nationalised under a worst-case scenario. The main threat to companies could be the lack of external funding rather than a fall in growth/recession. Erdogan has been attempting to diversify Turkey’s funding sources and trading partners, courting Russia, China and Qatar. A US $3.6bn loan was recently secured from China, but that is only a small part of Turkey’s $240bn funding needs.
• Unorthodox: Implementation of capital controls. This could spread the crisis to European banks with significant exposure to Turkish debt. This solution, as we saw in Argentina, could be more unpopular, as people would be forced to trade in local currency only.

Are these crises telling us anything about the state of the global economy?

People often say that turbulences such as these are warnings that bigger crises are ahead. But Turkey has been challenged for some time and Russia seems to have enough buffers to absorb the potential new sanctions, as long as oil prices don’t collapse. Russia has always been heavily oil price-dependent. In terms of global growth, China, the US, Europe and Japan have a much bigger influence, and these economies, although far from being at full traction, are still growing at a healthy pace.

Is there any danger of contagion to other EMs or Developed Markets?

Contagion is always a threat and recent events could heighten volatility. However, and over the long term, countries and assets are largely driven by their own fundamentals. As ever, thorough analysis and selection is paramount before making any investment.