Political strongman tactics come home to roost

17 August 2018

This week continued in decidedly risk-off mood in global stock markets, as concerns spread that Turkey’s currency tail spin could spread to all emerging markets and cause considerable damage to the Eurozone’s banking sector as well.

As so often when contagion is in the air, investors sell first and ask questions later. The exposure of European banks to the Turkish economy may be unpleasant but, on the basis of all the research we have been able to sift through, it is hardly going to constitute a systemic threat or extend to the scale of the Greek crisis. Furthermore, different to how it may be portrayed in the wider media, Turkey’s issues have been well known for quite some time and Trump’s sanction-slapping action was just another case of exerting maximum pressure on an opponent when they are on the ground already.

Turkey’s problems will therefore not be solvable on the political level but will require strongman Erdogan to concede that his dictatorial powers do not extend to capital markets. Unless Turkey stabilises its currency through a more restrictive monetary policy and weans off foreign capital for its economic growth ambitions, it is heading down the familiar Argentina route.

Trump used the same tactic with China, where the economy is slowing because its forward-looking leadership is reining in a profligate financial sector and restructuring its economy towards domestic demand to become less export dependent. However, China is not Turkey and, given its economic might and intellect of leadership, it matters a lot more for the global economy whether this trade war truly takes hold or gets resolved before much collateral damage is caused. Interestingly, China has a few more defence mechanisms in its arsenal than Erdogan’s threat to stop buying iPhones. And that is its currency. With the US$ already going up and the Chinese Yuan going down due to the relative weakness of the economy, all the Chinese central bank had to do was not to intervene as usual in FX markets and the Chinese currency had fallen almost as much as Trump had slapped in tariffs onto their exports. That may explain why Trump increased his tariffs so quickly from 10 to 25%. But the US$ strength is beginning to hurt US exporters and slowing the emerging market economies to a point where it is beginning to pose a risk to Trump’s economic ambitions.

No wonder then that markets sighed in collective relief when it became known that both sides will restart trade negotiations in the coming weeks. The US side stating its intention to discuss the Chinese currency weakness tells us that Trump may be beginning to realise that China has a better negotiating position than he anticipated (or at least his advisers did).

This brings us back to the UK, which is in a not too dissimilar position. The £-sterling weakness versus the €-Euro and the US$ is clearly supporting the economy and the latest retail sales figures are showing that there is still life in the UK shopper. Brexit scaremongering headlines will accompany us for the foreseeable future, as it is in the interest of both sides to rally their respective audiences to score points at the negotiating table. However, since time is running out to introduce anything overly complex (like trading under WTO rules and tariffs) in the remaining 7 months to March 2019 and the UK public is not favouring a hard Brexit, politicians and parliament are unlikely to go for anything overly radical. Brexit-in-name-only (BINO) remains the most likely starting point for the UK’s post-Brexit relationship with the EU27 next year.

In terms of capital markets, all the above tells us that the relative safety of government bonds is unlikely to lose its attraction anytime soon, which removes one of the concerns earlier in the year. This leaves the risk of a serious deterioration of trade relations as another potential reason for a premature end to the current cycle. Here, the latest developments between China and the US give us hope that both sides are aware what is at stake and that Donald Trump is keen to add another ‘big win’ before the November Midterm Elections.

For emerging markets at large, a stabilisation of the Turkey crisis is likely to be a necessary condition before investors are willing to rediscover the value of this asset class. Until this happens, we will be happy to retain the substantial underweight in emerging markets that we have had since March.