Portfolio picksSep 10 2018

Why we bought into an EM fund as Turkey struggles

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Why we bought into an EM fund as Turkey struggles

The country had been ailing for some time, with inflation running unsustainably hot and the currency bleeding value despite the central bank more than doubling interest rates to 17.75 per cent in less than two months.

But in early August the trapdoor opened and the currency plummeted and Turkish bond yields ballooned. The government bond yield is well and truly inverted: 10-year debt yields 21 per cent, while two-year debts yield 27 per cent.

At 5.5 per cent of GDP, Turkey’s current account deficit is worse than the UK’s (that’s saying something) and President Recep Tayyip Erdogan has made several worryingly incoherent economic pronouncements. US tariffs and embargos on the nation for its refusal to release a US pastor held on terrorism charges just exacerbated the country’s meltdown.

The scale of the rout in Turkish assets seems a little overblown to us, but that’s financial markets for you.

Bad news snowballs – especially when the number of shorts on your bonds increases four-fold in seven months. Still, we were nowhere near Turkish assets when it blew up, so it’s a little academic.

If the Turkish currency crisis does mutate into a larger problem down the road, we feel it’s most likely to be through the developed world, not the developing.

What’s not academic is the effect the crisis has had on other emerging markets. As is typical, many investors have reacted to Turkey’s problems by selling all emerging markets, lock and stock.

This kind of response has become particularly pronounced in the passive-obsessed world of today. These knee-jerk index-level reactions make for increased volatility, but they also create great opportunities for savvy investors to buy assets at an undeserved discount. 

We bought the GAM Emerging Bond fund, which invests solely in dollar-denominated debts in the developing world, as emerging market bond spreads reached 400 basis points.

Its exposure to Turkish government bonds is about 2.5 per cent, but we believe the chance of Turkey defaulting is low.

Its public debt to GDP is low at just 40 per cent and the government should come to terms to prevent the bad reputation and extraordinary pain that will come with a sovereign default.

Our research shows that few other emerging markets are as reliant as Turkey on foreign investment to service their debts. Most are actually in better financial shape than a few years ago, which gives us the confidence to move against the crowd here.

If the Turkish currency crisis does mutate into a larger problem down the road, we feel it’s most likely to be through the developed world, not the developing.

Several European banks have substantial Turkish debts on their books. Spanish lenders have about a quarter of their capital and reserves in Turkish assets.

UniCredit, Italy’s largest bank, sports large amounts of Turkish debt too. At the moment, it’s unclear whether these loans are with strong blue-chip companies or whether they’re more toxic.

To us, it simply underlines the reason we usually steer clear of Europe: its banks are still a mess, a decade on from the global financial crisis, and that’s not the only structural problem the bloc is wrestling with.

The banks we do like are, in the main, American. We own US Bancorp and Northern Trust precisely because of the quality of their assets.

You can never know exactly what a bank holds – they are too gigantic and complex – but these have a long-held reputation for restraint and careful management that we respect. They stick to what they know in markets they understand.

There are still risks in the emerging markets, however. Tightening US monetary policy means there are fewer dollars to go around. And that is typically hardest on developing nations.

Also, if trade is choked off by an escalation in US tariffs it will be trading nations – many of which are emerging markets – that take the largest hit to GDP growth.

We believe there is too much at stake on both sides of the Pacific for China and the US to get into a protracted trade war.

China needs to keep exports flowing and its people employed as it tries to transition to a more services-led economy; the US has become accustomed to cheap prices on everything from mobile phones to microwaves, courtesy of Chinese labour.

We could be wrong, however. That’s why we’ve recently renewed our put contract on the S&P 500. This will protect a significant portion of our equities if the American market corrects.

We don’t expect this to happen though, it’s an insurance policy. We are giving up a little of our returns now so that we can avoid the worst if markets go south.

David Coombs is Rathbones Multi-Asset Portfolio funds manager