The Real Lesson from Turkey’s Crisis

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 14, 2018, 12:25:47 PM

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Turkey's crisisAs Turkey’s crisis rumbles on, investors are on the watch for signs of contagion. Emerging markets in general are getting hit, so contagion remains a possibility. Still, there are reasons to believe the crisis will burn out in Turkey itself.

Turkey is an outlier

The main reason the crisis may not spread is that Turkey is exceptional in many ways—none of them good. It has borrowed more, as a percentage of its economy, in foreign currencies than any other country. There are only a handful of countries that are even close, including Hungary, Argentina, Poland, and Chile. Recently, its central bank effectively lost its independence and is now politically unable to take measures that might mitigate the crisis. In other words, Turkey is both more exposed and less able to do something about it than any other country. Notably, while the other exposed countries are also taking hits, no country is as bad as Turkey. Turkey is an outlier.

Other countries are also suffering, of course, but they are doing something about it. Argentina, for example, has seen its currency decline. But its central bank is raising rates, which appears to be constraining the damage. Emerging markets in general are seeing the same reaction. The damage is real and substantial, but it doesn’t yet seem to be spreading in a systemic way. We will keep watching, of course. But at the moment, the crisis seems to have paused—and may well subside instead of spreading.

Emerging markets are changing

If there is no systemic spread, problem solved, right? Yes, in the short term. But I think the real lesson of the Turkey crisis for us as investors extends well beyond whether we get yet another meltdown in emerging markets. Instead, it points to a real change in the nature of emerging markets in general—one that investors should be very aware of.

First, the Turkey crisis wasn’t supposed to happen. Nothing new there—no crisis is. But the narrative around emerging markets is that governance has improved enough that we were not going to see some of the historical problems come up again. Markets were supposed to discipline governments, and governments were supposed to have learned their economic lessons. Turkey shows us that both of those assumptions are wrong, in one very significant case. Signs are they might be wrong in others as well.

Second, and even more important, the growth and attractiveness of emerging markets to investors lie in the assumption that they will be able to trade within a global community and will be able to rely on that community for support and assistance when necessary. The Trump administration’s decision to impose tariffs on Turkey in the middle of its crisis calls the second assumption into serious question, and the whole ongoing trade war calls the first into question as well.

In other words, perhaps emerging markets are not as solid, as political economies, as investors had assumed. Perhaps the environment that supported the positive changes is now eroding. These two components are the real foundation of what makes emerging markets attractive as investments in the first place. The progress over recent decades and the investment returns have been real. We need to pay attention to whether that trend is changing.

What does this mean for investors?

To be clear, I don’t think the trend is changing—yet. There are many emerging markets where governance remains effective, where policy is supportive of investment, and where it makes sense to be invested. We do, however, need to be more selective in what we do and not just make broad bets on an asset class. Going forward, investing in emerging markets will be more complicated and difficult than it has been over the past decade or so. As investors, we need to pay attention and to be thoughtful and careful.

Mind you, that should always be the case.

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