Turkey: Contained or Contagion?

Market risks often come from the most unexpected places.

Last week, a possible economic meltdown in Turkey rattled global markets. I wouldn’t have guessed that as recently as a week ago, and while I still think that Turkey won’t affect US markets too much more than they did Friday, I also wouldn’t have thought that problems in Greece would have created an existential crisis for the euro.

I am not an expert on Turkey by any stretch, but here’s my understanding of how the crisis unfolded in very brief terms. For the past 15-years, current President and former Prime Minister Recep Tayyip Erdogan steered Turkey through a wide range of reforms that grew real Gross Domestic Product (GDP) and cut inflation drastically.

After a failed coup attempt in 2016, Erdogan made several unpopular decisions, domestically and internationally, which he tried to offset within Turkey by forcing their central bank to cut interest rates and explicitly encouraging borrowing. Inflation surged, and the value of the lire fell, but his policies did lead to substantial borrowing, including from overseas lenders.

According to the World Bank, Turkey’s external debts are now almost 55 percent of GDP, which is the among the highest in the world. Much of the debt is denominated in foreign currencies like dollars and euros, which becomes increasingly difficult to pay as the value of the lire falls. The Turkish central bank estimates that more than a third of the debt is denominated in currencies other than the lire.

That brings us to this year when their burgeoning problem turned into a crisis. To start, Turkey relies heavily on foreign oil, which is dramatically more expensive this year for two reasons. First, oil prices are higher, but more importantly, oil is priced in dollars, and the dollar has been very strong. What is about a 10-percent hike in oil prices for us, is about a 60 percent increase for Turkey.

Then, tensions with the United States ramped up dramatically due to the detention of an American pastor and Turkey’s decision to use a Russian missile defense system. Turkey had already been the subject of the broad steel and aluminum tariffs, but President Trump authorized doubling those tariffs for Turkey.

In addition to the falling lire, Turkish bonds are selling off sharply, and the cost of insuring Turkish bonds is soaring. Turkish stocks are down by half so far this year.

But here’s the thing, we barely own any Turkish stocks and don’t have any Turkish bonds. Here’s our stock exposure: the exchange-traded fund (ETF) that we own for our exposure to emerging markets contains about 0.9 percent Turkish stocks.

Emerging markets are about five percent of our equity portfolio, which means that for someone that has a 100 percent stock allocation, the exposure works out to be 0.05 percent. If you have a 50/50 stock/bond portfolio, you can cut that in half.

The issue isn’t our direct exposure; it’s the indirect exposure. Banks in Europe have lent a lot of money to the Turks, just like they did to the Greeks. There’s still trouble in Italy, and if the Italians lent too much money to the Turks, problems could grow there and then hit Europe at large.

And, in a larger, but even less direct sense, the market is wondering whether Turkey is the proverbial canary in the coal mine as it relates to trade wars.

Turkey had problems long before the spat with the US, but other countries have trouble too. Investors the world over have been worried about China and their debt problem for years, and now wonder what a trade war could do. And then there’s Brazil, Argentina, Russia, etc. That’s why they call it contagion.

That said, most crises stay contained and don’t become a contagion. Yes, crises in Mexico, Russia, and Thailand all turned into major world events that hurt US stocks in a material way, but I couldn’t even begin to remember all of the times that it turned out to be nothing.

I don’t know what will happen with Turkey, but you might say that if I had a nickel for all of the flare-ups I’ve seen over my career, I’d have a lot of lire.