Look out for Emerging-Market Contagion Effects

Even though summer technically lasts until Sept. 21, the reality is that after Labor Day, markets often snap into a hectic fall mode.

A recent Reuters article notes that, “President Donald Trump’s relentless “America First” trade push is hurting confidence in many countries, rising U.S. interest rates are putting strains on emerging economies and currency problems have hit crisis levels in Argentina and Turkey.”

When considering the markets over the last few weeks and seeing how the Turkish lira in particular has fallen 40% against the dollar since the start of the year, I started thinking back to my first job on Wall Street.

At the time, I was earning my degree in mathematics. And my senior thesis was on chaos theory.

Chaos theory aims to find “hidden order” in a seemingly chaotic environment. This hidden order is often reflected in symmetry and in repetitive events.

Within the field of chaos theory is a subtheory called the butterfly effect.

Built upon the math and science behind it, the main idea is that small changes somewhere can lead to drastic changes elsewhere over a given period of time.

The shock waves of the butterfly effect and its ripples don’t follow a straight path from one point to another. Instead, changes unfold in a more hectic or chaotic manner. For example, a hurricane in China can be connected to a butterfly flapping its wings in Brazil.

Applying this theory to financial markets, what Wall Street was learning back then is something that matters even more to markets today: that associated data, numbers and markets are all connected — and not always predictable.

With respect to markets, Wall Street discovered there are more than just mathematics driving behavior. Added into the market equation are factors such as human nature, the media, leverage, speculation, the cost of capital and geopolitics, to name just a few.

When the Turkish currency dropped by 20% alone in mid-August, it shocked the financial system.

What we saw was the “Turkish butterfly effect” as part of the reason that Wall Street’s major indexes have been jumping up and down over the last month.

On Aug. 13, Turkish President Tayyip Erdoğan started throwing his weight behind the latest trade war skirmish by declaring that Turkey would boycott electronic products from the United States.

The very next day, investors saw global markets sink as the lira plummeted, causing more foreign investor capital to leave Turkey.

The belief became that the lira was far from hitting its lows versus the dollar and that the Turkish central bank wouldn’t (or couldn’t) raise rates enough to stabilize its currency.

Turmoil and confusion had officially erupted in Turkey. While the Turkish currency temporarily stabilized, the worst is far from over.

By Aug 23 the lira resumed its dive and continued to show signs of weakness.

In many ways, President Erdoğan did exactly what the Fed and the European Central Bank (ECB) have done for a decade. He advocated for his central bank to lower rates and offer up cheap lines of credit.

The major difference from Europe and the U.S., however, is that Turkey’s central bank action led to more acute consequences.

It caused 16% inflation and a seismic current account deficit because foreign money zoomed in for the good times and out for the bad.

Loans were taken out in dollars and euros to finance companies and expensive projects across the country.

Now with the Turkish currency dropping and many of the country’s loans coming due, outflowing money means that Turkey’s problems will only get worse.

Turkey will be forced to reckon with how to repay debt amid rising interest rates and a diving currency.

In addition to the free-falling lira, Turkish companies are operating under the weight of an estimated $220 billion in foreign corporate debt. The harder that becomes to service, the more likely companies will default.

Sweeping defaults in Turkey, should they occur, would not be an isolated event. On a global scale, banks around the world, particularly in Europe, still have exposure to Turkish corporate debt.

Defaults would cause shocks across European banks, already beaten up by the Turkish situation, and ripple over to U.S. banks with greater exposure to Europe.

Adding more to the economic pain, President Trump had handed Turkey a death sentence by doubling the aluminum and steel tariffs (to 20% and 50%, respectively) that the U.S. imposed upon imports from Turkey on Aug. 10.

According to one report, “The United States is the fifth-largest country where Turkey exports its goods and trade volumes amounted to $20.6 billion in 2017.”

While this might seem to be more of Turkey’s problem, and a tactical move by Trump, it is more complicated than that.

Building from the butterfly effect, U.S. construction and engineering companies could see the cost of steel rise due to a lack of supply. That could induce them to cut American projects and American jobs to compensate.

Why Does This Matter to You?

If Turkish imports dry up, associated companies could default on their debt, causing negative impacts on the levels of stocks, some of which could be in your portfolio or attached to your 401(k) plan.

The butterfly effect in Turkey could alter the financial weather in Kansas, Ohio or Massachusetts.

That’s because major investors that have money tied into local Main Street economies have also invested in emerging markets (EM) — like Turkey.

If those investors decide to pull their investments or stop investing in EM economies, the risk is that they could back away from stock investments altogether to protect their money — triggering a broader crisis of confidence.

My colleague Jim Rickards has been on the front lines warning about how big names are increasing their cash allocations.

EM chaos could further such efforts as investors look for reduced portfolio volatility. As it stands, the crisis in Turkey appears to have more teeth and staying power. In part, that’s because end of summer trading is thin, meaning rumors and fear play larger roles.

However, it’s also because Turkey has major geopolitical ties with the rest of Europe.

As with Greece, those fears could travel throughout Europe and spread globally. Some already have.

What Turkey symbolizes is larger systematic instability. Central banks don’t like chaos.

What we saw following the 2008 financial crisis was trillions pumped into markets “to help the economy” and to reduce market fears.

With money at such low rates, governments could borrow for the future to pay for present costs. Corporates could do the same, as could consumers. The world became saturated in cheap debt.

Because debt was so cheap, the interest paid by government and corporations was also low. That meant investors and speculators had to pile on more and more risk to get higher returns. This is what has translated into one of the major drivers of the bull market we’re in today.

But at some point, an impasse between debt and stability will be reached.

As tension builds and markets remain volatile, questions will build around the Fed’s pivotal decision whether to raise rates or pause them when it meets on Sept. 25.

The Fed doesn’t just look at growth figures, inflation statistics and even jobs numbers. It undoubtedly is aware of liquidity and markets.

If Turkey ignites what’s already a looming debt crisis, the Fed may have no choice but to wait on raising rates.

Regards,

Nomi Prins
for TheDaily Reckoning