August always carries an extra risk for markets as trading floors — and liquidity — thins and this year the plunging Turkish currency has delivered a real crisis.
But the lira is not the only item on the investors’ list of August risks. US sanctions against Russia and Iran, escalating US-China trade tensions and the impending publication of a budget by Italy’s populist government are all unsettling.
If a hardening approach from the White House to sanctions and tariffs is proving a key driver this month, US markets have been spared the turbulence. An index of the dollar against its peers this week soared to a 13-month high while the S&P 500 is close to topping January’s record high.
The outperformance of the US is a reminder of a constant theme this year: that the American economy is outgunning major competitors and the Federal Reserve is raising rates while other central banks are tiptoeing away from quantitative easing.
That has left investors quick to exact punishment on other markets — particularly, as in the case of Turkey — when their problems are largely homemade.
While the Turkey crisis is fast-moving, yesterday’s turbulence was enough to hit the euro and European banks, as investors fretted over the fallout for the region of a tumbling lira and the darkening outlook for the Turkish economy.
“Perceptions are always key for market participants and investors,” said Stephen Gallo, forex strategist at Bank of Montreal, adding that eurozone trade with Turkey is small while eurozone banking claims on Turkey in the first quarter were not particularly significant.
“In the context of low bank profitability and the eurozone’s minimal resilience to shocks, the direct financial exposures of eurozone banks to Turkey matter more, especially for the euro.”
The Turkish crisis is also unfolding at a time when political tensions in Italy are returning to challenge the eurozone. Italian bonds lagged behind other markets yesterday with the yield on the benchmark 10-year bond jumping almost 10 basis points to 2.98 per cent.
Turkey’s travails underline that, in August, geopolitics are proving the catalyst for unease. But as currency strategist Simon Derrick of BNY Mellon said: “If there is a common theme, it’s not always US-related. It’s about frictions on one kind or another.”
Worries about China, Russia and Turkey could be sourced to US protectionism and sanctions, he acknowledged, but there are other contentious developments causing angst, including Brexit and the dispute between Saudi Arabia and Canada.
If a eurozone whose economy has lost momentum proved vulnerable to Turkey stress yesterday, the stand-off between President Recep Tayyip Erdogan and investors also rippled out to other emerging markets.
The JPMorgan EM currency index plunged this week, falling more than a full percentage point between Thursday and yesterday alone.
“Contagion is a word being thrown around a lot,” said Jane Foley, strategist at Rabobank. “On top of the already significant concerns about trade wars and dollar funding, [the lira’s slide] is really turning the screws. It’s one more reason not to own EMs.”
The escalating trade war between the US and China has hung over EMs all year, adding to the pain inflicted by rising US interest rates and the strengthening dollar.
JPMorgan’s EM currency index is 12.5 per cent below its January high. The MSCI EM equity index is down 16 per cent. Sovereign bonds are down 4 per cent and local government bonds 11 per cent, according to JPMorgan indices.
“As long as the Fed is going to raise rates twice more this year, it is very hard to see a reversal of the march into the US dollar,” Ms Foley said.
While the chaotic drop in the lira hurt other EM currencies, analysts cautioned against concluding that the contagion will be significant and lasting.
For a start, the lira is just one of 10 components of JPMorgan’s EM currency index, with a weight of 8.33 per cent, compared with just 0.55 per cent in the MSCI EM equities index.
Any fall in the lira, especially in conditions of tight liquidity, can exaggerate the effect.
As the Turkish lira plunged against the dollar yesterday, the moves in other EM currencies were far more muted.
The Russian rouble fell 1.5 per cent in dollar terms before paring its losses, the South African rand was off 3 per cent and the Mexican peso down 0.6 per cent.
“The time when the Brazilian real fell because the Argentine peso fell has long gone,” said Paul McNamara, EM bond and currency strategist at GAM Investments. The EM sell-off, he said, was not really about Turkey but about the continued strength of the dollar.
That said, a particularly messy conclusion to Turkey’s crisis — capital controls, for example — could unleash more pressure on other EMs.
“If Turkey ends up doing capital controls, markets will ask who’s next? Pakistan? Russia?” said Charles Robertson, chief economist at Renaissance Capital.
“They will ask whether it isn’t trade being hit by the reversal of globalisation seen in Trump’s trade wars but the free movement of capital.”