BlueBay AM: Turkish bath

BlueBay AM: Turkish bath

March 26, 2021

Monetary policy
Turkse vlag.jpg

By Mark Dowding, CIO at BlueBay Asset Management

Markets wait for the steam to clear after a week of headlines from the central bank.

In a quieter week in developed markets, events in Turkey stole the headlines following President Erdogan’s surprise decisions to remove the head of the central bank. Under Agbal’s leadership, the Central Bank of the Republic of Turkey had hiked rates by more than 800bps over the past six months, showing resolve to bring down inflation, which had led to a rally in Turkish assets. 
 
However, Erdogan himself has never liked the idea of higher interest rates, given the restraint this imposes on the economic outlook. Indeed, he (and his acolytes) have espoused the notion that high inflation is actually the product of high interest rates, which certainly isn’t a theory you will find in many economics textbooks! 
 
Consequently, the decision to remove Agbal and appoint new governor Kavcioglu has seen investors seek to pull out of Turkish assets, fearing a path that will lead to higher inflation, deposit flight, a potential balance of payments and a funding crisis. Forward FX rates in Turkey depreciated by as much as 20% on Monday, with sovereign credit spreads around 150bps wider in a rush to the exit. 
 
This saw some limited spill over into other emerging markets and pushed Treasury yields a little lower on flight-to-quality flows. However, the very Turkey-centric nature of this shock has meant that there are relatively few parallels or ramifications for other markets, with direct overseas banking sector exposure at relatively limited levels. Investment grade corporate credit spreads have widened slightly at an index level as government bond yields have firmed, but with equity indices still not far from record highs, it seems that there has not been too much to drive further weakness.
 
Economic overview
 
Generally speaking, the macro backdrop continues to be dominated by prospects for robust US growth in the months ahead and it appears that Q2 could well record a double-digit pace of expansion. The US economy continues to re-open, with everyday life normalising as quickly as the weather is improving. Upbeat data is already expected by markets. Consequently, a further material move upwards in Treasury yields may be contained until more tangible evidence of higher inflation emerges. 
 
In the interim, it seems unlikely to us that rates will be able to rally very much against the bullish growth backdrop. In this context, risk assets may benefit somewhat, after the loss of liquidity around quarter-end and the Japanese fiscal year-end is out of the way. Nevertheless, as any rally seems to be dependent on ongoing stability in yields, it is hard to express much conviction with any confidence.
 
Currency directions
 
One area where we have recently increased conviction is with respect to direction in FX markets, where we now see a clearer path to dollar strength in the coming weeks. The US dollar weakened materially in 2020 but a return to US growth exceptionalism calls this underperformance into question. With the yield gap between 10-year Treasuries and 10-year Bunds at 200bps, we see scope for robust US data to drive the euro down to USD1.15 or lower over the next few months. 
 
We are at a point when the divergence between the respective economies may be at its greatest, with European growth forecasts more at risk of being revised lower as the Covid third wave sweeps the Continent and sees national governments tightening restrictions on mobility and economic activity. 
 
Ultimately, we would be more confident of the EU getting its act together with respect to the vaccination programme in the months to come; by the end of 2021, it seems likely that the world may be awash in an abundant supply of vaccines. However, recent mis-steps and a spat with the UK over vaccine exports means that, in the near term, sentiment remains fragile.
 
Beyond the US
 
Eurozone sovereign spreads remain rangebound. Evidence of increased PEPP purchases by the ECB was greeted with relief by fixed income investors, yet it is also understood that a wind-down of the PEPP may begin in 12-months from now. In this context, it is difficult for spreads to rally very far for the time being. 
 
A similar pattern is seen in corporate credit, with spreads trading in a range at relatively tight levels. A backdrop of ultra-low yields may continue to see a bid for credit given the hunt for yield, which seems unlikely to dissipate. However, with plenty of supply to sate demand, it seems as if spreads at an index level can remain range bound, with greater potential opportunities at the sector and issuer level.
 
In this context, we continue to favour subordinated financials and corporate hybrids. Buying the junior debt of solid investment grade-rated issuers seems an attractive path to enhance yields, in our view, and we continue to look for opportunities both in primary issuance and the secondary market.
 
Sentiment across emerging markets was adversely affected by developments in Turkey during the week. Limited liquidity in the FX forwards market means that some investors will undoubtedly remain trapped in long positions and so have needed to de-risk portfolios elsewhere. 
 
Meanwhile, the rising threat of sanctions risk has weighed on Russian assets, while a softer oil price has been somewhat detrimental to commodity-exporting countries. As a result, hard currency EM indices are nursing losses of 4% year-to-date, whereas returns of -6.5% have been recorded in local market indices. 
 
In addition to country-specific events, a trend towards higher US rates and a firmer dollar both present headwinds to emerging economies – we continue to see those countries dependent on importing overseas capital to meet their financing needs as potentially vulnerable. This said, a stronger global economy should ultimately favour much of EM. From this point of view, the cyclical, value-oriented aspect of the asset class could mean that a lot of bad news is now already in the price, at a time when valuations on some other asset classes seem to defy logic.
 
Looking ahead
 
The Easter holidays will make for a shortened week ahead. Payrolls are released next Friday and we see scope for a material surprise to the upside, as the labour market clicks back into gear. In months to come, there may be ‘one million plus’ months, with respect to jobs added and we foresee the unemployment rate falling to 4% by the end of the year. 
 
We see US yields moving to new highs in April, but with 5-year, 5-year forward rates already above 2.5%, so this will likely lure buyers and limit the speed and magnitude of moves for the time being, until such a point when market complacency around low future inflation rates is called into question in a few months from now.
 
A new calendar quarter may see renewed demand for risk assets, though broadly speaking we tend to view corporate and sovereign credit spreads as broadly within a range. Currency markets could see larger moves if we are correct in the view that this is the place where valuations have the most scope to normalise. 
 
Otherwise, events of the past few days serve as a reminder of the risks and also the opportunities to be had in EM-related assets. 
 
In Turkey, it may feel like we have taken a trip to the baths, had a pummelling and are now waiting for the fog in the steam room to clear. However, in a world where rates in developed markets are materially depressed and valuations in many asset classes are looking pretty full, we believe that it continues to be attractive to identify opportunities, particularly at a time when prices may be falling for no fundamental reason and may just be re-pricing on contagion fears. A Turkish bath always leaves a ‘hammam very clean’ feeling and in financial markets the same may also be true.

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