It isn't every day that one thinks about the Turkish lira. The lira, however, has quickly become part of the market narrative, having collapsed on Friday to a record low against the U.S. dollar.
Lira weakness has been in the making for some time. Friday's collapse thrust the lira into the spotlight, showing that it could potentially invite bigger problems.
Actually, it was an article in the Financial Times that compelled market participants to set their sights on the lira. The article suggested the lira's weakness could be a problem for some banks in Europe that lent money to borrowers in Turkey.
The inference is that the weakening lira could increase default risk among Turkish borrowers who might not find it affordable now to repay euro-denominated loans.
Expanding on that idea, a market that didn't have much "new" news to think about got a little anxious and started to think about the prospect of a bigger currency crisis unfolding.
Today, we'll walk readers through that thought process in an effort to help them understand how the overall market can be impacted when the specter of a currency crisis slows things down for the bull market.
The weak lira has been a byproduct of bad policies in Turkey. We won't get into them here since our objective isn't to discuss how Turkey got where it got, but rather to examine what the market is thinking now that Turkey is here.
There is a lot of thought-based ground to cover so we will keep things brief, highlighting only the questions that most likely crossed the market's mind and took some wind out of its sails.
- "Could there be contagion risk?"
- "Will there be competitive devaluation?"
- "Will banks slow their lending activity, thereby contributing to a slowdown in economic growth?"
- "Will global economic activity slow because weaker currencies lead to higher inflation and higher interest rates?"
- "Will Turkey, and other countries with weak currencies, raise interest rates to keep capital from fleeing?"
- "Might there be a geopolitical conflict brewing since Turkey -- at odds with the U.S. -- feels like a disenfranchised NATO member and plays an important part in controlling the flow of migrants to Europe?"
- "Will a currency crisis lead to systemic financial risk?"
- "Is it time to shift to a more defensive-oriented investment stance?"
- "Might the currency problems elsewhere lead to undue strengthening in the Japanese yen that triggers a dislocation in global markets that is tied to carry-trade unwinding?"
- "Will the U.S. dollar continue to strengthen, creating an earnings growth headwind for U.S. multinationals, a competitive disadvantage for U.S. exporters, and a difficult repayment burden for foreign holders of dollar-denominated debt?"
- "Even if Turkey's economy isn't large enough to feed a global economic crisis on its own, might the collapse of the lira create a confidence crisis that drives other emerging market currencies into a downward spiral and fuels a global economic crisis?"
- "Will there be civil unrest that cuts across borders?"
- "How might this affect the outlook for monetary policy for the world's leading central banks?"
What It All Means
The stock market's knee-jerk reaction to the Turkish lira was not a positive one.
In fact, it held true to the form we thought it would take in a column we published at the end of June (Is a Summer Swoon Emerging?) that highlighted the weakness in the Chinese yuan and other emerging market currencies.
The Treasury market rallied, the U.S. dollar rallied, the financial sector fell as the yield curve flattened, the iShares Emerging Markets ETF (EEM 43.08, -1.05, -2.4%) underperformed, the cost of portfolio protection picked up, evidenced by the CBOE Volatility Index (13.60, +2.33, +20.7%), and stocks in general were sold.
There wasn't anything that was panicky about the selling activity in the U.S. market, other than perhaps by investors with short positions in the bond market, yet the reaction lacked the same level of complacency that had been driving the S&P 500 to the doorstep of its all-time high.
A currency crisis, whether it starts in Turkey or elsewhere, is a breeding ground of uncertainty that can be a dislocating factor for a bull market.
To be sure, it creates a lot of questions that don't always have easy answers. One might not have been thinking about the Turkish lira a day ago, but now that it is in the market narrative, consider it a story line that should give you a better appreciation for the risk of complacency.