View on Russia & Turkey

 

Before we dive into the details, it is essential to understand that what is driving the negative performance in one country is likely to be very different from those in the next country. In other words, this is not the “EM Contagion” effect of the old days, rather these are a set of challenges unique to each country that are coincidental rather than systematic.

 

 

 

 

 

 

Russia credit spreads vis-à-vis the BM spread evolution YTD began the year trading in line with the index, then meaningfully spiked in April as new and unusually harsh targeted sanctions were levied by the US against certain Russian individuals and selected corporates. We then saw a meaningful spread recovery in May through July where Russia outperformed the index. That reversed again this month as threats for new sanctions were rumored and turned into fact with last week’s announcements by the US Treasury.

 

 

 

 

 

The new sanctions announced last week were for the most part a reaction to and condemnation of the alleged biological weapon attacks against a former Russian Spy in the UK earlier this year. These sanctions were expected, and are mostly focused on certain hi-tech exports to Russia that will have less of a material impact, and are meant to send a “message” to the Russians. The more concerning aspect of the US Treasury announcement is that they left the door open for further more aggressive sanctions that could begin to target certain aspects of the banking sector. The US wants to see Putin et-al change their ways, something that is unlikely to happen. What that means is that we will have to prepare ourselves for additional sanctions ahead.

 

 

 

 

 

 

We are currently running a „Market Weight“ in our EM Defensive strategy and an “Underweight” in our EM Opportunistic strategy.

 

Current security selection in both strategies reflects defensive sector allocation (no bank exposure) and higher credit quality. The underweight in the Opportunistic strategy clearly helps, and hence we are outperforming the BM by 6bps. In the Defensive Strategy, we are comfortable with our current market weight given the conservative security selection. This positioning, however, is something that we will continue to review for its appropriateness in the current environment. Nonetheless, given that the high quality names we do own in the EM Defensive strategy (Gazprom, Lukoil, Severstal, etc), we have the ability to adjust our positioning under most market conditions.

 

Conclusion: While these developments are clearly negative and are unlikely to go away anytime soon, we do take the view that geopolitical realities ultimately give both Putin and Trump a strong incentive to get to a better place over the next few months. Talks of potential mutual state visits between both Presidents are reflective of the fact that both sides have more to lose than to gain by not reaching some sort of acceptable compromise on a variety of issues. While that compromise is unlikely to include the Russian annexation of the Crimea, any meaningful progress on other issues could give the US Congress a reason to wait before implementing further sanctions.

 

 

 

 

Turkey is a vastly different story and one that we are truly worried about. The below credit spread evolution year-to-date shows are near 300% increase in the Turkey risk premium since the beginning of May.

 

 

 

 

 

 

While there are many issues in play here that are individually contributing to this rapid rise of Turkey’s credit spreads, they all have one common denominator – which is President Erdogan who is rapidly concentrating his power base. The snap elections he held in May were designed to only further solidify his political support. Since then, monetary policy has ceased to be independent from Erdogan’s wishes. The recent Central Bank of Turkey’s (CBT) decision to not hike rates in the face of rapidly increasing inflationary pressures only confirmed the CBT’s unwillingness to take decisive action contrary to Erdogan’s wishes precisely when it is needed the most.

 

If that wasn’t enough, Erdogan’s other actions (such as purchasing a Russian anti-aircraft missile system, arresting a US Pastor in Turkey, etc.) may in fact translate into real US sanctions against Turkey – a highly significant move between two “Nato-partners”.

 

The resulting impact on the FX markets has been nothing short of brutal, with the Turkish Lira losing more than half its value vs the US dollar.

 

 

 

 

 

Turkey is a country that his highly sensitive to not only US rates, but also to the USD and euro given the size of its external deficits that need to be funded in the hard currency markets. This sensitivity is even more acute in the Turkish banking sector, where the loan-to-deposit ratio exceeds 100% (which requires banks to fund a portion of their balance sheets in the wholesale markets via issuing bonds in the external markets).

 

Why does that matter? It is highly unlikely, if not impossible, for Turkey (sovereign as well as banks/corporates) to be able to come to the international debt markets via a bond transaction without a significant change in market tone and much improved headline news flow. Even if it could do so, this funding has now become incredibly expensive in Turkish Lira terms. In the meantime, the asset quality of the Turkish banking sector is deteriorating as non-performing loans are rapidly on the rise. This is reflected in the trading levels of Turkish sub-debt bank debt which now yield well over 20% – the same bonds had a yield of 6.5% at the beginning of the year.

 

 

 

 

The current situation is unsustainable. If meaningful new US sanctions were to emerge along with further FX weakness, then the risk of defaults or forced restructurings in the banking sector becomes increasingly likely. While we don’t think a sovereign default is currently a realistic scenario over the foreseeable future, possible IMF support in case of a liquidity crisis is also unlikely without significant policy adjustments. Consequently, we are currently significantly “Underweight” Turkey exposure and expect to remain that way over the near term, absent a dramatic change of events.