The Risk Posed By Europe & A Downgrade Of Turkey
Russ Koesterich: |Call #1: Despite some progress in Europe last week, elevated Italian and Spanish bond yields still remain a risk to the European and global economies.
Europe’s two-year tradition of failing to adequately act continues. The announcements last week by European institutions were a step in the right direction, but they failed to settle whether Europe will be able to tackle its longer-term, sovereign debt problems.
On Thursday, the European Central Bank took a number of steps to ease monetary conditions. The ECB lowered rates by a quarter percent and, more importantly, extended the period that banks can obtain loans to three years from 13 months. The latter action will provide a funding source for European banks now that US money market funds are no longer willing to buy European banks’ obligations. However, the ECB didn’t provide a plan to buy more Spanish and Italian debt, which is what the market really wants to see.
The drama continued on Friday, when European politicians discussed their plans for fiscal integration, describing how they are inching toward common budget rules and more fiscal discipline. While the plan appears sensible over the long term, it’s still a vague roadmap. With so much still left unanswered, figuring out fiscal integration will carry over into 2012.
As a result, very elevated Italian and Spanish bond yields remain a short-term risk for both the European and global economies. If Spanish and Italian bond markets remain under pressure, it’s still not clear that the European Union will have the necessary time to implement the fiscal integration they are envisioning.
Call #2: Lower to neutral on Turkey
Since I first advocated an overweight to Turkey and the iShares MSCI Turkey Investable Market Index Fund (NYSEARCA:TUR) in February, the country has underperformed other emerging and developed markets. I’m now moving to a neutral stance.
1.) A change in Turkey’s inflation outlook. The primary reason why I’m downgrading Turkey is the country’s changing inflation landscape. In February, Turkish inflation was a relatively modest 4%. Since then, Turkish inflation has accelerated to nearly 10%. This rise in inflation is arguably due to a combination of an overheating domestic economy, evidenced by a growing current account deficit, and very unconventional monetary policy. It also comes as inflation in most other emerging market countries is falling.
2.) Turkey no longer appears to be a bargain. In addition to higher inflation, Turkey no longer appears that cheap on a relative basis. The country is trading for about 9.5x earnings and 1.2x book value. This valuation is roughly on par with valuations for large, developed markets in Europe such as Germany and the Netherlands, and Turkey arguably should not be worth as much as them.
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments typically exhibit higher volatility.
Past performance is not indicative of future results.
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm (originally Barclays Global Investors) in 2005 as a Senior Portfolio Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several research groups focused on quantitative and top down strategy. Russ began his career at Instinet in New York, where he occupied several positions in research, including Director of Investment Strategy for both US and European research. In addition, Russ served as Chief North American Strategist for State Street Bank in Boston.
Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008, Russ published “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.