A lot has happened since my last dispatch on the Three Phases Model. I’m asked frequently if it’s still in place and if I am still using this framework to guide positioning. In a word, yes, though unsurprisingly, markets are not evolving uniformly to one script, even a nuanced one. This week I’ll detail where I think we are in the evolution of the Three Phases, notwithstanding the continuous assault on it from the chaotic news flow.
As a quick reminder, so far this year I have characterized the shift from accommodative monetary policy to restrictive monetary policy as the single most important driver of markets for 2018, and that I envisioned this shift would unfold in three distinct phases over the course of the year. Below is a summary of how I anticipated it could happen (in a vacuum). The reality is much less clean and I’ll get to that, but in theory:
So then, in light of so many market developments which don’t appear to factor into the Three Phase Model, where are we? The chart below depicts several key variables as a percentage of their year-to-date high-low range, with the tighter financial conditions direction for each variable as higher on the chart. For the period between the peak in S&P 500 in late January (maximum looseness) until just prior to the Italy scare in late May, generally we had Phase 1-type price action across all components shaded in medium gray. It was a little noisy, but generally all lines trended higher, and the black line is the official GS Financial Conditions Index, scaled the same way. Then, when the Italy political scare happened, the correlation between bonds and stocks flipped back to what we would expect in Phase 2, right-way. So, rates went lower in yield during the acute bout of risk-off, and only when that risk-off abated did yields trend back higher, preserving Phase 2 correlation. Generally over the time period labeled as “Phase 2 ?” in dark gray, spreads and the dollar continue to trend higher while rates trend lower, and the broader Fin Con Index also trends higher/tighter. All of this is on-expectation for Phase 2. The outlier is, of course, US equities which have managed to escape my prescribed “weakness” during Phase 2. Earnings were just too good, and US economy’s intensifying outperformance versus all others globally has given strong support to US equities. Notwithstanding the equity strength, I still think we are in Phase 2, and we may be able to see further financial conditions tightening even without the participation of equity market weakness, especially if the dollar continues to strengthen. The DXY was at the year-to-date range top on August 13th, the final data point on the chart.
According to the way I laid out the transition from Phase 2 to Phase 3 in the model, it’s too soon to expect the broader relief rally of Phase 3, because pipeline financial conditions tightening is only modestly affecting the economic data quality. The Citi surprise index for the US recently turned negative, but only slightly:
Until it starts to affect the data materially, tighter financial conditions from here are still desirable from the Fed’s perspective, because the US economy continues to operate far above potential growth, and the economy is at or near full employment. So, I generally expect that we’ll remain in Phase 2 for some time longer.
There are some possibilities out there which could give us an early reprieve from the doldrums of Phase 2. None of them are good from a long term perspective, but again it would feel nice over the short term. First, if inflation pressure (and most importantly, the Fed’s expectation of imminent inflation pressure) is muted or weak, then that can still precipitate the dovish course correction even without further financial conditions tightening. Secondly and more provocatively, if the Trump administration via the Treasury were to take action to devalue the dollar through intervention, well that would do it. And thirdly (and most provocatively) if the president were to get more aggressive in his attempts to influence monetary policy which he’s done so far through a tweet and a CNBC interview, expect a rapid pivot to Phase 3.
Trade wars, sanctions, and the fraying of international security pacts, though they occupy a huge portion of the news flow bandwidth, are so far unrelated to the Three Phases, but I also think they are mostly unrelated to the price action I’ve described. Generally, and this is obvious by now, I believe that waning liquidity is the main cause of what we’re seeing, and it’s intentional on the part of the Fed. To the extent geopolitical noise exacerbates tightening of financial conditions, it would accelerate the move to Phase 3. The EM weakness is a separate issue, because as I suggested back in May, it’s likely a direct result of the financial conditions tightening in Phase 1 (and now Phase 2). Not so much the balance sheet unwind itself, but the combination of factors which led to tighter conditions onshore in the US, and then offshore for dollars, is especially painful for EM. Is it over? A move to Phase 3 would ease the pressure on EM. But between now and then, the factors at play which are headwinds to EM assets are still set to intensify.
“Respect the law”
The story goes that back in 2001 (on February 19th, to be precise), President Ahmet Necdet Sezer waved a copy of the Turkish Constitution in a National Security Council meeting and then threw it at Prime Minister Bülent Ecevit, demanding that he “respect the law”. Deputy PM Hüsamettin Özkan subsequently hurled the book back, simultaneously accusing the president of being “ungrateful”. When PM Ecevit left the meeting and called a press conference to announce that “there was a serious crisis at the top of the state”, markets tumbled. Interest rates shot up to +1000%, equities lost 15% on the day, and the Central Bank of Turkey (CBT) was no longer able to maintain the fixed exchange rate regime. Within days a severe economic crises had unfolded, as a banking and balance of payment crisis followed the devaluation of the Turkish lira (TRY). By May 2001, the International Monetary Fund (IMF) stepped in with a USD 19bn bailout, at that time the largest amount with respect to a country’s quota at the Fund.
While “the constitution throwing” incident is sometimes seen as the catalyst for the subsequent crises, the main underlying reasons instead lay in the country’s large macro imbalances that were not consistent with the fixed exchange regime. That the domestic crisis overlapped with the start of US recession in 2001 and broader outflows from Emerging Markets did not help. Against a less than forgiving backdrop, the market showed little tolerance for domestic political tension, and the subsequent crises. As the old adage goes, it is not the speed that kills but the sudden stop.
As then, Turkey’s current woes have little to do with the political crisis around the imprisonment of Pastor Brunson and the subsequent US retaliation. It is true that the pressure on Turkish external and local bonds and the TRY have escalated dramatically over the last couple of days due to increasing tensions with the US administration, but the real problem lies deeper.
Weak macro has been flagged for some time
Turkey has been flagged as one of the weakest EM credits facing tighter funding conditions for much of the year given its wide current account deficit (c.6% of GDP), large private sector USD liabilities (USD 325bn), and low international reserves position ( USD 80bn gross FX reserves and net USD 26bn). In addition, the economy has been overheating with GDP growth way above its potential (6% real growth on average over the last 3 years vs. long-term average of 4.5%) due to government’s domestic credit expansion via Treasury guaranteed loan facilities. Annual inflation has been one of the highest in the EM (15.9% as of July) and looks to continue increasing.
Although these fundamental challenges have been widely known by investors for a long time, Turkey has successfully muddled through the external shocks since the taper tantrum in 2013. Three recent developments changed the stasis and contributed to a rapid repricing of Turkish risk:
Few external backstops
A scarcity of backstops in this sell off further complicates the situation, thus prompting investors to price in fatter tail risks and worst-case scenarios. President Erdogan is strongly opposed to IMF-sponsored macro stabilisation programs and will therefore explore other routes before asking for the Fund’s help. Given the Turkish government’s deteriorated relations with both Saudi and the UAE over Qatar and Jerusalem, the probability of GCC support (minus Qatar) remains limited. China is unlikely to offer a blanket bailout, although might step in at a later stage in an exchange of assets at distressed valuations. Turkey is still important for the EU, at least for its role on controlling refugee flows and close economic links, but outright support without IMF-World Bank involvement seems unlikely.
This leaves us with the possible scenario of burden sharing with the local and external stakeholders before government steps in. After all, Turkey’s vulnerability is private sector leverage, rather than the sovereign balance sheet.
While the situation is still quite fluid, the government’s first response has been maintaining confidence in the banking system via Lira and FX liquidity injections and easing collateral constraints. This, however, may add more fuel to Lira weakness in the absence of marked tightening by the CBT, and/or a comprehensive economic plan to keep the sovereign and the banks’ access to the international capital market open. After all, the high refinancing need over the next 12 months is much higher than the CBT and authorities can plug exclusively with domestic funds.
There is a risk that the next reaction is of a less constructive nature. The authorities could choose to try tackling symptoms instead of causes, using regulatory and administrative means in order to mitigate the impacts of the ongoing economic and financial market pressures. Such a strategy could include inconsistent policies, such as fiscal stimuli or targeted loans for example, which would work against the adjustment required to reduce Turkey’s large and growing imbalances. In such a scenario, Turkish financial assets would remain under heightened pressure. Whilst contagion has been limited so far, Turkey is too large an emerging market to ignore, meaning spillover risks will have to be monitored.