HIGHLIGHTS OF THE WEEK
- Concerns about Turkey drove market volatility this week, but U.S. equity markets managed a rebound.
- Strong retail sales and historically-high small business optimism suggest a strong economic expansion in the U.S. this quarter.
- Although concerns eased by week’s end, Turkey is not out of the woods yet. It remains in the early stages of a balance of payments crisis, and is likely to trigger further bouts of market volatility.
Markets Brush Aside Emerging Market Fears For Now
Concerns about Turkey drove volatility in global financial markets this week, but U.S. equity markets rebounded as contagion fears diminished. A key factor driving emerging market concerns is the strong U.S. economy. Robust economic growth and rising interest rates favor U.S. assets, and the safe haven flows driven by emerging market fears drives dollar strength (Chart 1). This week, we received further affirmation that the U.S. economy is on course to post another strong showing this quarter. Retail sales, a key indicator of consumer spending, expanded 0.5% in July, well above expectations (Chart 2). Moreover, despite trade policy uncertainty and ever more acute labor shortages, small business optimism remains at a historical high. Although housing starts in July were somewhat disappointing, the combination of strong permits and rising wages should support a gradual uptick in construction in upcoming months.
As the U.S. economy hums along nicely, other economies are not faring so well. Turkey experienced a large selloff of assets and the lira as it failed to take action to calm debt fears. Last quarter, concerns about the financial outlook for Argentina drove a dramatic depreciation in the peso, forcing the central bank to raise domestic policy interest rates to 40% in an attempt to slow capital outflows. Like Argentina, Turkey depends heavily on foreign capital to finance domestic spending. Moreover, President Erdogan has weakened Turkey’s political institutions and refused to allow domestic interest rates to rise. This has amplified concerns that Turkey is headed for a debt crisis.
Like Argentina, Turkey is too small in the scope of the global economy to trigger a broader global crisis. Turkey’s economy is responsible for about 1.7% of global annual output (2016 purchasing power parity), a little more than Canada at 1.4%. Contagion risk via trade linkages is low, although Europe is most exposed. Similarly, financial contagion is limited, with Spanish, Italian, and French banks at risk to lose a tiny proportion of foreign loans.
That said, contagion to other economies can still occur through confidence and sentiment channels. That was evident this week with the turmoil in global financial markets that drove a selloff in risk assets and emerging market currencies, and a bid for developed market bonds. Further bouts of volatility are likely as emerging market economies with large imbalances are targeted one-by-one by increasingly discerning investors.
Although concerns eased by week’s end, Turkey is not out of the woods yet. It remains in the early stages of a balance of payments crisis. A sudden stop to capital inflows has occurred, and the next step for Turkey involves spending cuts and an emphasis on boosting exports to help generate foreign currency required to pay for its large external obligations. The medicine will be bitter, but the sooner Turkish authorities follow through with interest rate increases, capital controls, and fiscal spending cuts, the more likely they can mitigate the economic fallout.
Fotios Raptis, Senior Economist | 416-982-2556
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