Turkish Bath or Turkish Delight?
TRY and FIT this to other markets
As the western summer chop continues with stocks strong to range bound, the market’s focus remains drawn to the fallout from Turkey and the Lira, the threat to the Euro and risk related assets and the associated strength of the Dollar and weakness of Gold. It is easy both to dismiss or over-estimate the significance of this ‘side issue’. The trade war remains the most important variable in what remains the key 1920s and 1980s stock market narrative to all markets. And yet, we believe, Turkey provides an important catalyst in the emerging index blowout into crash.
You may be bored of our continuous reference to the historical crash scenario. We certainly are. But we cannot ignore its importance now and later to all financial markets. It has been and will remain the narrative of the decade. Yes, it is taking longer than we originally anticipated. And yet not only is it still working (as evidenced by our January projection of stock consolidation before a further final blowout) but the more we compare the current market to those of the 1920s and 1980s the closer they appear. The coincidence of a trade war to all crash years is uncanny to say the least. In this context, The Turkish crisis could well be the trigger to get the market short and caught before the blowout, analogous conceptually if not technically to the June 1929 new high.
Our confidence in this view stems partly from our analysis of the individual stock markets and currencies that we cover but also particularly how the Turkish Lira is behaving. The Lira, like many exponential melt ups or downs, is following what is a fairly standard bubble (Rodrigue) model for emerging market forex that was developed by Kindleberger and Minsky.
It therefore highlights longer term opportunity not just in this market but also other EM currencies. It also explains how and why an abatement of the Turkish crisis will stabilise the Euro at the end of a downtrend sequence and assist stock markets into new highs.
Back in 2013 we highlighted how BRICS (Brazil, Russia, India, China and South Africa) appeared to be following a sequence set by the quantitative easing inspired Gold bubble.
The reason for this sequence helps explain how this approach is working and should continue to work.
In an increasingly small world, the relationship between markets is bound to get closer. It is easier and therefore quicker to move money from one similar or related asset and therefore currency to another in a bid to get a better return. The fact that investors or traders are aware of these correlations makes them self-fulfilling to some extent. And yet just as markets do not perform as many would expect so correlations are prone to vary and break down.
The rotation between stocks and indices in the last year is eloquent evidence of this and the fact they remain in the final leg of an historic market. But this nervous jumping in and out of assets also explains why contemporaneous correlations appear to have broken but many are still working over different time frames. An instrument may not move with a related market today but may still correlate in the next week or month or quarter or year. This can be extremely useful as rather than rush to put on a collection of trades simultaneously the trader can pick their moments in sequence. That is the story of emerging markets.
The details of Emerging Markets may not be uniform. The cause of EM economic growth or crises may be different. But how those markets perform later in highly volatile states as the Lira is now, is often governed by how they started but also the standard Rodrigue template either set or led by Gold. This is exemplified by the Lira where it is matching both the first leg and the entire uptrend or bubble.
Why? Investment/risk assessments by decision makers (investors/traders) during the early stages will often be systematically similar to those in the later stages even though volatility may be much greater. The nature of panic and greed does not really change.
Indeed this model was most eloquently outlined by Benoit Mandelbrot, Nobel Prize winner and father of fractals.
In The Misbehavior of Markets, Mandelbrot used the Sierpinski Triangle (the Matrix Logo) to show how a seemingly unique or independent first triangle (‘the initiator’) or market move helped define the further triangles and later marker moves and indeed the whole triangle (trend).. by what he called long term dependence. Many trends are characterised by their infancy.
Mandelbrot also showed that, by taking a random Brownian movement (called the Mother generator – a classic Rodrigue 3 legged or zig-zag move) two such generators/ initiators could, by incorporating time variation (Father generator), be transformed into a typical market move that looks suspiciously like an Elliott Wave trend sequence. It also accounts theoretically for why, for example, the stock index is taking longer than we anticipated and how the final leg can still be similar but extended in time and scale due to volatility. Esoteric or academic maybe. But it demonstrates how, through the use of logic and maths, disconnected market moves can help produce similar, predictable and therefore precise market outcomes whatever level of volatility.
On which note—what does the Gold template imply for EM currencies and the Turkish Lira in the shorter term?
Although we tend to think of emerging markets as one bloc, each country or bloc is distinctive at different stages of their economic development and prone to individual political influences. It is no great revelation to find some EM currencies in a similar place in the Gold template. For example, the South African Rand and the Brazilian Real.
And clearly the Polish Zloty correlates highly to the Hungarian Forint.
Nor is it unusual that countries will be very different positions. The way money flows in and out of a currency over a 5 year period can be compared to a 50 year period but where each currency sits in the sequence can be substantially different. The development of the Russian Ruble is so mature that it actually appears to be leading Gold in a cycle supporting our view that the current sell off in the precious metal will eventually fade into a bottom of some significance.
Perhaps more interesting from a global market perspective is the similarity between the Chinese currency and Gold.
And yet both the Indian Rupee and Mexican Peso appear so early in the Gold or Rodrigue template that there is insufficient evidence to be sure they really belong there.
The details of Emerging Markets may be extremely diverse but the buy-sell decisions and impact on price are more uniform as reflected by the similarity between some quite distinct currencies.
So what does this say about the Turkish crisis, the Lira and its possibly pivotal role in the global stock blowout?
Turkish Lira problems are not new even if they appear sudden. It has relied on foreign money to prop it up for many years in spite of persistent double digit inflation and calls for higher interest rates. The central bank’s failure to raise rates last month was seen by many as the last straw. So when Donald Trump escalated the heat last week by announcing a doubling of tariffs on steel and aluminium imports from Turkey, the currency literally took a Turkish bath. The lira fell 16% in one day.
The core problem is that President Erdogan will not raise interest rates to reverse the lira’s decline, nor will he release a detained US citizen. His finance minister (who is also his son-in-law) has stopped the depreciation by halting TRY shorting, and saying he won’t introduce capital controls. A rescue package of $15Bn from Qatar has helped. If Erdogan will not implement the obvious solution, he may have to turn to the IMF or even Iran for help, although he is unlikely to do this until the last moment.
If our somewhat brave view that the current crisis is a blowout (and therefore possibly the trigger for a return Euro stability and general risk appetite), then we need evidence beyond what appears to a complete trend sequence.
There are 3 factors that are consistent with the end of a crisis.
1. Price Stability.
A remarkably simple indicator of a reversal is that most EM currency tops (or bottoms) are soft. After exceptional crisis inspired currency weakness, a period of consolidation often marks a turn. This is extremely helpful as one doesn’t need to pick the end of the meltdown but wait for a reversal, a slowing of the price action and then fade the retest of the top (or bottom). The price action at the end of this week is consistent with such a turn and indeed the 2000 reversal in the Polish Zloty.
If the Lira follows a similar pattern then a reversal to 5.50-60 should allow a retest of the 6.40 highs and expanding top that then shifts the range to 5.00 in a slow nervous reversal.
2. Resolution and Containment.
In an interesting note from Citibank, they highlight a number of observations of what typically happens at an Emerging Market currency top.
Just as Turkish problems threaten European and to a lesser extent global markets so an abatement or indeed resolution produces a recovery. A Euro/DAX rally or a US stock market new high could prove to be leading evidence of a Lira reversal and Turkish delight.
Similarly other emerging currencies are a reverse indicator. The most vulnerable are typically those that combines a larger balance of payments deficit with a reliance on short term funding. With In this respect both the Czech Republic and South Africa stand out.
But it is the South African Rand has by far the highest contemporaneous correlation or beta to the Lira.
Although the longer term outlook for USDZAR is bullish, while the current rally holds below the January 2016 high of 17.76 then further consolidation is supportive of Turkish Lira stability.
With such volatility it is easy to get over-excited not just about Turkish prospects but the impact on other markets. It is tempting to seek specific news or an event that will either confirm or deny an end or deterioration in the Turkish crisis. As we saw with the Euro meltdown at the end of the Greek crisis in June 2014, markets can either lead or lag resolution. No news can be news in itself. Similarly the trigger for a currency crisis in South Africa or indeed new highs in the SPX can come from elsewhere. Both the Turkish Lira crisis and the US stock market uptrend appear to be in the last stages. The fact that Donald Trump now appears inextricably linked to both doesn’t mean he will stay that way or that either market will be influenced by the other. They could but that is just detail.
Here’s to making the very best.