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On the latest edition of Market Week in Review, Senior Investment Strategist Paul Eitelman and Consulting Director Sophie Antal Gilbert discussed the Turkish financial crisis, its impact on emerging markets and whether or not the turmoil could disrupt U.S. markets.

Significant market volatility still a risk as Turkey grapples with crisis

Turkey’s currency crisis is largely a result of its overheating economy, Eitelman said, noting that the nation is running a 6% current account deficit as a share of its gross domestic product (GDP). “Essentially, what this means is that Turkey is very reliant on foreign money to sustain growth—which in turn makes the country very vulnerable to changes in investor sentiment and capital outflows”, he explained. Recent strains in the country’s relationship with the U.S. have helped spark a flight of capital assets, Eitelman said.

There were a few positive developments in the situation the week of Aug. 13, he noted, including the Turkish central bank’s announcement that it would step in to provide liquidity to domestic banks. In addition, Turkey has also been attempting to clamp down on the ability of investors to short the Turkish lira—a resolution which has stemmed capital outflows a bit, Eitelman noted. “Collectively, I believe these developments probably don’t go far enough in solving the fundamental economic issues in Turkey”, he stated, adding that aggressive interest rate hikes are probably needed to get a better handle on the situation. In addition, Eitelman noted that the Aug. 16 threat of additional sanctions against the country by the U.S. has served to sour the mood again.

“All things considered, we’re probably not out of the woods yet as it relates to Turkey, as the potential for significant volatility going forward remains,” he concluded.

Emerging markets react to Turkish financial woes

Broadening the conversation to emerging markets as a whole, Eitelman noted that the impact of the Turkish crisis hasn’t been uniform throughout. “From a contagion perspective, Turkey represents less than 1% of the MSCI Emerging Markets Index—so, unsurprisingly, the effect there hasn’t been that significant,” he remarked. However, the turmoil has rippled into emerging market economies with similarities to Turkey, such as South Africa and Indonesia, Eitelman said. “At Russell Investments, we’ve noticed that nations like these—that run similar large current account deficits and are likewise vulnerable to capital outflows—are also experiencing some pressure on their currencies in the wake of the Turkey crisis,” he stated.

The financial woes in Turkey have also caused a little stress in Europe, Eitelman said, because some European banks (especially those in Spain) have exposure to Turkey, due to loans they’ve extended to the country. However, he pointed out that these loans tend to amount to less than 5% of European bank capital. “With this in mind, I don’t think there’s a systemic risk to Europe”, Eitelman said, “and furthermore, it looks like the European economy is holding up reasonably well”. Second-quarter GDP growth in the region was recently upgraded to 2.2%, year-over-year, by Eurostat, he said.

Meanwhile, in China, the situation is a little more mixed, with a bit of deceleration in the country’s recently-released retail sales and industrial production numbers for July, Eitelman said. “Context is key here, however, as this deceleration was from a GDP growth rate of roughly 6.5% to about 6%,” he said, “so, while it’s a step down, broadly speaking, economic conditions still look good overall in China.”

U.S. economy churns on

Turning to the U.S., Eitelman said that the country continues to look very resilient to the turmoil in Turkey. “The retail sales numbers for July were really encouraging—even outpacing economists’ expectations”, he said, “while the corporate sector has been generating really strong earnings growth”. In addition, preliminary numbers for August surrounding business sentiment still look quite positive, he added.

“All things considered, I would suspect we’re on pace for another strong GDP number in the U.S. this quarter”, Eitelman said—“perhaps at the level of 3% or slightly less”. The nation’s economy, he stressed, still looks like it’s on rather firm footing.

Watch the video or listen to the podcast.