The Weekly: Black Swan or Cygnet?


Experience teaches us that just as you think it is safe to relax, something is bound to come around the corner to surprise. This was exactly what happened towards the end of last week. Not only has the UK weather appeared to have reverted to norm for the school holidays, but we have a minor currency crisis going on in Turkey.

The sudden escalation of this followed the failure of a Turkish delegation to the White House with a remit to reach agreement on the release of a US pastor being held in Turkey on supposed links to the failed coup d’état in 2016. Exacerbating this is the refusal of the US to extradite Fethullah Gulen who was behind the so-called Gulenist movement, considered largely responsible for the coup attempt. In addition, US support for Kurdish rebel groups in northern Syria and Turkey’s closer ties to Russia haven’t helped. Pulling this all together amid suggestions that Turkey may close a Nato air base used to fight IS in the region and you have all the ingredients as to why the meeting probably didn’t go too well.

Literally the day after the delegation returned to Turkey empty handed, Donald Trump tweeted that he was doubling tariffs on imports of Turkish aluminium and steel, on top of those recently imposed. This, along with the broader spat served to weaken the Lira by 20% in two days. This then caused investors to panic that Turkish companies and banks, which are heavily indebted with Euro and US Dollar denominated debt, would fail to service that debt as the currency collapses. We talked about unknown unknowns at the beginning of last week and this serves to remind us how short a few days can be in markets. Market volatility as measured by the VIX rose by 30% on Friday illustrating the sudden realisation that this could be quite a big deal.

As with all events of this nature, it is important to keep things in perspective but also not to be too dismissive about the risks of contagion to other connected economies such as European Banks, which have exposure. Turkey’s economy accounted for 1.4% of Global GDP in 2017 and is the 17th largest according to the IMF. To put this in context, this is just above the Netherlands and Switzerland but just below Indonesia and Mexico within the G20. Relative to Greece, which is 53rd in the world economic league and 0.3% of Global GDP, this is a much bigger deal. Turkey, who is not part of the EU, has its own currency which is adjusting through depreciation and can be printed by the central bank if needed or bailed out by the IMF. So whilst this would qualify as a Black Swan event springing out of the blue from relative obscurity, for now, this is more of a cygnet. All eyes are watching to see what happens next.

Turkey is the sixth largest steelmaker in the world and exported 500,000 tons to the US in the five months to May. This compared with 1 million tons in the same period last year, is a sign that the current tariffs are reducing US exports already. Whilst unhelpful, there are many other markets for Turkish steel in the world and no commentators are predicting the demise of the Turkish steel industry. However, it has infected several Emerging Market economies and illustrates the potential economic consequences of falling out with the US. Whilst the issue has created some degree of turmoil in isolated market areas, we are not aware of any significant contagion risk as was the case with Greece and the linkage with the EU.

Sticking with the mighty US economy, the second quarter results season is now largely complete with over 90% of companies having reported. Of note is the fact that over 80% of those reports have exceeded forecasts which is being hailed as the strongest reporting season, relative to forecasts since the credit crisis in 2008. No doubt Donald Trump will waste no time in taking credit for this as further evidence of his policies working, but we feel there is a real need to stand back from the numbers and think a bit more deeply before getting carried away in the tide of bullish sentiment.

The Trump administration implemented its corporate tax bill at the start of 2018 which has presented a huge windfall to corporate America. The steel and aluminium tariffs came into force on 1st June 2018 but were delayed until July for China and some other countries. Commentators appear to be surprised that the latest Chinese export figures don’t yet reflect any impact of the tariffs. We find that hardly surprising given the short period of time since their imposition. In addition, the delay allowed companies to maximise their imports ahead of the tariff imposition date, building up inventory as much as possible ahead of the price rise. There will be some delay before buyers in the US have to go into the global wholesale markets and pay the higher prices, which will be sustaining current earnings in the US.

In addition, it is no surprise to us that US companies beat their earnings forecasts so convincingly. Any finance chief worth his salt operating within the US is going to book as much revenue in 2018 as he can, rather than 2017, when tax rates were higher. We all know that companies have some degree of flexibility around when they book profits.  Is it either at the point of receiving an order, when 50% of the order has been completed, when the order is finished, when the order has left the factory, when the customer has been invoiced or when the customer has paid? As with any major change to tax rates, there are always distortion effects around the timing of the introduction and this will be no different especially with such a sizeable move from 35% to 21%. We therefore believe that this round of earnings reports is likely to be boosted by the follow through from the tax cuts and before the tariffs come into effect, which will eventually raise raw material prices. There are many calling out that the US economy is likely to slow into 2019 due to stalling momentum but we believe this could be rather more of an issue and could rear its head in October when the third quarter results are reported. At this point, the tax cut benefit will start washing through on a like-for-like basis whilst the tariffs will be starting to show themselves in terms of price rises, reducing margins from connected manufacturers and weakening consumer demand as a result.

So for now, outside of Turkey, most are on the beach and not thinking forward to the autumn and what may present itself.  We would be rather more sanguine.  When commentators refer to record reports beating forecasts, it is easy to question the accuracy of those forecasts. Subsequently, analysts adjust their forecasts upwards under pressure having been proved too conservative. We would argue that short term opportunity to enhance earnings around a major change to the current tax and pricing environment is at play here and we have just had a golden scenario for the second quarter which could bite back with a vengeance if the US falls.

UK GDP is reassuring but Turkish currency crisis weighs on market sentiment

The UK’s FTSE 100 index held its ground with a +0.1% movement during the week whilst most overseas equity markets made modest losses.  The US S&P 500 lost just -0.25% over the course of the week.

UK economic growth rebounded in the second quarter according to the latest Office for National Statistics estimate. Gross Domestic Product (GDP) grew 0.4% quarter-on-quarter which was in-line with market expectations, as retailers and construction benefited from a prolonged spell of warm weather. This comes after growth slumped to a 0.2% quarterly growth rate during a snow-hit Q1.

The Pound came under further pressure as the chance of the UK leaving the European Union without a deal is seemingly increasing. Sterling fell to its lowest level in a year against the US Dollar, depreciating -1.9% over the week and falling -0.5% against the Euro.

A plunge in the Turkish Lira of over 70% year-to-date and an 18% overnight fall last week has raised concerns that European lenders may be overly exposed to the region.  As the Lira falls, Turkish borrowers that have significant exposure to debt denominated in Euros and US Dollars may see their ability to pay back those debts disappear. The latest blow was Friday’s news that President Trump intends to place tariffs on steel and aluminium imports from Turkey in response to the detention of an American by Turkish President Erdogan, who was accused of helping to organise a coup against the Turkish leader. Most European equity markets made modest losses during the week.

Tariffs on an additional $16bn of mainly Chinese industrial goods were also brought in to force by the US last week.  The total volume of imports from China subject to the new 25% levies now totals $50bn. China was quick to match the US action with reciprocal tariffs. A rise in Chinese exports in July was a surprise to many economists and suggests to some that exporters are trying to move goods to the US ahead of further anticipated tariffs.

The price of oil slipped a little lower last week; Brent crude dropping -0.6% on the week to $72.81 per barrel, a fall of -9% from its recent peak just under three months ago.

Week ahead

UK employment data is due on Tuesday but is forecast by most to show little change to the unemployment rate of 4.2% of current wage growth levels. The Average Earnings index stands at an annual growth rate of 2.5%.  Preliminary GDP readings for Q2 are due from European countries early in the week. Advance estimates suggested economic growth across the Eurozone had slipped to 0.3% for the quarter.

Retail Sales data is also due on both sides of the Atlantic. US sales figures are due to be published on Wednesday whist the embattled UK high street will see updated numbers on Thursday morning.