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Quarantine Your Wealth From Turkey’s Contagion

The trend in stock market action began strong last week, with the S&P 500 Index and Nasdaq both closing in on new highs.

In fact, the blue chip S&P made it within a whisker of notching an all-time high Thursday. This before an epic failure Friday.

Stocks gapped down to end the last trading day of the week as fear swirled about “contagion” from Turkey’s currency collapse.

The lira has been under selling pressure all year as inflation in Turkey spirals out of control. The currency lost nearly 25% of its value between Friday and Monday alone.

That sparked fears of a global market meltdown over the weekend, leading to fresh selling to start this week.

Between Friday’s gap lower at open and Monday’s follow-on selling, the Dow dropped nearly 350 points, or 1.3%.

Emerging-market equities really got whacked, down nearly 4% last week and through Monday’s low.

Oh the pain!

If you know your stock market history, you’ll recall that in 1997 another emerging-market currency contagion infected global markets.

That one started innocently enough too, with an outbreak in one small Asian country, Thailand. But it spread like wildfire to Indonesia, Malaysia, South Korea and others.

Ultimately, another emerging market, Russia, defaulted on its debts and was forced to devalue its currency a year later.

Even the S&P 500 got clipped due to the contagion effect back then, dropping about 10% twice during the opening act of the currency crisis and plunging over 20% during the Russian default finale in 1998.

It’s understandable why investors with long enough memories are nervous about currency tremors in Turkey. These things have a way of spreading due to counterparty risk.

Counterparty risk is a fancy Wall Street term that simply means a chain is only as strong as its weakest link.

The global banking system is now, more than ever before, interlinked with digital chains tying banks in Europe to the U.S., Japan and emerging markets. If any nation (Russia in ’98, Turkey in ’18?) defaults and a bank in, say, Europe fails, it can drag down banks from Boston to Beijing.

That’s the fear.

Turkey has lived beyond its means for some time, running up a current account deficit equal to 6.5% of its entire economy.

That’s the same danger zone that Greece’s deficits reached before its own debt crisis followed earlier this decade. According to estimates, Turkey owes nearly $200 billion in dollar-denominated debts. And the cost for Turkey to pay it back has roughly tripled as the Turkish lira plunges in value.

Weak Link Watch: Who’s most at risk? European banks have the most to lose, especially Spanish banks, which are owed about $83 billion from Turkish borrowers.

French banks are next in the line of fire at $38.4 billion worth of exposure and U.K. lenders at $20 billion.

U.S. bank exposure is relatively small at only $18 billion, so it’s no major concern so far, but here’s an easy indicator to keep a watchful eye on.

The iShares MSCI Europe Financial ETF (NASDAQ: EUFN) tracks a basket of Europe’s biggest banks. Not surprisingly, it’s down more than 6% in just the past two weeks and has plunged 15% in value since the start of 2018.

By contrast, the SPDR Select Sector Financial ETF (NYSE: XLF), which tracks the biggest U.S. banks, is roughly flat this year.

Granted, this performance divergence has a lot to do with dollar strength this year, but it’s also very much a reflection of the relative weakness of Europe’s financial system compared with the U.S.’

Keep an eye on EUFN. If it continues to plunge and, even worse, if XLF follows, contagion could be spreading.

Here’s to growing your wealth,

Mike Burnick

Mike Burnick
Chief Income Expert, Mike Burnick’s Wealth Watch

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Mike Burnick

With over 25-years of professional investment experience, Mike Burnick was a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. Mike joined Weiss Research in 2002 as an analyst and writer, and in 2008 was named Director of Research and Client Communications at Weiss Capital Management, where he assisted...

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