A beauty contest for markets

These past few weeks have taught me that even John Maynard Keynes, who usually got it right, could err once in a while.

In Chapter 12 of his “The General Theory of Employment, Interest and Money,” Keynes uses the analogy of a newspaper beauty contest, where readers are asked to choose the most beautiful among six faces, with those picking the most popular face eligible for a prize. Keynes argues that you should not vote for the girl who you think is the most beautiful, but for the one you think other readers will choose.

You can use a similar logic in financial markets: I have argued before that the Turkish economy is faced with significant vulnerabilities, which were neatly summarized by the IMF’s most recent report on the Turkish economy. Like the Fund, I feel neither monetary nor fiscal policy is going in the right direction. Similarly, Turkish political risks, from unrest near the southern border and growing attacks by Kurdish terrorists to deadlock on the new constitution, are completely ignored by the markets.

But at the end of the day, what I think does not matter. If investors continue to believe that Turkey is the most beautiful, or at least that it is more beautiful than its peers, they will continue to rush into Turkish assets. Unfortunately, that has not been the case.

Turkish equities performed poorly from late last year up to late summer. Of course, some of this was due to global risk aversion. Despite the fact that it is the eurozone and U.S. economies that are shaky, emerging markets, or EMs, have seen sharper falls than G-7 countries. But Turkish equities were doing worse than other EMs until recently as well.

It seems that Turkey and some other emerging markets are being punished for their beauty. As journalist Christopher Fildes noted, emerging markets are aptly named because you cannot emerge from one in an emergency. This is not true anymore for liquid EMs with deep capital markets such as Brazil and Turkey.

In fact, non-residents’ share of Turkish equities has been on a freefall for almost a year and is now around 62 percent. Having already seen its share of sell-offs, Turkish stocks have been relatively resilient since August, but especially in the last couple of weeks, after trailing behind other EM equities for more than a year. This trend is likely to continue.

However, it is a different matter altogether for Turkish government bonds. For one thing, all EM bonds have been hit hard by risk aversion. According to data from EPFR, which tracks fund flows, this past week (up to Sept. 28) saw the sharpest outflows from EM bonds, as all inflows from the third quarter were wiped out.

The relative performance of EM bonds against U.S. Treasuries is usually a good predictor of future flows. Therefore, the recent underperformance of EM bonds is hinting that even more outflows might be on the way. Then, countries such as Poland, South Africa, Turkey and Hungary, where we have seen significant non-resident flows, are likely to be faced with the largest sell-offs.

Never mind the fact the latter’s macroeconomic fundamentals are much weaker than the other three. Sometimes, markets just don’t care about looks at all.