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Crisis in Turkey: What you need to know before Monday's market open

By David Nelson, CFA

Turkish military tank

The sound of gun fire followed by images of tanks rolling into position is rarely good news for equity investors. But that’s just what we got, as news of an attempted military coup in Turkey swept across trading desks shortly after the market close on Friday.

It’s just over three weeks since investors stared into the abyss created by the Brexit. And Thursday, a radicalized 31-year-old Tunisian, Mohamed Lahouaiej-Bouhlel, used a large truck to mow down hundreds of onlookers during a Bastille Day event in Nice, France, leaving 84 dead.

The speed with which investors are forced to asses geopolitical mayhem is matched only by the human tragedy of man’s ability to kill each other in the name of God.

Before we discuss potential market reaction here, let’s recap the events in Turkey and the strategic importance of the region.

While Friday’s news of an attempted military coup in Turkey surprised the world, those who study the region understood full well that Turkey was an accident waiting to happen. The Wall Street Journal points out that “the coup attempt against Turkish President Recep Tayyip Erdogan is the culmination of a long-mounting discontent with the man who has essentially ruled the nation since 2002.”

Erdogan on FaceTime

Erdogan FaceTime

Like most military coups, the first move was to secure communication centers and, at least for a time, that appeared successful.

Using FaceTime from a seaside resort, Erdogan urged civilians to take to the streets and quash the revolt. Video hit the airwaves showing thousands of citizens blocking and challenging military vehicles with soldiers firing shots in the air.

Regardless of the outcome and the massive support Erdogan received to help end the crisis, his control seems suspect. Thousands have been arrested with more to follow and, for the moment, Erdogan has prevailed. He may have ended this rebellion, but it shows there is a high level of discontent within the country—especially in the wake of terrorist attacks like the explosion that killed 44 at Istanbul’s Ataturk airport.

Western leaders were quick to condemn the coup, but I’m not sure I heard any support for Erdogan until it was clear he had regained control. All of this raises big questions over the Turkish leader who will likely now step up his control. He’s been trying to change the constitution and has increasingly become problematic for the Obama administration and NATO to deal with on many levels.

Muslim cleric Fethullah Gülen

Fetullah Gulen

US-Turkey relations will be put to the test, as Erdogan’s government demands the return of Muslim cleric Fethullah Gülen, who Erdogan believes orchestrated the coup. “Any country that stands behind him is no friend of Turkey [and] is engaged in a serious war with Turkey,” Prime Minister Binali Yildirim said from his office in Ankara.

Military assets in Turkey

Turkish military assets

The strategic importance of Turkey as a NATO ally can’t be overstated. One look at the map shows the location of key military assets and the geographic importance Turkey plays. With Syria and Iraq to the south and Iran to the east, it is a key outpost for US and NATO assets, including the Incirlik air base.

In the hours after the failed coup attempt, the Turkish government had shut down the airspace surrounding the US air base, temporarily halting air strikes against the Islamic State.

The biggest danger for investors

Once again, Monday and the days that follow will be a test of investor resolve. Will they look through the event or will the cumulative effect that many point to be enough to force investors to walk away?

The biggest danger investors face isn’t the event itself but the temptation to overreact. In the short run, panic can prove profitable, but remember selling is a two-step decision. What will be the process that gets you back into the market? Stocks hitting a new high? Or will you have the resolve to buy into the weakness when there’s blood in the street?

Professionally managed quantitative programs have a process to move in and out of asset classes, but the key is that it is rule-based, devoid of emotion. A subjective, emotion-laden reaction to fluid events rarely produces good results. For many, the best decision usually is to do nothing.

The big picture

Turkey ranks 18th in nominal GDP. So it’s hardly an economic powerhouse that could tip the world economy on its own. Europe is the bigger question. Seen as a gateway to the continent, Turkey is a buffer zone to the massive migration of those seeking to escape the ravages of war-torn areas surrounding the country. Immigration was a key component in the Brexit referendum vote, and already, right wing parties are looking for similar votes throughout the EU.

The cumulative effect of so many events taking place in such a short space of time has to be at least considered.

With US markets hitting all-time highs and an easy target for profit taking, many are saying the market is overvalued. Compared to what? In a vacuum, stocks look stretched. But with the 10-year yielding just north of 1.5%, I can argue for a higher multiple. If there’s a bubble out there, the bond market is the primary suspect.

Monday

For the moment, order seems to have returned to the streets in Turkey after the failed coup. Needless to say, the situation is fluid, with some headlines suggesting the US and Turkey are on a collision course. What if Erdogan demands U.S. military assets leave the country?

After the close Friday, nearly 16 million shares of the S&P 500 ETF (SPY)* traded down $1.28. Some of the selling was certainly funds looking to cut exposure into an uncertain weekend. They are, of course, potential buyers if they don’t get the market reaction they were expecting.

As news from the region changes with each passing hour, it’s impossible to predict the market reaction. However, there’s a bid to this market with a lot of funds under-invested that need to catch up. Many will use any correction as an opportunity to get long.

In most geopolitical sparked selloffs, the usual suspects are thrown in jail. Airlines (JETS), cruise lines and other transportation stocks are an easy target—often taking the brunt of the selling. With rare exception, it’s an overreaction that corrects shortly after the noise subsides.

With the perceived safety of consumer staples (XLP), names like Clorox (CLX), Colgate (CL) or Kimberly Clark (KMB) could prove disappointing. There’s nothing proprietary about toothpaste and diapers—and yet these companies trade with valuations like they have the cure for cancer.

Putting it all together, this is the world we live in. Geopolitical uncertainty is part of the daily investment matrix we deal with each and every day. If you’re waiting for the world to come to its senses or a message that the coast is clear—forget about it. It’s not going to happen. There’s opportunity each and every day for those willing to do the work and take it.

*At the time of this article funds managed by David Nelson were long SPY.

David Nelson, CFA
Chief Strategist