Hedge Fund Veteran Shorts Eurozone Debt on Turkey Fallout

(Bloomberg) -- For many investors, Turkey’s economic troubles are self-inflicted and bound to stay isolated. For John Floyd, they’re symptoms of a malaise that will spread to Europe in the coming months.

The head of macro strategies at Record Currency Management, which oversees $63 billion in assets, is shorting government bonds of Spain, France and Italy -- as well as the euro itself -- on the expectation that Turkey’s market ructions will soon be felt on the balance sheets of European banks.

In his quarter-century career, the former Deutsche Bank AG trader says he predicted the Asian crisis and the Argentine currency board collapse. Now, he says the lira’s slump and the nation’s net negative foreign-exchange reserves point the way to a trading opportunity in developed markets as the risk of damage from bad loans grows. Moody’s Investors Service cut Turkey’s debt rating deeper into junk on Friday, saying a balance-of-payments crisis is “increasingly likely.”

“It’s a Turkey trade, but also it’s not just a Turkey issue,” New York-based Floyd said in an interview. “Europe is severely challenged. Their economies are weakening, Covid-19 is increasing again, unemployment is very high, debt levels are very high, they are in a straitjacket of being in the single currency.”

Foreign bank exposure to Turkey has fallen since the 2018 currency crisis, but overseas lenders still had a total of $166 billion of claims on Turkey at the end of 2019, with European banks accounting for the lion’s share, according to data from the Bank for International Settlements. Turkey’s $740 billion economy is set to shrink 4% this year, the lira has lost more than 20% of its value in 2020 -- the second-biggest drop in emerging markets -- and the cost of insuring Turkish sovereign debt has almost doubled.

READ: Watch Turkey’s External Pressures to Decipher Lira Path

Floyd is basing his bet on an assumption that Turkish borrowers will struggle to pay foreign-currency debt because of the slide in the lira, ultimately contributing to an increase in non-performing loans at European lenders.

“The risk of feedback mechanisms from Turkey to Europe exist through European bank exposure in, and to, Turkish banks and corporates,” said Floyd, who was chairman and chief investment officer of the Floyd Plus Currency Fund before joining Record last year. “The shock from Covid-19 and the shutdown to GDP has gone far beyond the European Central Bank’s stress tests and thus risks to the banking system are amplified.”

The lira was little changed on Tuesday after hitting a record low against the dollar the day before. The shares of Spain’s Banco Bilbao Vizcaya Argentaria, which owns an almost 50% stake in Turkiye Garanti Bankasi AS, Turkey’s second-largest private bank, dropped 1.8%, extending this year’s losses to more than 50%. The shares of BNP Paribas SA, another European bank with a Turkish unit, fell 1%.

There’s potential protection in the EU’s planned pandemic recovery fund -- Italy and Spain were hit hardest in Europe by the coronavirus and will therefore be its biggest beneficiaries. But Floyd says this won’t stop the deterioration of peripheral economies and meets only 10% of Italy’s financing needs for the next few years.

“Italy, Spain and France have very real challenges. Is this Covid relief package a step in the right direction? Absolutely. Do I think it is enough to solve the problems? No way.”

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