Stock-market investors weather Turkey storm, but should watch the dollar

As if global trade spats weren't exciting enough, August has defied its sleepy reputation to bring investors a taste of an old-fashioned currency crisis in Turkey.

The underlying worry is that other countries that, like Turkey, heavily rely on external financing in currencies other than their own are vulnerable to a continued rise in the U.S. dollar could begin to face trouble, causing problems for financial institutions that hold that foreign-denominated debt.

"I think we're far from that right now, but I think it weighs on investors' minds," said Michael Arone, chief investment strategist at State Street Global Advisors, in a phone interview.

Indeed, Wall Street analysts and economists don't seem overly afraid that Turkey's woes will morph into a global crisis that will threaten U.S. economic growth or corporate earnings -- the Dow on Friday posted its highest close since February -- but that doesn't mean geopolitical headlines won't continue to inject volatility into financial markets.

While there are some crucial differences between Turkey's woes and the emerging-market woes that led to the Asian financial crisis of 1997-98, "man-made financial crises tend to occur at the end of a long run of strong economic growth/financial asset returns, and every investor knows this," wrote Nick Colas, founder of DataTrek, in a Wednesday note.

"That's an important reason why the situation in Turkey resonates as an important risk factor just now," he said.

Meanwhile, investors might be underestimating the impact that dollar volatility is having on the overall market, Arone said, noting that a touch of the binary, "risk-on/risk-off" framework that prevailed in global markets in the aftermath of the financial crisis has re-emerged this summer amid trade turmoil and other geopolitical turmoil.

The phenomenon appears to emanate from the dollar, which tends to rally on haven-related buying inspired by negative headlines on the trade front or the Turkey situation, while setting back on positive developments. Stocks have tended to move in the opposite direction of the greenback, while within the market, defensive sectors lead when the dollar is strong and global cyclicals strengthen when the buck weakens.

As Turkey's lira plunged, the dollar saw broad strength, pushing the ICE U.S. Dollar Index to a 14-month high on Wednesday. Hopes for a breakthrough on the trade front saw the index retreat, leaving it on track for a 0.3% weekly decline.

U.S. stocks, meanwhile, were lifted sharply Thursday on plans for U.S. and China officials to resume trade talks. Equities got a further lift Friday after The Wall Street Journal reported that Washington and Beijing were drawing up a road map for talks to end their trade impasse culminating with meetings between President Donald Trump and Chinese leader Xi Jinping in November.

The action left the S&P 500 up 0.6% for the week. The Dow Jones Industrial Average advanced 1.4% on the week, bouncing back from weakness earlier in the week as the dollar strengthened.

"As an investor, you want to see, not dollar weakness, but certainly a slowdown in its strength and some relief from all this trade talk and this conflict with Turkey," he said.

Arone said he thinks the Trump administration will be looking for a trade "win" before midterm elections in November. That could come in the form of an agreement on a renegotiated North American Free Trade Agreement, or Nafta, with Canada and Mexico.

Meanwhile, Arone said investors should avoid the more defensive sectors of the market despite their recent strength, instead favoring stocks that offer strong revenue and earnings-per-share growth, including the tech and consumer discretionary sector. That should be balanced by stocks that will benefit from rising input costs and building inflationary pressures in a late cycle environment, he said, including energy, materials and industrials sectors.

With the Federal Reserve on track to deliver up to two more rate increases before the end of the year, Arone expects defensive, income-oriented sectors of the market, including utilities, consumer staples, telecoms and real-estate investment trusts to run into headwinds.

Meanwhile, minutes of the Fed's last policy meeting are due on Wednesday, but are expected to deliver little new information, wrote analysts at RBC Capital Markets.

"The most interesting part of the minutes will be about the balance sheet outlook. Unfortunately, recent speeches by [Federal Open Market Committee] members suggest that there is not yet a strong consensus, so we think that at most we will see the various options being laid out," they said.

The bigger event will be the Kansas City Fed's annual symposium for global central bankers in Jackson Hole, Wyo. Fed Chairman Jerome Powell is set to deliver a Friday speech on "monetary policy in a changing economy."

And the rising dollar may be on the agenda, said Michael Hewson, chief market analyst at CMC Markets UK, arguing that the currency's strength is likely to pose "significant challenges" to U.S. policy makers in the months ahead.

"With this being Jerome Powell's first symposium as Federal Reserve chief, markets will be looking for clues as to whether the recent currency crisis in emerging markets, and notably Turkey, is causing anxiety amongst U.S. policy makers, at a time when they want to continue to normalize rates further," he said.