Joshua Brockwell is Investment Communications Director at Azzad Asset Management. He can be reached at joshua@azzadfunds.com

A selloff in Turkish markets over the last few days has reverberated around the globe, prompting investor flight to safe havens like U.S. Treasuries, the Swiss franc, and the Japanese yen. Turkey’s inability to prop up its tumbling lira, prompted in part by diplomatic tensions with the U.S., led to the currency’s largest losses since 2001 on Friday.

Turkey has faced economic difficulties since the start of the year. The lira has lost more than 40% of its value this year thanks to presidential intervention in central bank policy, fiscal stimulus, growing inflation, and a hefty current account deficit.

As markets remain jittery over possible spillover effects, investors are left to piece together the real impact of recent events on their portfolios. Is the Turkish economic engine stalling out? Could contagion there spread to foreign shores?

If Turkey wants to right the ship, it’s clear that more of the same cannot continue. Until things level off, financials and emerging markets look likely to lag.

Bank exposure

Reports on Friday suggested that the European Central Bank (ECB) is concerned about southern European banks, which have loaned sizable sums of money in Turkey. Investors in European bank stocks may suffer–as might the ECB as a whole, if it’s forced to step in and prop up the lenders. That’s a tricky thing to do considering how few tools the ECB has in its policy tool belt since it’s in the middle of a quantitative easing program that limits its options. The ECB has declined to comment on those reports.

Data from the Bank for International Settlements (BIS) show that Turkish borrowers owe Spanish banks $83.3 billion, French lenders $38.4 billion; and banks in Italy $17 billion.

But it’s not just European banks that are exposed. U.S., Japanese, Chinese, and Middle Eastern banks all have Turkish debt. BIS figures show that Japanese banks are owed $14 billion, U.K. lenders $19.2 billion, and the United States about $18 billion.

One bright spot amid the carnage may be Islamic banks, which are poised to weather the storm better than their local peers, thanks to their well-capitalized Middle Eastern parent companies. Because several Gulf countries are overbanked, Turkey has served as a source of diversification for those firms, many of which have implicit sovereign backing. All sectors of the Turkish economy have been hit, including Islamic banking, though the country’s so-called participation banks look resilient due to their ownership.

More money, more problems

Looking at the big picture, Turkey is a $900 billion economy that grew at a rate of 7% last year thanks to government incentives to borrow, especially a credit guarantee scheme for industries and exporters to borrow from commercial banks. This is compared to a longer-term average growth rate of about 4%. Erdogan’s growth-at-all-costs approach to economics has made Turkey a country that depends on the rest of the world to fund its high rate of consumption. And it is starting to reap the instability that it’s sown. Double-digit inflation and a yawning current account deficit are now at untenable levels.

Foreign loans, many of them priced in U.S. dollars, are a big reason Turkey is in dire straits. A low savings rate and skyrocketing debt creates high demand for foreign capital. The private sector in Turkey has borrowed heavily in U.S. dollars — in part thanks to unusually low interest rates in the U.S. following the Great Recession and in part because Turks are wary of their own currency’s prospects. (Fifty percent of total bank deposits are in foreign exchange, specifically U.S. dollars.) If the lira continues its spiral downward, which it seems likely to do, that makes repayment on those foreign currency loans more expensive.

Two options are then available to Turkish debtors: more borrowing/restructuring to service the existing debt, which could hasten a vicious cycle, or default. Neither is good for those who invest in Europe or emerging markets as a whole.

Bitter pill

What is Turkey going to do to fix this mess? Because it’s beholden to financial markets in order to roll over its debt, analysts say that Turkey needs to play by the rules now more than ever. Those rules include a real economic plan for the future, significantly higher interest rates, and the release of US. pastor Andrew Brunson to mollify U.S. antagonism. Announcing a deal with the International Monetary Fund, though not at all likely considering the negative optics for the ruling AK Party, could also be a temporary salve.

There is currently, however, a complete lack of confidence in Turkish economic leadership. The country’s finance minister, Erdogan’s son-in-law Berat Albayrak, has not reassured markets, which want big gestures like austerity. Monday’s liquidity pledges from the Turkish central bank have been deemed too little, too late. The likelihood for more turmoil is high, and investors with exposure to emerging market financials should be particularly wary.

Don’t get panicked

Market volatility outside the immediate region looks to be a short-term psychological phenomenon; attention-grabbing headlines have a habit of stoking investor fears. But the crisis in Turkish markets looks like a localized incident for now. U.S. markets are still strong, with low inflation and strong corporate earnings serving as tailwinds.

But problems in Turkey can still cause turbulence in the U.S., of course. Stocks are trading near all-time highs and by some measures are somewhat overvalued. Turkey could be the catalyst markets need for a pullback, which is healthy. The bull market in U.S. stocks celebrated its ninth anniversary in 2018. That’s the second-longest run in history, boasting the greatest percentage gain since World War II. Stocks that sell into Turkish markets, of course, are at greater risk of losses.

If you’re an investor, emerging markets are a risky proposition right now, but that’s not a forecast for the future. Keep a diversified portfolio. And if you need help along the way, give us a call.

Note: Azzad Asset Management is investment advisor to the Azzad Wise Capital Fund, the first Shariah-compliant fixed income mutual fund in the United States. As of June 30, 2018, Islamic bank deposits comprised 29% of the Fund. Over the past year, the Fund’s exposure to Turkish Islamic bank deposits was reduced from 9% to 3%.

For more information on the Fund, including objectives, risks, charges and expenses, please download the prospectus at azzadfunds.com or call (888) 862-9923 to request a copy. Please read the prospectus carefully and consider the investment objectives, risks, charges, and expenses before investing. The Azzad Funds are self-distributed.

The opinions and views expressed herein are current as of the date indicated, and are subject to change without notice. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed.