JOE GILL: Turkey troubles has Ireland exposed to the financial butterfly effect

The butterfly effect is a description of how one seemingly irrelevant action has enormous consequences in an apparently unrelated outcome.

JOE GILL: Turkey troubles has Ireland exposed to the financial butterfly effect

The butterfly effect is a description of how one seemingly irrelevant action has enormous consequences in an apparently unrelated outcome.

It was coined in relation to how a flapping butterfly wing could end up in a distant tornado some weeks or months later.

In financial markets, we think about the butterfly effect as a trigger in one financial instrument that has material implications for other, unconnected assets.

It is often extremely difficult to trace where the origin of a major problem surfaced, particularly if you are in the midst of crisis management.

Last week, Turkey’s currency, the lira, fell sharply amid a developing geopolitical spat between it and the US.

From Ireland, you could be forgiven for wondering why any of this should matter.

Turkey has no large economic ties with Ireland and is not even inside the EU.

However, it is through second and third-level derivatives that we feel the chill from this macroeconomic shock. A number of large international banks, some of them in Europe, have very significant investments exposed to Turkish companies and projects.

Last week, the euro value of those exposures fell by almost 20%, in dollar terms. That implies a $1bn (€880m) book of business lost about $200m (€175m) in one day.

Across multiple banks, the losses could be in the billions.

This explains why share prices of banks around the world weakened last week, as investors fretted about the effect on profits in the Turkish currency crisis. As global bank valuations sunk, a comparative analysis made it easy for investors to opt to sell the banking sector indiscriminately.

I remember, in the summer of 2007, there was an article buried in a UK financial newspaper that referred to unusual and arcane loan movements by the ECB.

While it received little attention, it was actually a red flag about disturbing developments deep inside the banking system, which were early indicators of a looming credit crisis.

That mushroomed into a monster event, which consumed the global economy for years.

In the late 1990s, an arcane and low-profile hedge fund, Long-Term Capital Management, collapsed.

It lost $4.6bn in just four months and created chaos for a number of banks, before it was bailed out.

All of these examples are reminders that we live in a highly unpredictable world.

While it is neat to imagine any of us can confidently predict economic or personal futures, we have only limited control over what happens tomorrow, never mind next year.

I remember this when listening to pundits confidently explain how investors will make a fortune because X, Y, and Z will occur over the next number of years. These gurus make a living pretending that they understand the future, when all they are outlining is a series of probabilities.

Many of these experts, especially on US financial TV channels, are often in their early to mid-30s.

That means none of them have ever actually experienced a proper bear market.

Those of us old enough to have scars on our backs from the spectacular crash that started in 2008 know Mr Market has a nasty habit of upturning all confident predictions and delivering a devastating collapse in financial asset values.

Any investor, be they professional or someone saving for a pension, must remember those historic events, when putting hard-earned money to work.

It is vital to have a diversified portfolio, shares in companies with strong balance sheets that can absorb shocks, and an ability to distribute dividends, even when times are difficult.

Think about geographic and asset class diversification, too, because, if you do not, a risk exists of a butterfly effect obliterating your investment, at short and unpredictable notice.

Joe Gill is director of corporate broking with Goodbody Stockbrokers. His views are his own.

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