Turkey To Continue Under-performing

sunset and mosque

The Turkish government’s medium-term economic program released this morning is, quite frankly, uninspiring. We expect Turkish assets to continue underperforming in the weeks ahead.

POLITICAL OUTLOOK

In the wake of July’s failed coup, President Erdogan continues to consolidate his grip on the nation. Purges of Turkey’s institutions continue, which so far have included the military, police, media, and education. Today, the government shut down two TV channels and a radio station whilst suspending another 12,801 police officers. The 3-month emergency rule declared July 20 was just extended by another 3 months.

Parliamentary and presidential elections aren’t due until H2 2019. Local elections will be held in Q1 2019. An interesting outcome of the coup is that it has (for now) united both the secular elite and Erdogan’s Islamic supporters. Both favor civilian rule over a military one.

Turkey has swung towards better relations with Russia, at the likely cost of the US and the EU. Erdogan and Putin will meet in Turkey this Monday. Meanwhile, the EU deal to help limit the flow of refugees moving through Turkey has frayed over delays to granting visa-free travel for Turks. Turkey has, however, stepped back from threats to end the deal outright as negotiations continue.

ECONOMIC OUTLOOK

Prime Minister Yildirim released the government’s medium-term program earlier today. It cut the 2016 and 2017 growth forecasts to 3.2% and 4.4%, respectively, but they still remain above market forecasts. Forecasts for the budget and current account deficits were also revised higher for 2016-2018.

The economy remains sluggish. In the latest update to its World Economic Outlook, the IMF cut its Turkish growth forecasts to 3.3% in 2016 and 3.0% in 2017. These are more in line with consensus market forecasts than the government’s forecasts. GDP growth was 4% in 2015 and 3.1% y/y in Q2. The Q2 reading was slightly weaker than expected, and the slowest since Q1 2015. As such, we see downside risks to the growth forecasts.

Price pressures are easing, with CPI rising 7.3% y/y in September. This is the lowest rate since May and suggests that the easing cycle will continue. The central bank next meets October 20 and is likely to cut the overnight lending rate again by 25 bp to 8.0%. With inflation still above the 3-7% target range, cutting the benchmark rate will likely be delayed until year-end or early 2017.

Fiscal policy will be loosened. The wider government budget deficit (forecast by the government at -1.9% next year) will be the result of increased government spending and investment. The deficit came in around-1.2% of GDP in 2015. It is expected to widen to around -2% in both 2016 and 2017, but we see upside risks here.

The external accounts bear watching. The Russian sanctions had hurt exports, but they are being phased out as bilateral relations have improved. On the other hand, low energy prices and sluggish growth have helped reduce imports. The current account gap will be stable around -4.5% of GDP in both 2015 and 2016, but is expected to widen to near -5% in 2017.

Turkey’s external deficits are financed mainly by hot money flows, as FDI continues to dry up. The 12-month total FDI of $11.2 bln is the lowest since October 2013, and covers around 40% of the current account deficit (and falling). As the current account gap rises, that coverage will fall, making Turkey more vulnerable to swings in hot money.

Foreign reserves have risen modestly to $103.3 bln in September and cover nearly 6 months of imports. However, total reserves are only about 60% of short-term external debt. More importantly, usable reserves (netting out commercial bank foreign currency deposits at the central bank) are only around $38 bln.

INVESTMENT OUTLOOK

The lira has generally underperformed. In 2015, TRY lost -20% vs. USD. This was behind only the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), and RUB (-20%). So far this year, TRY is -4% YTD and is ahead of only the worst performers ARS (-15%) and MXN (-10.5%). Our EM FX model shows the lira to have WEAK fundamentals, so this year’s underperformance is to be expected. For USD/TRY, the break above 3.0275 today sets up a test of the all-time post-coup high near 3.10 from July 20.

Turkish equities have underperformed this year after a decent 2015. Last year, MSCI Turkey was -12% while MSCI EM was -17%. So far in 2016, MSCI Turkey is +4% YTD and compares to +14.5% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has Turkey at an UNDERWEIGHT position.

Turkish bonds have outperformed this year. The yield on 10-year local currency government bonds is about -102 bp YTD. This is behind only the best performers Brazil (-506 bp), Indonesia (-176 bp), Peru (-154 bp), Colombia (-150 bp), Russia (-146 bp), and South Africa (-110 bp). Clearly, much of the EM bond rally has been driven by the global quest for yield. With inflation likely to continue falling and the central bank likely to continue easing, we think Turkish bonds can continue outperforming but will be subject to rising downgrade risks.

Our own sovereign ratings model rates Turkey at BB/Ba2/BB. S&P quickly cut Turkey to BB with a negative outlook right after the July coup attempt. We have long felt that both Moody’s and Fitch were premature in upgrading Turkey to investment grade. In September, Moody’s cut Turkey’s rating by a notch to Ba1 with a stable outlook. In August, Fitch cut the outlook on its BBB- rating from stable to negative and we expect it to also move Turkey to sub-investment grade soon.