Turkish Underperformance to Continue

turkey flag with euro banknotes marc

Turkey continues to suffer from a mix of political risk and poor economic fundamentals. Neither factor is expected to go away anytime soon, and so Turkish assets are likely to continue underperforming. 

POLITICAL OUTLOOK

President Erdogan continues to purge alleged Gulenists from Turkey’s institutions. To date, it’s estimated that more than 100,000 workers in the judiciary, education, military, and media have been detained or dismissed on suspicion of being involved in the coup. The initial three-month emergency rule was extended another three months until January 2017, and is likely to be extended again.

The next presidential election will be held in August 2019. Parliamentary elections must be held by October 2019. The AKP currently holds 317 seats. Tensions with the pro-Kurdish HDP are strained after the recent arrests of several HDP leaders and lawmakers. Those arrested denied links to the PKK Kurdish rebel group.

Ahead of those votes, the ruling AKP recently submitted a proposal to change the current parliamentary system into a presidential one. This would further concentrate Erdogan’s power, but it’s unclear whether the AKP has the required 330 votes in the 550 seat parliament to call for this constitutional referendum. If passed, a president would be able to serve two 5-year terms, though previous terms as president would not count, allowing Erdogan to run.

Terrorist attacks continue. A bombing in Istanbul over the weekend killed dozens, with Kurdish militant group TAK claiming responsibility. Furthermore, Turkey’s military presence in Syria and northern Iraq has raised regional tensions and potentially fed into ISIS terrorist activity within Turkey.

Relations with the EU remain strained. The EU Parliament last month held a non-binding vote to suspend Turkey’s accession talks, stemming in large part from Turkey’s crackdown on the opposition. Austria recently said that it wants to freeze Turkey’s EU accession process. If frozen, it would require a unanimous vote by all EU nations to unfreeze it, according to EU officials.

ECONOMIC OUTLOOK

The economy faces increased recession risk. Q3 GDP unexpectedly shrank -1.8% y/y, as the fallout from the attempted coup in July hit the economy. GDP growth is forecast at 3.3% in 2016 and 3.0% in 2017, but the risks are clearly to the downside in light of the Q3 contraction.

New methodology used by Turkstat to measure GDP in Turkey has led to significant upward revisions. Using 2009 as a new base, the size of the economy last year was revised up by $140 bln to $862 bln total. Furthermore, 2015 growth was revised up from 4% to 6.1%. The revisions improved upon the previously reported figures for 14 of the last 15 years, and boosted the average growth rate for the last five years to 7.1% from 4.4% previously. Yet the lack of any detailed breakdown has left many investors skeptical.

Price pressures are still easing, with CPI up 7.0% y/y in November. This is the lowest rate since May. However, with inflation still at the top of the 3-7% target range and the lira remaining under pressure, easing is unlikely until 2017, if at all. The central bank next meets December 20. If the lira remains weak, we think the bank will be forced to hike again. The central bank hiked the policy rate unexpectedly by 50 bp at its November meeting.

The central bank could hold an extraordinary meeting if needed. It did this back in January 2014, when it hiked rates sharply intra-meeting after leaving rates steady at the regular meeting on January 21. The benchmark rate was hiked 550 bp to 10% on January 28, but no further tightening was seen and the bank started an easing cycle in May 2014.

Fiscal policy has for the most part remained prudent. The IMF estimates that the budget deficit came in around -1.2% of GDP in 2015. It is expected to widen slightly to -2% this year and -2.2% in 2017. However, the sluggish economy suggests that the deficit is likely to come in a bit larger than expected. The government will also be tempted to use fiscal stimulus to boost the economy.

The external accounts bear watching. The end of Russian sanctions should help exports recover, while slow growth should help reduce imports. However, the recent rise in oil prices is likely to have a negative impact on the external accounts. The current account gap was -4.4% of GDP in 2015, and is expected to remain fairly steady in 2016 before widening to almost -6% in 2017. The 12-month current account gap widened in October for the second straight month. At -$33.8 bln, the 12-month total is the highest since November 2015.

To make matters worse, 12-month FDI has shrunk to $10.7 bln, the lowest since June 2013. FDI covers only 32% of the current account deficit (the lowest coverage since mid-2015), making Turkey more dependent on hot money even as sentiment on EM sours.

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 -16.5% YTD and is ahead of only the worst performer ARS (-19%). MXN is third worst at -15% YTD. Our EM FX model shows the peso to have WEAK fundamentals, so this year’s underperformance is to be expected.

We expect USD/TRY to test and move above the all-time high near 3.60 from this month. USD/TRY has tested the top of an upward sloping channel on the weekly charts dating back to 2012. The top currently comes in around 3.60, and a break above that would target another parallel channel top that comes in near 3.75.

Turkish authorities are growing more concerned about the weak lira. Deputy Prime Minister Simsek said the government would be willing to help companies manage a gap in FX liabilities and assets. He added that the government may have to limit the amount of foreign currency debt companies can issue. The central bank also warned that it can intervene directly in the FX markets to support the lira. This is simply jawboning, as we don’t think they have enough reserves to go down this road. Gross reserves stood at $98.6 bln for the week ended December 2, which is the lowest since May and does not even cover the nation’s short-term external debt.

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 up 3% YTD, and compares to 10% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has Turkey at a VERY UNDERWEIGHT position.

Turkish bonds have underperformed this year. The yield on 10-year local currency government bonds is +72 bp YTD. This is ahead of only the Philippines (+94 bp) and Mexico (+98 bp). With inflation likely to turn higher and the central bank likely to continue hiking, we think Turkish bonds will continue underperforming.

Our own sovereign ratings model shows Turkey’s implied rating steady this quarter at BB/Ba2/BB. In light of the weaker economy and rising external deficits, we suspect that the implied rating will come under downward pressure again in the coming quarters.

After the coup attempt in July, S&P quickly downgraded it by one notch to BB and maintained a negative outlook. Moody’s put it on review for a downgrade and then followed up with a one notch move to Ba1. Fitch moved the outlook on its BBB- rating from stable to negative, but has yet to downgrade Turkey. Despite these moves already seen, we believe Turkey continues to face strong downgrade risks to its BB/Ba1/BBB- ratings. The investment grade rating from Fitch seems way out of line now.