TRY Stability Very Fragile

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The Turkish lira continues to stabilize.  Given political tensions (both domestic and regional) as well as worsening economic fundamentals, we think this stability is very fragile. POLITICAL OUTLOOK

Erdogan and his ruling AKP remain firmly in control.  Purges of the nation’s institutions continue, which will have negative long-term effects on the bureaucratic efficiency of the government.  As Erdogan continues his clampdown, it appears that his ruling AKP will easily serve out a full term.

Tensions with the military may be simmering.  Local press reported this week that top military officials remain “disturbed” due to criticism of its leadership.  However, the army distanced itself from the story, claiming that any remarks were taken out of context and did not use the word “disturbed.”

Parliament recently passed a controversial constitutional reform bill that would create an executive presidency that greatly increases Erdogan’s power.  It now goes to a popular referendum, which officials say will be held on April 16.  The proposed changes eliminate the post of Prime Minister, and would allow the president to issue executive decrees, declare emergency rule, appoint ministers and top state officials, and dissolve parliament.  Polls show the nation is split on the matter.

The next parliamentary and presidential elections are scheduled to take place by November 2019.  The proposed changes call for limit of a two five-year terms as president.  However, it would not count time already served and so Erdogan could theoretically serve until 2029.  Local elections in March 2019 will be a good litmus test for the AKP.

Regional tensions remain high.  Press reports that Turkey is seeking US support for a ground offensive against ISIS in its main Syrian stronghold.  Such an advance would reportedly go through territory held by Kurdish rebels, threatening potential reprisals.

Meanwhile, there are reports that Syrian peace talks in Geneva are not going well due to deepening differences between Russia and Iran.  Talks are being sponsored by the UN, and seek to build on the ceasefire brokered by Russia with Turkey back in December.  Unfortunately, fighting continues in several areas of Syria, including near Damascus.

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast to accelerate modestly to around 2.5% in 2017 from an estimated 2.2% in 2016.  GDP contracted -1.8% y/y in Q3, but this was due in large part to the fallout from the failed coup attempt in July.  Monthly data for Q4 suggest the economy recovered and is growing again.

Price pressures are rising, with CPI accelerating to 9.22% y/y in January.  Turkey reports February CPI Friday, which is expected to rise 9.74% y/y vs. 9.22% in January.  CPI would move even further above the 3-7% target range, but the central bank has hesitated to hike rates outright.  Instead, it has used the rates corridor in recent months to push interbank rates higher.  Next policy meeting is March 16.  If the lira remains firm, then no change is likely then.

Fiscal policy has deteriorated.  The budget deficit came in slightly above -3% of GDP in 2016, up from -1.2% in 2015.  It is expected to narrow to around -2.5% in 2017.  However, the 12-month total has been rising over the course of 2016.  Furthermore, we see upside risks given Erdogan’s desire to boost the economy via increased spending.  The primary balance is currently near zero, down from relatively large surpluses in recent years.

The external accounts bear watching.  Russian sanctions (since lifted) hurt exports last year, but low energy prices and the sluggish economy have helped reduce imports.  The current account gap was about -5% of GDP in 2016, up from -4% in 2015.  The gap is expected to widen to nearly -6% of GDP in 2017.  Furthermore, capital flows have dried up with FDI accounting for only about a third of the current account deficit.  The rest is covered by so-called “hot money.”

Foreign reserves have fallen steadily.  At $89 bln in mid-February, they are the lowest since July 2012.  Gross reserves cover 5 months of import but account for only half the stock of short-term external debt.  Usable reserves (netting out commercial bank FX deposits at the central bank) are even lower at an estimated $33.7 bln.  FX intervention is really not possible under these circumstances, and higher interest rates are frowned upon.  As such, we see further reliance on unconventional measures of lira support, as needed.

INVESTMENT OUTLOOK

The lira continues to underperform, but it has done better after a particularly poor start to the year.  In 2016, TRY was -17% and was behind only the worst performer ARS (-18%).  So far in 2017, TRY is -3% YTD vs. USD and is the worst EM performer.  The next worst is PHP (-1% YTD).

Our EM FX model shows the lira to have VERY WEAK fundamentals, so this year’s underperformance is to be expected.  Key support for USD/TRY around 3.57 has held so far.  A break below would set up a test of the December low near 3.34.  Recent measures to support the lira have helped at the margin, although we think the currency’s recent rebound is due in large part to wider EM FX gains.  If TRY starts to weaken as we expect, near-term targets for USD/TRY come in near 3.6915 and 3.7335.

Turkish equities have also done better after underperforming in 2016.  In 2016, MSCI Turkey was up 4% vs. 7% for MSCI EM.  So far this year, MSCI Turkey is up 13% YTD and compares to 9% YTD for MSCI EM.  This outperformance should ebb, as our EM Equity model has Turkey at a VERY UNDERWEIGHT position.

Turkish bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -47 bp YTD.  This is behind only the best performers Argentina (-241 bp) and Brazil (-116 bp).  With inflation likely to continue rising and the central bank likely to have to tighten further this year, we think Turkish bonds will start underperforming more.

Our own sovereign ratings model shows Turkey’s implied rating at BB/Ba2/BB.  Despite some negative moves already seen after the coup attempt, we think Turkey continues to face downgrade risks to its actual BB/Ba1/BBB- ratings.  The investment grade rating from Fitch seems way out of line now, and its negative outlook suggests an adjustment will eventually be made.