Turkey's First Direct Presidential Election

(from my colleagues Dr. Win Thin and Ilan Solot)

The first direct presidential elections in Turkey’s history will be held on Sunday. While not likely to be a market moving event, it will have important consequences for the country’s future. Current Prime Minister (PM) Erdogan should easily win the contest, and is expected to continue ruling the country from his new position. 

There is only one hitch: the Turkish constitution does not grant executive powers to the president. In the current parliamentary system, the presidency is a mostly (though not entirely) ceremonial role – the head of state, not the chief executive.   

So how will this work? We see three – not entirely mutually exclusive – paths forward.

1) Puppet Prime Minister: Erdogan could rule via proxy by installing a PM that he controls. This could turn out to be something like the Putin-Medvedev “tandemocracy.” In fact, we suspect that the most likely candidate for this setup will be the current president Abdullah Gul. But Gul is not a member of the parliament so, at least until next year’s parliamentary elections, he will have to wait on the side lines while someone else holds his PM job. This would probably be the more benign scenario since, while not ideal, would be the least disruptive. 

2) Super Presidency: Erdogan could just try to expand the powers of presidency and rule from his new post without going through the trouble of changing the constitution or using a proxy PM. After all, he will be popularly elected and will likely win by a large margin. In our view, this will leave Turkey in very murky legal territory and could heighten the sense of institutional uncertainty already present. 

3) Changing the constitution: Erdogan has tried to pass a new constitution, but has not succeeded so far. The AKP has the majority (just under 60% of seats), but not the 2/3 necessary to pass a new constitution, or the 3/5 needed to call a referendum for a new constitution. The next parliamentary elections are scheduled for June 2015.

INVESTMENT OUTLOOK

Whatever the path taken, we see policy and politics remaining largely as is. We do not think investors are very confident in Turkey’s path right now, but high yields have helped insulate the lira. As regional tensions pick up, Turkey and other EM countries with weak fundamentals are likely to suffer the most.

USD/TRY is making new highs for this move near 2.1750, levels not seen since late March. Other levels to look for ahead are 2.20and 2.25, other highs from March. 10-year government bond yields are around 9.35%. With real yields in negative territory, Turkey bonds do not look attractive. The Istanbul 100 stock index is moving lower, in line with global equities. It is still up 17% YTD outperforming most of its regional peers. We do not expect this outperformance to continue.

ECONOMICS AND POLICY

On the economic front, the fundamental backdrop remains weak. CPI inflation accelerated in July to 9.32% y/y, moving farther away from the 5% target and 3-7% target range. Core inflation fared even worse, rising to 9.75% y/y. At some point, policymakers should acknowledge that the target needs to be shifted in light of recent trends. 

Despite the negative inflation dynamics, the government continues to strong arm the central bank into maintaining a dovish bias. That is because growth remains soft. GDP rose 4.3%y/y in Q1 2014, and has not grown faster than 4.5% since Q4 2011. This is well below what can be considered potential growth. The next central bank meeting is August 27, and we believe that central bank cut the lower end of the corridor once again. Real rates remain deeply negative, and appear likely to move even further into negative territory. This will likely keep Turkish government bonds under pressure.

June IP will be reported Friday, with consensus at 2.5% y/y vs. 3.3% in May. However, we see downside risks as PMI fell below 50 in June and July, with the 48.5 reading in July the lowest since the series began in 2011. 

The only good news from the fundamental side is that the external accounts have improved. However, this is due largely to collapsing imports, down y/y for five straight months. When growth picks up, the trade and current account gaps will widen out again. 

Our proprietary model saw Turkey’s implied rating fall a notch this quarter to BB-/Ba3/BB-, as weak fundamentals continue to feed into strong downgrade risks. The investment grade rating given by Moody’s and Fitch seems premature now, but even S&P’s BB+ rating is subject to strong downgrade risks.