Some Thoughts on Turkey

(from my colleague Dr. Win Thin)

INTRODUCTION

 
After last Friday’s failed coup attempt in Turkey, a measure of calm has returned to global markets.  We did not think Turkish developments have wide-reaching implications for EM assets, but we do remain very negative on Turkish assets in the wake of the coup and ongoing political uncertainty.

POLITICAL OUTLOOK

Democracy has (so far) been upheld as the coup attempt has failed.  That Erdogan was democratically elected is important.  Yet ironically, his remaining in power is likely to usher in a period of less democracy in Turkey.  Why?

The failed coup attempt gives President Erdogan a golden opportunity to consolidate his power even further, a “gift from God” as he called it.  He has already begun to purge the military, the police, and the judiciary, continuing efforts that began years ago.  In doing so, Erdogan will further erode the natural checks and balances that different branches of the government are supposed to provide.

Erdogan claims that his onetime ally Gulen, who left Turkey in 1999 and now resides in the US, was the mastermind of the coup, and demands his extradition.  The US (and Europe) quickly supported the democratic government in Turkey in the face of the coup, but has requested evidence of Gulen’s guilt before sending him to home.  

Regionally, the coup attempt has far-reaching implications.  We suspect that Erdogan will focus his efforts on shoring up the domestic political landscape now, perhaps diverting attention away from the festering issues of the refugee crisis and ISIS.

 
Relations with the West will be strained further.  US Secretary of State Kerry said NATO will be scrutinizing Turkey to make sure it fulfills the requirements for democracy and the rule of law.  Elsewhere, EU foreign policy chief Mogherini warned Turkey not to execute coup plotters, noting that countries with the death penalty cannot join the EU.  Yet Erdogan told his supporters that Parliament should consider reinstating the death penalty, which was abolished in 2004.

Clearly, Turkey’s EU accession has become much more difficult.  Can the EU continue negotiations with a nation that has been curtailing press freedoms and judicial independence?  Surely, what Turkey has done (and is likely to continue doing) is far worse than anything we’ve seen in Hungary or Poland, two nations that have come under scrutiny under the EU’s so-called Rule of Law Framework.  

Yet the West needs Turkey to help control the flow of refugees into Europe.  Turkey recently agreed to take back some Syrian refugees.  However, that agreement was already under strain even before the coup attempt, as the EU claimed that Turkey was not meeting the conditions of that agreement.  Any resumption of destabilizing refugee flows could further widen the fissures within the EU itself.

ECONOMIC OUTLOOK

The economy remains sluggish.  GDP growth is forecast by the IMF at 3.8% in 2016 and 3.4% in 2017 vs. 4% in 2015.  GDP rose 4.8% y/y in Q1.  This was slightly stronger than expected, but was boosted by a low basis for comparison.  Base effects for the rest of the year are higher and so less favorable for y/y comparisons.

Consumer and business confidence are likely to weaken in the wake of the failed coup.  Consumer confidence had been stabilizing in 2016, but now seems likely to revisit the lows from 2015.  This will likely weigh on consumption and growth.  Tourism has collapsed under the weight of Russian sanctions coupled with the terrorist attacks. 

Price pressures are rising again, with CPI up 7.6% y/y in June.  This is the highest rate since February, and suggests that the timing of a cut in the benchmark rate will get pushed out.  With inflation back above the 3-7% target range, outright easing is unlikely near-term. 

The central bank next meets July 19, and no change in the 7.5% benchmark rate is expected.  However, it is expected to cut the overnight lending rate by another 25 bp to 8.75%.  Yet markets are split here.  Of the 21 analysts polled by Bloomberg, 7 see no change in the overnight lending rate, 7 see a 25 bp cut, and 7 see a 50 bp cut.

New CBT Governor Cetinkaya will be under pressure to ease more aggressively.  However, the lira weakness stemming from the coup attempt complicates matters since it will likely push inflation higher in Q3.  It remains to be seen whether government officials will become more vocal in their criticism of the central bank.

Fiscal policy had remained prudent, but the recent deterioration is worrisome.  The budget deficit  has been close to -1% of GDP for the past three years.  It is expected to widen slightly to around -2.5% for both this year and next.  However, we see risks of wider than expected deficits.  Expenditures have surged this year, pushing the primary balance into deficit in June and widening the 12-month nominal deficit to its highest since September.

The external accounts also bear watching.  Lower oil and energy prices have helped lower imports, as has the slowdown in the economy.  The current account gap was about -4.5% of GDP in 2015, but is expected to widen to around -5% of GDP this year and next.  Foreign reserves have risen modestly, and at $102 bln in June, they cover almost 6 months of import.  However, short-term debt is almost double total reserves.  Turkey remains too dependent on hot money flows.  Furthermore, using the concept of usable reserves, Turkey’s holdings are a mere $30 bln. 

INVESTMENT OUTLOOK

The lira has generally underperformed in EM.  In 2015, TRY lost -20% vs. USD.  This was ahead of only the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), and RUB (-20%).  So far this year, TRY is -2% YTD and is amongst the worst performers that include ARS (-13%), MXN (-7%), and CNY (-3%).  Our EM FX model shows the lira to have WEAK fundamentals, so this year’s underperformance is to be expected.

USD/TRY made a new high for this move Friday around 3.05.  This fell just shy of the all-time high near 3.0750 from last September.  After today’s relief rally in the lira, we expect the dollar to eventually test the 2016 high near 3.06, followed by new all-time highs. 

Turkish equities outperformed last year, but are underperforming within EM this year.  Last year, MSCI Turkey was -12% while MSCI EM was -17%.  So far in 2016, MSCI Turkey is up 4% YTD, and compares to 8.5% 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 -97 bp YTD.  This is behind only Brazil (-463 bp), Indonesia (-158 bp), Peru (-157 bp), and Russia (-112 bp).  With inflation likely to continue rising and the central bank’s next move likely to be a cut, we think Turkish bonds will underperform more.  As it is, Turkish 10-year yields are +59 bp just today.

Our own sovereign ratings model shows Turkey at BB/Ba2/BB.  Both Moody’s and Fitch were a bit premature in upgrading it to investment grade.  But even S&P’s more conservative BB+ rating seems at risk.  Deteriorating fiscal and external balances coupled with worsening political risk are likely to be the triggers for a downgrade this year.     

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