New Developments in Turkey But Same Old Problems Remain

Recent Turkish developments are noteworthy.  With fundamentals likely to remain weak and political risk rising (both internal and external), we believe Turkish assets are likely to continue underperforming.

INTRODUCTION

Recent Turkish developments are noteworthy.  With fundamentals likely to remain weak and political risk rising (both internal and external), we believe Turkish assets are likely to continue underperforming.

POLITICAL OUTLOOK

On the positive side, Turkey finally engaged the international community with regards to ISIS/ISIL, asking NATO to hold a rare emergency meeting this week.  This is only the fifth such meeting in NATO history, and reportedly discussed the establishment of a safe zone near Turkey’s border with Syria due to the ISIS/ISIL threat.  Recent attacks in Turkey linked to ISIS/ISIL seem to have given Turkish officials a greater sense of urgency.  NATO involvement is a positive step, although we would caution against any sort of quick resolution to the building problem.

On the negative side, the Turkish government launched airstrikes against the Kurdistan Worker’s Party (PKK).  This effectively ends a truce that has held for the most part since 2013.  Turkey is responding to recent PKK attacks.  Yet the heightened tensions come after a Kurdish party (HDP) won representation in parliament for the first time ever.  PKK could step up attacks on government installations such as gas and oil pipelines.

Rather than use the presence of HDP in parliament to reach a long-lasting political solution, Erdogan instead chose to attempt a military solution.  It seems counterproductive for Turkey to engage on two fronts at the same time.  Why not concentrate on the ISIS/ISIL threat, where Turkey will have international backing?

Turkey has also agreed to allow the US to launch air strikes in ISIS/ISIL from its Incirlik base, signifying a thaw in what had become frosty relations.  Yet the US stressed that it played no role in the strikes in PKK camps even while recognizing Turkey’s “right to self-defense.”  The situation is made more complicated by the fact that the PKK is affiliated with Syrian Kurds (YPG) that are fighting ISIS/ISIL.

On the domestic front, fresh elections are getting more and more likely.  None of the opposition parties appear willing to join a coalition led by the ruling AKP.  If an agreement is not reached, then fresh elections will be called, most likely this autumn.  If so, will the HDP build on its strong showing?  Or will the AKP be able to claw back some support?  We had thought that an AKP-HDP coalition was the most likely outcome, but government attacks on PKK camps this week have probably scuttled this possibility.

ECONOMIC OUTLOOK

Minutes from the July 23 policy meeting show that the central bank is considering a move to a simplified monetary policy framework with one policy rate.  Recall that it currently runs policy by managing liquidity within a rates corridor.  The bank has asked its technical units to complete these preparations and to submit them at the August policy meeting.  These preparations are thought to include a potential timeline for making the shift.  The rates corridor was introduced over five years ago, and was roundly criticized for needlessly complicating matters.

If true, the move should be seen as marginally positive since it would be a step towards orthodoxy.  Governor Basci said “This is not an effort to loosen or tighten our policy stance.  I see this as a step to increase confidence. I believe it will result in increased demand and investment by foreign investors.”  Part of the technical studies will be to determine the new policy rate (which ever rate is chosen) that keeps monetary conditions the same as the current framework.

Inflation remains high but is slowly moderating.  CPI rose 7.2% y/y in June, and Basci said that inflation could fall below 7% in July.  Data is out August 3.  This would be the first time in the 3-7% target range since May 2013.  Lower energy prices should help keep inflation low.  Yet we note that above-target inflation didn’t stop the central bank from easing over the course of 2014 and early 2015.  Policy has been on hold since the last 25 bp cut in the policy rate to 7.5% back in February.

Basci’s cautiousness earned the scorn of President Erdogan and his government.  After attacking Basci repeatedly in the run-up to the elections, officials have since been very quiet.  We take this as a good sign too.  We do expect cautious easing to resume, but most likely not until political risks have eased.  The weak lira also complicates matters.  The central bank blames the exchange rate for the rise in core inflation, which came in at 7.5% y/y in June.

The external accounts have improved, but mainly from imports collapsing faster than exports.  The central bank has noted that further improvement will likely be limited by weak external demand, and we agree.  If the economy manages to pick up, then this would put upward pressure on the trade and current account deficits.

Q1 GDP growth was 2.3% y/y, down from 2.6% in Q4.  So far, the Q2 outlook remains soft.  Manufacturing PMI remained below the 50 boom/bust level in June.  IP growth is so far around 2% y/y in Q2 vs. 1% y/y in Q1.  Exports are contracting still, as are real retail sales.  Consumer confidence remains near the lows, and the deteriorating security situation won’t help matters.

In our most recent EM ratings model update, Turkey’s implied rating was steady at BB/Ba2/BB and thus continues to face strong downgrade risks to its BB+/Baa3/BBB- ratings.  The investment grade given by Moody’s and Fitch seem premature now, but even S&P’s BB+ rating is subject to downgrade risk.  Indeed, S&P just released a report on Turkey that was decidedly negative.

INVESTMENT OUTLOOK

Turkish bonds have been the worst performers in EM, with 10-year local currency government bond yields up 161 bp YTD.  This is followed by Peru (+135 bp), Indonesia (+73 bp), and Brazil (+64 bp).  With domestic inflation set to move lower, the long end of Turkey can perhaps get some traction.  However, rising political risks are likely to offset this.

Weak economic fundamentals and rising political risk have dragged Turkish stocks lower.  It’s underperforming this year within EM (MSCI Turkey at -8.0% YTD vs. MSCI EM at -6.8%).  We believe the weak growth outlook and rising political risks will keep Turkish equity markets under pressure.

We remain negative on TRY, and expect USD/TRY to soon make new all-time highs above 2.81.  TRY is the third worst performer in EM, -16% YTD and behind only COP (-17% YTD) and BRL (-21% YTD).  It’s noteworthy that TRY is the only non-commodity currency to be doing so badly.  Other EM currencies under the most pressure include MXN (-10% YTD), CLP (-10%), ZAR (-9% YTD), and MYR (-8% YTD).  An upward sloping channel for USD/TRY dating back to 2006 can be found on the weekly charts, and the top comes in around 2.86 currently.  After that, the obvious round number target of 3 looms.