Poor Turkish Fundamentals and Rising Political Risk Argue for Caution

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Despite poor fundamentals and rising political risk, Turkish assets have help up relatively well.  While Turkish equities should do OK, we remain less constructive on bonds and the lira. 

POLITICAL OUTLOOK

Turkish forces started an offensive last month against Kurdish YPG forces in Syria.  This has put further strains on US-Turkey relations, as the Kurds have been the biggest allies of the US in the fight against ISIS.  Indeed, the US acknowledged that anti-ISIS operations with the YPG are in “operational pause” due to the Turkish offensive.

The regional situation remains messy.  Pro-Assad militias arrived in Afrin late last month to lend support to the Kurds, even though they have clashed elsewhere.  Assad has also reportedly cleared the way for Kurdish reinforcements to get to Afrin.  What the two sides have in common is an interest in limiting Turkey’s incursion into Syria.  Russia has also increased its involvement in Syria, and so with all these moving parts, it’s not hard to imagine this situation somehow erupting into a broader international conflict.

President Erdogan remains firmly in control.  The presidency has been transformed by the constitutional referendum from a largely ceremonial post to the most powerful post in the nation.  After the next elections, the post of Prime Minister will be eliminated and most of its powers will be shifted to the presidency.

The opposition remains divided, and yet Erdogan is taking no chances.  His ruling Justice and Development Party (AKP) just entered an electoral alliance with the Nationalist Movement Party (MHP).  Whilst the MHP has opposed Erdogan in the past, it is facing the prospect of failing to win 10% of the vote in the next election.  As such, it has entered this alliance in order to avoid extinction.

The other main opposition parties are the Republican People’s Party (CHP) and the People’s Democratic Party (HDP).  These four were the only parties to surpass the 10% threshold in the 2015 elections that is needed for parliamentary representation.  The CHP remains the largest opposition party.  Like the MHP, the HDP saw its vote share fall from the prior election to barely over 10%.

The next parliamentary and presidential elections are scheduled for November 2019.  Under the recently approved constitutional amendments for presidential reform, Erdogan can now run for two more 5-year terms, which could theoretically see him rule the country until 2029.  Ahead of those elections, municipal votes will be held in March 2019.

However, there is growing speculation that early elections may be called.  Erdogan’s decision to take military action in Syria has boosted his popularity, and he may seek to cash in on this with an early vote.  One local poll showed 90% of Turks support the Syrian offensive.  The fiscal spigots have also been opened, adding to the speculation.

Turkey scores well in the World Bank’s Ease of Doing Business rankings (60 out of 190).  The best components are protecting minority investors and enforcing contracts, while the worst are dealing with construction permits and resolving insolvency.  Turkey does slightly worse in Transparency International’s Corruption Perceptions Index (81 out of 180) and tied with Ghana, India, and Morocco.

ECONOMIC OUTLOOK

The economy is expected to slow.  GDP growth is forecast by the IMF at 3.5% in 2018, down from an estimated 7% in 2017.  GDP rose 11.1% y/y in Q3, but this was due to the low base effect from 2016 after the attempted coup.  Given the likelihood that fiscal stimulus will increase in the leadup to the 2019 elections, we see upside risks to the growth forecast.

Price pressures remain high, with CPI inflation at 10.3% y/y in February.  While this is the lowest rate since July, it remains well above the 3-7% target range.  Core inflation remains even higher at 11.9% y/y in February.  What’s worse, PPI inflation picked up to 13.7% y/y from 12.1% in January and suggests upside risks for CPI ahead.  This argues for tight policy.

The central bank last tightened with a 50 bp hike in the Late Liquidity Window rate to 12.75% back in December.  This rate has become the de facto policy rate, which quickly and fully feeds through to the weighted average cost of funding for commercial banks.  The next policy meeting is tomorrow March 7, and no change is expected.  Until inflation is on a sustainable downward trajectory, we think the bank will remain in hawkish mode.

The fiscal outlook is worsening.  After running a primary surplus since 2001, this measure returned to deficit last year as the government increased spending ahead of elections next year.  The nominal budget deficit widened to an estimated -2.1% of GDP in 2017, and is expected to rise further to -2.3% in 2018 and -2.5% in 2019.  We see upside risks to these forecasts.

The external accounts are deteriorating.  The current account was an estimated -4.6% of GDP in 2017, the largest annual deficit since 2014.  The IMF expects the deficit to remain steady at -4.6% of GDP in 2018, but we see upside risks.  Export growth has slowed in recent months to around 10% y/y, while import growth has surged to nearly 40% y/y in February.

Worse yet, FDI has dried up, with the 12-month total of $10.8 bln in December the lowest since February 2011.  This covers less than a quarter of the 12-month current account gap.  Turkey will depend on so-called hot money to cover the rest of the shortfall, which raises its external vulnerabilities.

Foreign reserves have fallen to multi-year lows.  Gross reserves were $88.7 bln in February, up slightly from the cycle low of $84.1 bln in December.  They cover 4 months of imports but are barely a third of its stock of short-term external debt.  However, usable reserves (which net out commercial bank FX deposits at the central bank) are only about $23.3 bln, and shows even greater external vulnerability.

INVESTMENT OUTLOOK

The lira continues to underperform.  In 2017, TRY fell -7% vs. USD and was ahead of only the worst EM performer ARS (-14.5%).  So far in 2018, TRY is basically flat YTD and is ahead of only the worst performers ARS (-8%), PHP (-4%), INR (-2%), IDR (-1.5%), KRW (-0.5%), and PEN (-0.5%).  Our EM FX model shows the lira to have VERY WEAK fundamentals, and so it should continue to underperform.

Turkish equities are underperforming after a solid 2017.  In 2017, MSCI Turkey was up 44% vs.  34% for MSCI EM.  So far this year, MSCI Turkey is up 2% YTD and compares to 4% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Turkey at an OVERWEIGHT position.

Turkish bonds have underperformed.  The yield on 10-year local currency government bonds is +37 bp YTD.  This is behind only the worst EM performers the Philippines (+129 bp), Hungary (+68 bp), Colombia (+43 bp), and India (+38 bp).  With inflation likely to remain high and the central bank unlikely to ease anytime soon, we think Turkish bonds will continue to underperform.

Our own sovereign ratings model showed Turkey’s implied rating falling a notch to B/B2/B after remaining steady last quarter after two straight quarters of decline.  We think Turkey faces even greater downgrade risks to its BB/Ba1/BB+ ratings.