Turkey CPI Likely to Trigger Another Leg Lower for TRY

Turkey reports July CPI data tomorrow and could trigger another leg lower in the lira. We suggest several measures that are necessary (but not sufficient) conditions to stabilize Turkish markets. Like the rest of EM, Turkey must still cope with heightened trade tensions and rising US rates.POLITICAL OUTLOOK

After President Erdogan won reelection, he immediately consolidated control of the economy. He appointed his son-in-law Berat Albayrak to head up the new combined Treasury and Finance Ministry. Albayrak pushed out Mehmet Simsek as the economic czar, who was well-respected by the markets and one of the last market-friendly members of the cabinet.

Erdogan will continue to reshape government institutions so that he has even more control. He will exert more influence on central bank policy after issuing a degree to take sole responsibility for appointing the Governor and Deputy Governors. Previously, the Governor was named jointly by the President, Prime Minister, and Deputy Prime Minister, while the Governor had control over selecting his Deputies.

The US just imposed sanctions on two Turkish officials over the continued detention of American pastor Andrew Brunson. The sanctions target Minister of Justice Abdulhamit Gul and Minister of Interior Suleyman Soylu, both of whom “played leading roles in the organizations responsible for the arrest and detention of Pastor Andrew Brunson,” according to the US Treasury statement.



The economy is in danger of overheating, but we feel those risks are starting to shift towards a hard landing. GDP growth is forecast by the IMF at 4.4% in 2018 and 4.0% in 2019 vs. 7.4% in 2017. GDP rose 7.4% y/y in Q1 and 7.3% in Q4, down from 11.3% rate in Q3 but still quite strong. However, monthly data so far suggest growth slowed in Q2. The longer rates stay high, the greater the economic costs. As such, we see downside risks to the growth forecasts going forward.

Price pressures remain high and likely to rise further. CPI rose 15.4% y/y in June, up from the 12.1% in May and the highest since October 2003. Core inflation has also accelerated to 14.6% y/y, the highest since this series began in 2003. More worrisome, PPI rose 23.7% y/y in June vs. 20.2% in May, the highest since this series began in 2010 and portending further acceleration in CPI inflation.

July CPI will be reported tomorrow and is expected to accelerate to 16.3% y/y. If so, it would move further above the 3-7% target range. TRY weakened 7% in July, and so we see upside risks to the data tomorrow. Indeed, TRY has tagged on another 3% loss so far in August. if the central bank remains behind the curve, we could easily see inflation approach 20% in the coming months.

Note that a reading of 16.3% in July would push the real rate down to only 1.5%. Compare that to Argentina, where a 40% nominal policy rate is currently translating into a 10.5% real rate. As we warned after CBT’s last hike of 125 bp back in June, more needs to be done.

Officials pledged to hike rates further if inflation rises and yet the Central Bank of Turkey delivered a dovish surprise last month. Despite the higher June inflation print, the bank left rates steady at 17.75% even as consensus saw a 100 bp hike. Next scheduled CBT meeting is September 13, but an intra-meeting hike will be needed if market sentiment goes further south.

The external accounts remain worrisome. The current account deficit was -5.2% of GDP in 2017, and the IMF expects the deficit to widen to -5.4% of GDP in 2018. Due to the so-called J-curve effect, we expect recent lira weakness to pose risks of an even wider current account deficit ahead. Higher energy prices are also boosting imports. June current account data will be reported next Friday.

Foreign reserves have dropped steadily over the course of the year. In June, reserves stood at the cycle low of $75.6 bln but recovered to $78.3 bln in July. They cover about 3.5 months of imports and are equivalent to about a third of the stock of short-term external debt. However, usable reserves (which net out commercial bank FX deposits at the central bank) remain low at $22.8 bln in July, and shows even greater external vulnerability.



What would it take to stabilize Turkish markets? We believe the central bank should be given free rein to hike rates aggressively, along the lines of what Argentina did. Hiking 100 bp here and there just won’t cut it any more as the bank needs to make a much stronger statement. By waiting too long, the bank should now hike rates to at least 25%.

On the political front, Erdogan is facing two battles that must be addressed. Internationally, he must work to improve US-Turkey relations. If relations continue to worsen, we would have to expect more sanctions by the US. Domestically, Erdogan must appoint or promote more market-friendly officials in order to regain a degree of market confidence.

All of these suggested measures are necessary (but not sufficient) conditions to stabilize Turkish markets. Like the rest of EM, Turkey must still cope with heightened trade tensions and rising US rates. Perhaps the best that Turkey can hope for is to stop its massive underperformance.

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 -25% and again is ahead of only the worst performer ARS (-33% YTD). Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect underperformance to continue.

USD/TRY trade at a new all-time high today just below 5.10. With pressure on EM expected to continue, we see this pair moving higher. There is an upward sloping channel on the daily charts dating back to December. The top of that channel comes in near 5.42 currently.

Turkish equities are underperforming after a stellar 2017. In 2017, MSCI Turkey was up 44% vs. 34% for MSCI EM. So far this year, MSCI Turkey is -19% YTD and compares to -7.5% YTD for MSCI EM. With tight monetary policy posing downside risks to growth, we expect Turkish equities to continue underperforming.

Turkish bonds have underperformed. The yield on 10-year local currency government bonds is +713 bp YTD and is by far the worst EM performer, well ahead of the next worst (Argentina) at +309 bp. Shorter-dated paper has fared even worse as a result of the 17.75% policy rate. With inflation likely to move higher and the central bank eventually forced to tighten policy further, we think Turkish bonds will continue to underperform.

Our own sovereign ratings model showed Turkey’s implied rating fell a notch to B/B2/B, reversing last quarter’s rise. Fitch just downgraded Turkey a notch to BB last month. We still think Turkey faces very strong downgrade risks to its BB-/Ba2/BB ratings.