Turkey on a Knife Edge 

This next couple of days could be decisive for Turkey. Many are hoping that a coalition government that would break the stalemate in Turkish politics will be announced or hinted at by Friday, but possibly even today. Markets are clearly trading off this news, with Turkish assets outperforming earlier in the week  despite weak risk appetite globally and the intensification of the conflict with the Kurds.

This next couple of days could be decisive for Turkey. Many are hoping that a coalition government that would break the stalemate in Turkish politics will be announced or hinted at by Friday, but possibly even today. Markets are clearly trading off this news, with Turkish assets outperforming earlier in the week  despite weak risk appetite globally and the intensification of the conflict with the Kurds.

At stake is the possibility that the ruling AKP party may enter into a coalition with either the opposition CHP, or the nationalist MHP. The former appears the most likely at this junction, if it happens. Much of the optimism came from acting PM Davotuglu talking about the necessary sacrifice to construct an AKP-CHP coalition and other comments. This helped the lira appreciate against the dollar on the eve of the Chinese devaluation, while every other major EM currency was weakening. The same day, the XU100 index was up 2.8% while MSCI EM was down 1.1%, though some of these gains were reversed today.

We always doubted that an AKP-CHP grand coalition would materialize, but momentum and recent headlines seem to be against us. Still, we warn investors about getting too excited before an actual deal is struck. PM Davutoglu has already downplayed hopes of a coalition, saying that a “historic” announcement shouldn’t be expected on Thursday. In addition, anecdotal reports suggest that the most important politician in the AKP, President Erdogan, is not keen on a deal, preferring to try his luck on new elections. He also hinted at trying a coalition with the nationalist MHP, again deflating hopes of an AKP-CHP coalition.

Either way, we don’t see enough arguments to be optimistic about Turkey (except for maybe lower oil prices). Even if a coalition government is formed, it will be a very fragile one. Moreover, the government has openly waged war on the Kurds, a minority that makes up some 20% of the country’s population, depending on how you count it. Erdogan called the elected Kurdish party, the HDP, the political extension of a terrorist organization. Meanwhile, F-16 planes bombed PKK targets in the Southeast of Turkey.

It’s hard to grasp how this situation is positive for Turkey’s assets in the near term. Still, the recent price action has proven just how important the political backdrop is to investors. If a coalition is agreed we will surely see a rally, but if we get to the point of new elections we fear that the selloff will be even greater. The risks are asymmetric to the downside, in our view.