Turkey Underperformance Likely to Continue As Central Bank Surprises

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Despite the November elections, we believe that the political situation in Turkey remains very unsettled. Furthermore, the underlying economic fundamentals remain weak, and so we believe that underperformance in Turkish assets is likely to continue in 2016.


Erdogan and his AKP won an unexpected victory in November elections. The end of lingering political uncertainty since the inconclusive June elections has been welcomed by markets, but we think a continuation of the increasingly autocratic rule of Erdogan is not necessarily a positive development. The next elections are not due until 2019.

Terrorist activity stemming from ISIS and the civil war in neighboring Syria will severely test Erdogan’s foreign policy. Furthermore, the domestic situation with the Kurdish PKK remains unsettled.

Relations with Russia remain tense, with Putin enacting economic sanctions after the downing of the Russian jet last month. Among other things, Russia has restricted imports of Turkish goods and suspended visa-free travel. Russia is Turkey’s second largest trading partner, behind only Germany. Russia is the number one source of Turkish imports, but is only the seventh largest destination for Turkish exports.



The economy is picking up. Growth is forecast at around 3% in both 2015 and 2016. GDP grew 4% y/y in Q3, the fastest since Q1 2014 and suggests potential for upward revisions to those forecasts. On the other hand, the ERBD recently warned that persistent sanctions by Russia may reduce GDP growth by 0.3-0.7 percentage points in 2016, with much of the impact coming from tourism. Deputy Prime Minister Simsek estimated the economic impact of sanctions at around 0.4 percentage points.

Price pressures remain high, with headline CPI inflation rising 8.1% y/y in November. This is well above the 3-7% target range and is the highest since May. Core inflation is even worse at 9.2% y/y, the highest since September 2014. We have long felt that a rate hike was overdue. The central bank has been on hold since February, when it cut the policy rate by 25 bp to 7.5%.

Governor Basci has hinted that Turkish rates would follow US rates higher, but that did not happen today. He also suggested that simplification of the bank’s rates corridor would be seen after the Fed meeting. That too did not happen. The next policy meeting is January 19. Given the negative market reaction to today’s surprise move, we would expect some efforts at further clarity ahead of that meeting.

Fiscal policy is not a big concern (yet). The budget deficit is forecast to rise modestly to around -2% of GDP this year. It is seen rising further to around -2.5% by 2017, which is still manageable. However, the government appears ready to follow through on its campaign promise to boost the minimum wage by 30% in early 2016. Subsidies may be given to employers, which would pose upside risks to the budget deficit.

The external accounts have improved. Lower oil prices have helped reduce imports, as has slow growth. There is a risk that it will not outweigh downward pressure on exports coming from the Russia sanctions. With growth picking up, the current account deficit is seen widening from -4.5% of GDP this year to around -5% next year.

Foreign reserves have fallen to $99.7 bln. However, usable reserves (that net out commercial bank FX deposits with the central bank) continue to sit at a meager $27 bln. FDI has started to pick up in recent months, and now covers about 40% of the current account gap. This is the highest coverage since early 2010, but the country is still reliant on hot money flows.



The lira is one of the worst performing EM currencies this year. TRY is down -21% YTD vs. USD, and trails only ZAR (-24%), COP (-28%), BRL (-34%), and ARS (-35%). Our EM FX model shows the lira as having VERY WEAK fundamentals. As such, we expect lira underperformance to continue in 2016. In the coming weeks, we expect USD/TRY to test and move beyond the all-time high near 3.0750 from September.

Turkish equities have outperformed within EM. MSCI Turkey is down -13% YTD, and compares to -17% YTD for MSCI EM. This outperformance is likely to ebb as the central bank eventually embarks on a long-overdue tightening cycle. Indeed, our EM Equity model has Turkey at a NEUTRAL position.

Turkish bonds have underperformed this year. The yield on 10-year local currency government bonds is up 269 bp YTD. This is behind only Brazil (+404 bp), and is worse than Peru (+181 bp), Colombia (+167 bp), and South Africa (+144 bp). With inflation likely to remain high and the central bank likely to start a tightening cycle in early 2016, we think Turkish bonds are likely to continue underperforming.