Turkey’s Post-Election Outlook Remains Poor

President Erdogan and his AKP were the unequivocal winners of the weekend election.  He was given free rein to continue remaking the nation in his own image, which should concern investors.  The Turkish lira remains volatile and we do not think the worst is over yet. 

POLITICAL OUTLOOK

President Erdogan was reelected with 53% of the vote.  Please note that the results are not yet official.  This was the first election under the recently approved constitutional amendments for electoral reform.  The presidency, once a ceremonial post, has now been turned into a strong executive.

The post of Prime Minister was eliminated and most of its powers shifted to the presidency.  Erdogan can run for two more 5-year terms, which could theoretically see him rule the country until 2028.  A loophole could allow him to run for a third, if parliament calls early elections during his second term.

Main opposition Republican People’s Party (CHP) candidate Muharrem Ince came in second with 31% of the vote.  Whilst conceding the race, Ince disputed the vote count and warned of the growing danger to democracy in Turkey.  The state of emergency in place since the July 2016 coup attempt has been extended several times, but now that Erdogan has secured victory, perhaps he will finally end it.

The new parliament was expanded to 600 seats vs. 550 previously.   The ruling Justice and Development Party (AKP) won 42.6% of the vote and 295 seats, down from 49.5% and 317 seats in the November 2015 election.  This was the AKP’s lowest share of the popular vote since 2003, and should serve as a warning sign to Erdogan and his party.

The Nationalist Movement Party (MHP) entered into an electoral People’s Alliance earlier this year with AKP.  Whilst the MHP has opposed Erdogan in the past, it faced the prospect of failing to win 10% of the vote in the election.  However, MHP did end up winning 11.1% of the vote and 49 seats, up from 40 won in November 2015.  Together, this bloc won nearly 54% of the parliamentary vote and 344 seats.

The CHP won 34% of the parliamentary vote, giving it 146 seats vs. 134 in November 2015.  The other main opposition party is the People’s Democratic Party (HDP), which represents the Kurdish minority.  It won 12% of the vote and 67 seats, up from 59 in November 2015 and above the key 10% level needed for parliamentary representation.  That the HDP did so well while its presidential candidate Selahattin Demirtas is in jail is a testament to its solid support amongst the Kurds.

These four were the only parties in the 2015 elections to surpass the 10% threshold needed for parliamentary representation.  In this election, they were joined by the new centrist Good (Iyi) party.  Founded in October by its leader Meral Aksener, Iyi is made up of many former members of MHP and CHP.  Iyi quickly gained traction with its anti-establishment message, winning 10% of the vote and 43 seats.

CHP and Iyi entered into the so-called Nation Alliance, which together hold 189 seats.  This also includes the Islamic Felicity Party and the center-right Democrat Party.  These last two parties did not win any parliamentary seats, but are represented in several local and regional governments.

ECONOMIC OUTLOOK

Erdogan will continue to reshape the government so that he has even more control.  Besides promising to exert more influence on central bank policy, reports suggest Erdogan will consolidate the economic team into three ministries from six currently.  The Treasury and Finance Ministries would be merged, with the other two ministries being Trade and Industry & Technology.  This is part of a broader plan to lower the total number of ministries to 16 from 27 currently.

The economy is in danger of overheating, though those risks are ebbing.  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 suggest Q2 has slowed.  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 due to the weak lira.  CPI rose 12.1% y/y in May, up from the 10.8% in April and nearing the cycle peak of 13% in November.  This is well above the 3-7% target range.  Core inflation has also accelerated to 12.6% y/y, a new cycle high.  PPI rose 20.2% y/y May vs. 16.4% in April, the highest since August 2003 and portending further acceleration in CPI inflation.

The central bank started the tightening cycle with a larger than expected 75 bp hike in the de facto policy rate at the Late Liquidity Window to 13.5% at its April meeting.  The bank was then forced by the lira free-fall to move intra-meeting, hiking that rate another 300 bp to 16.5% in May.  It hiked a larger than expected 125 bp at the June meeting to 17.75%.  Next policy meeting will be held July 24.  Officials have pledged to hike rates further if inflation rises.  June CPI will be reported on July 3 and is widely expected to accelerate.  If the bank doesn’t hike again, we think more credibility will be lost.

The central bank has simplified its interest rate regime.  The official policy rate is now back to the one-week repo after that role was usurped by the Late Liquidity Window (LLW) rate back in January 2017.  It remains to be seen how quickly and decisively Erdogan moves to take greater control of monetary policy.

For now, the central bank’s moves have helped stabilize the lira.  However, we think more will eventually need to be done.  Many investors like to focus on real rates rather than nominal.  Argentina has a 40% nominal policy rate and 26.4% inflation, which gives a real rate of 12.8%.  Compare this to Turkey, where the 17.25% nominal rate doesn’t look so high when adjusted for inflation.  CPI rose 12.1% y/y in May and is expected to accelerate again.  Inflation of, say 13% in June would give us a real rate of less than 5%.  Whilst that compares well with others in EM, it may not be enough for Turkey, where investor confidence remains low.

The fiscal outlook bears watching.  The consolidated budget deficit was equal to -2.3% of GDP in 2017, and the IMF expects it to widen to -2.9% in 2018 and -3.2% in 2019.  We see upside risks to these forecasts due to increased spending ahead of the elections.  For instance, a week before the elections, over 12 mln retirees got the first of two payments from the government.  The two payments of TRY1000 each will cost Turkey an additional $5.9 bln by year-end.

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.  May current account data will be reported this Friday, with consensus at -$7.7 bln.  If so, the 12-month total would rise to -$87 bln, the highest since June 2014.

Foreign reserves have dropped steadily over the course of the year.  In November, reserves stood at $96.4 bln but have fallen to $78.9 bln in mid-June.  They cover about 3.5 months of imports and are equivalent to less than a third of the stock of short-term external debt.  However, usable reserves (which net out commercial bank FX deposits at the central bank) are only about $26.6 bln in mid-June, 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 -19% and again is ahead of only the worst performer ARS (-31% YTD).  Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect underperformance to continue.

USD/TRY initially dropped as low as 4.5380 after the election before reversing higher.  Using the last May drop in USD/TRY, a clean break above the 4.7430 area would set up a test of the May 23 all-time high near 4.9255.  With pressure on EM expected to continue, we see this pair eventually moving above 5

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% 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 +491 bp YTD and is by far the worst EM performer, well ahead of the next worst (Argentina) at +244 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 likely to tighten policy further, we think Turkish bonds will continue to underperform.

Our own sovereign ratings model showed Turkey’s implied rating rose a notch to B+/B1/B+, reversing last quarter’s drop.  However, we still think Turkey faces strong downgrade risks to its BB-/Ba2/BB+ ratings.  Fitch has already warned that unhedged external debt obligations will weaken the nation’s credit metrics.