Turkish Assets to Continue Underperforming

US-Turkey relations are fraying. With regional political risks remaining high, we think the lira will continue to underperform. Fundamentals also remain poor, with inflation likely to move higher due to the weak lira and higher oil prices.

POLITICAL OUTLOOK

President Trump recently and abruptly announced the withdrawal of US troops from Syria via Twitter. Approximately 2000 US troops are stationed there and have been working with Syrian Kurdish forces in the fight against ISIS. The decision to withdraw reportedly came after Trump had a phone conversation with Erdogan, and apparently took many of Trump’s advisors by surprise.

Senior US officials have since walked it back. National security advisor John Bolton recently set forth certain conditions for an orderly US withdrawal, prompting President Erdogan to cancel a meeting. Bolton still met with other Turkish officials and delivered key US demands that the Kurds not be mistreated and that they play a substantial role in Syria after the US exits.

President Erdogan is planning to start military operations soon against the Kurdish forces in Syria. This has been planned for weeks, with Turkish troops reportedly massed on the border. Erdogan reportedly wants to make sure that the Syrian Kurds are unable to maintain control of what is in effect an autonomous region within Syria, for fear of its potential support for Turkish Kurds (more on this below).

Local elections will be held in March. Since Erdogan just won the presidential vote last June handily, these local elections have limited implications for the ruling AKP. In the last local elections in 2014, the AKP won control of both Istanbul and Ankara and so those races will be closely watched. Whatever happens, though, Erdogan is likely to maintain or even strengthen his grip on power ahead of the next general elections in 2023.

 

A BRIEF HISTORY LESSON

The concept of a Greater Kurdistan encompasses the mountainous regions of southeastern Turkey, northeastern Syria, northern Iraq, and western Iran. There are large Kurdish minorities in all four nations that share a common culture and heritage. The majority of Kurds are Sunni Muslims.

The goal of establishing an independent Kurdistan took hold in the early 20th century. After World War I ended with the defeat of the Ottoman Empire, the Western nations made provisions for the establishment of a Kurdish state. When the Treaty of Lausanne was later signed in 1923 to set the boundaries of modern Turkey, the idea of a Kurdish state was eliminated from the agreement.

Kurdish rebellions against the Ottoman Empire were seen for centuries, even before modern-day Turkey was established. In modern times, the separatist movement has been spearheaded by the Kurdistan Workers’ Party (PKK) after it was founded in 1978. It launched an armed struggle in 1984, leading the PKK to be classified as a terrorist group by the Turkish government, the EU, and the US. In the 1990s, the PKK ended its demands for a separate state and will instead settle for more autonomy within Turkey. The pro-Kurdish People’s Democracy party (HDP) denies links to the militant PKK.

Syrian Kurds established a de facto autonomous region in their nation as the civil war deepened. Syrian Kurdish militias banded together to form Popular Protection Units (YPG). YPG has been very effective in fighting ISIS and has been one of the main partners with the US in this conflict. On the other hand, Turkey considers YPG to be an extension of the PKK.

 

ECONOMIC OUTLOOK

The economy is in danger of a hard landing. The IMF expects GDP growth of 0.5% this year and 2.7% next year vs. an estimated 3.2% in 2017. GDP rose only 1.6% y/y in Q3, the slowest since Q3 2016. Data in Q4 suggest the slowdown has intensified and so we see downside risks to these growth forecasts. In real terms, money supply and bank loans are already contracting y/y. NPLS are rising steadily and likely to spike if the economic slowdown deepens.

Price pressures are easing but remain high. CPI rose 20.7% y/y in December, the lowest since August and the first month of deceleration since March. The 3-7% target range has been rendered meaningless. With the lira down 4% so far this month and oil prices moving higher, there are risks that inflation readings will tick higher in 2019. PPI rose 33.6% y/y in December. While down from the 46.2% y/y peak in September, elevated PPI readings suggest potential for further acceleration in CPI inflation.

The opposition CHP filed an inquiry in parliament asking government agency TurkStat about possible irregularities in collection of inflation data. TurkStat has denied it and said that its inflation data is up to international standards, both transparent and verifiable. That said, TurkStat confirmed that it will make some changes to the 2019 CPI basket.

The central bank’s inflation forecasts were revised down but remain too low. From its October quarterly inflation report, end-2019 inflation is seen at 15.2% and end-2020 at 9.3%. This compares to consensus forecasts of 18.8% and 12.3%, respectively. The bank said that these forecasts were “based on a monetary policy framework where the tight monetary policy stance will be maintained for an extended period.” The next inflation report is due out January 30 and these forecasts should be raised again.

With growth collapsing and inflation perhaps topping out, many are concerned that the central bank will start the easing cycle prematurely. While the January 16 meeting seems too soon, we think that every meeting will become live as the year progresses. After the central bank’s quarterly inflation report on January 30, the March 6 and April 25 policy meetings need to be watched closely. So too does the June 12 meeting. Much will depend on how the lira is trading. The more it weakens, the less likely a rate cut becomes.

The external accounts are improving sharply. The 12-month total trade deficit has narrowed five straight months, with imports contracting y/y since June. Furthermore, the monthly current account readings have moved into surplus for three straight months. November data will be reported Friday.

The IMF sees the deficit narrowing to -1.4% of GDP this year from -5.7% in 2018 and -4.6% in 2017. Note that after the 1994 crisis, the current account moved from a deficit equal to -3.6% of GDP in 1993 to a surplus equal to 2% of GDP the next year. After the 2001 crisis, the current account moved from a deficit equal to -3.7% of GDP in 2000 to a surplus equal to 1.9% of GDP the next year.

Foreign reserves have edged higher recently. In January 2018, reserves were $91.4 bln but fell to a trough of $67 bln in September. Whilst recovering to $72 bln in December, reserves still barely cover 3 months of imports and are equivalent to less than of the stock of short-term external debt. Usable reserves (which net out commercial bank FX deposits at the central bank) have edged higher but were only $30.2 bln in December and shows even greater external vulnerability. Lastly, Turkey’s Net International Investment Position is a rather high -55% of GDP.

 

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%). In 2018, TRY fell-28% and was behind only the worst performer ARS (-50.5%). So far in 2019, TRY is the worst EM performer at -4%, with KRW a distant second at -0.7%. Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect this underperformance to continue.

Turkish equities are still underperforming. In 2018, MSCI Turkey fell -20.5% and compares to -17.55% YTD for MSCI EM. So far in 2019, MSCI Turkey is flat vs. a 2.5% gain for MSCI EM. With growing risks of a hard landing, we expect Turkish equities to continue underperforming and this supports the UNDERWEIGHT in our EM Equity Allocation model. The banking sector remains particularly vulnerable.

Turkish bonds are still underperforming. The yield on 10-year local currency government bonds is +29 bp YTD and is the worst EM performer. The next worse are India (+26 bp) and Singapore (+15 bp). With inflation likely to remain uncomfortably high, 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. We still think Turkey faces very strong downgrade risks to its B+/Ba3/BB ratings. What happens going forward will depend on how long the current slowdown persists, as a protracted recession will hurt many of Turkey’s already poor credit metrics.