US-Turkey relations are in flux. After seemingly capitulating to President Erdogan and withdrawing US forces from Syria, President Trump later threatened to destroy the Turkish economy if anything “off-limits” is done. The heightened uncertainty comes at a time when geopolitical risk is already elevated, and so EM and risk assets should remain under pressure, led lower by Turkish assets.RECENT DEVELOPMENTS
The US announced it will withdraw its troops from northeast Syria. Approximately 2000 US troops are stationed there and have been working with Kurdish Syrian Democratic Forces (SDF) in the fight against ISIS. Basically, this will allow Turkey to launch a military operation unimpeded against Kurdish forces in Syria that had been allied with the US. However, US Defense Department officials said that Trump’s warning is a strong signal to Turkey not to launch any operations in Syria after the US withdraws.
The move also raises questions whether ISIS will become a destabilizing force in the region again. Trump has claimed that ISIS has been destroyed, but most experts disagree. And what about the fate of thousands of ISIS detainees held by the Kurds? Trump said Turkey will take control of the detainees, but it is not clear if Turkey has the desire or capability to do so.
President Trump claims the move is meant to fulfill his campaign promise to extricate the US from “endless wars.” He said, “It’s time to come home.” Yet the Syrian operation was widely considered a success that entailed very low costs and casualties to the US.
President Trump is facing unusual pushback from senior lawmakers in his party, including Senators Mitch McConnell and Lindsey Graham. McConnell warned that a supermajority in the Senate opposed this move, indicating the possibility of a veto-proof measure to oppose the withdrawal. Graham has reportedly spoken with Democratic Senators about introducing new sanctions if Turkish forces invade Syria. Stay tuned.
This move is not a total surprise. Last December, President Trump abruptly announced the withdrawal of US troops from Syria via Twitter without consulting his national security team, Congress, or our allies. The initial decision to withdraw reportedly came after Trump had a phone conversation with Erdogan, and apparently took many of Trump’s advisors by surprise. Senior advisors were able to walk him back. Until now.
President Erdogan is obviously planning to start military operations soon against the Kurdish forces in Syria. This had originally been planned back in December, when Turkish troops reportedly massed on the border. When Trump reversed that decision, Erdogan was forced to bide his time. Until now. Erdogan wants to ensure 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).
A BRIEF HISTORY LESSON
Turkey borders Syria, and so has taken a keen interest in seeing a lasting solution its neighbor’s civil war. Syrian refugees have poured mostly into Turkey, straining the nation’s ability to absorb them. ISIS has also made incursions into Turkey with deadly bombings in some major cities. Yet Turkey is also struggling with how to deal with its own Kurds.
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. Most 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.
Syria had been part of the Ottoman Empire. After World War I, Ottoman territory was largely split between France and Britain, with Syria eventually falling under the former. Syria gained independence from France in 1946. The population is mostly Sunni Muslim, though senior government and military leaders are dominated by the Alawites (Shia Muslim).
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 instead would 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.
Not surprisingly, Syrian, Iraqi, and Turkish Kurds are natural allies in the fight against ISIS. The US also sees the Kurds as its most effective ally in the efforts to remove Assad from power. Abandoning the Kurds now would seem to cede victory to Assad. Indeed, most believe that any decision by the US to withdraw would help Russia, Iran, President Assad of Syria, and ISIS.
The economy is crawling out of recession. The IMF expects GDP to contract -2.5% this year before growing 2.5% in 2020. GDP contracted -2.4% y/y in Q1 and -1.5% y/y in Q2. However, GDP grew 1.57% and 1.25% q/q, respectively. Data so far in Q3 suggest the recovery continues but we still see downside risks to these growth forecasts.
Price pressures are easing. CPI rose 9.3% y/y in September, the lowest since January 2017. The deep recession has helped push price pressures down. So has recent lira stability. PPI rose only 2.4% y/y in September, the lowest since September 2016. The 3-7% target range has been rendered meaningless, however.
Turkey central bank has delivered two dovish surprises so far totaling 750 bp of total easing. It next meets October 24 and another large cut of 300-400 bp from the current policy rate of 16.50% seems likely. Another cut may be seen at the December 12 meeting. However, we do not believe Erdogan’s professed plans for single digit interest rates will come to fruition anytime soon. Not when regional political risks are decidedly on the upswing.
The central bank’s next quarterly inflation report is due out October 31. In the last report released July 31, the central bank’s inflation forecasts for end-2019, end-2020, and end-2012 were 13.9%, 8.2%, and 5.4%, respectively. The new inflation forecasts are likely to be revised down. How much lower could hold some clues to monetary policy going forward. How fast and how much rates come down will be dictated by market reaction, which up until now has been muted.
The external accounts have improved sharply. The 12-month total trade deficit has narrowed every month since June 2018. Exports have slowed but import demand has collapsed. Furthermore, the 12-month total current account moved into surplus in June for the first time since November 2002 and climbed further into surplus in July.
The IMF sees the current account moving to surplus of 0.7% of GDP this year from -5.7% in 2018 before moving back to a modest deficit of -0.4% in 2020. 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.
Gross foreign reserves fell sharply ahead of the June Istanbul election do-over but have since recovered. Reserves were $79.1 bln in February but then fell to $73.4 bln in June. Gross reserves have since recovered to $75.7 bln in August. At this level, they still cover less than 3 months of imports and are equivalent to about 45% of the stock of short-term external debt.
Usable reserves net out commercial bank FX deposits at the central bank. These hit a new low of $24.7 bln in mid-May before recovering to nearly $36 bln in September. This low level still shows great external vulnerability. Lastly, Turkey’s Net International Investment Position is still a rather high -47% of GDP.
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 second worst EM performer at -9.5%, behind only ARS at -35%. Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect this underperformance to continue.
Turkish equities are outperforming after a poor showing last year. In 2018, MSCI Turkey fell -20.5% and compares to -17.55% YTD for MSCI EM. So far in 2019, MSCI Turkey is up 12.2% vs. a 4.4% gain for MSCI EM. With growing political risks, we expect Turkish equities to start underperforming and this supports the UNDERWEIGHT in our EM Equity Allocation model. With NPLs on the rise, banking sector remains particularly vulnerable.
Turkish bonds are outperforming. The yield on 10-year local currency government bonds is -380 bp YTD and is the best EM performer. The next best are Philippines (-247 bp) and Brazil (-216 bp). With inflation likely to continue falling and thereby allowing the central bank to cut rates further, we think Turkish bonds will continue to outperform.
Our own sovereign ratings model showed Turkey’s implied rating fell a notch to B/B2/B. We think Turkey faces even stronger downgrade risks to its B+/B1/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. Heightened geopolitical risk will also be a headwind on its ratings.