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Rob James

Globe WorldWatch

Turkey: the Sick Man of Emerging Europe out of Intensive Care

WorldWatch
21 July 2021

By

Emerging Markets Portfolio Manager

After years of deterioration under Erdogan, Turkey may finally be on the road to recovery, with potential political change and rock-bottom valuations possibly allowing it to recapture the attention of value investors and contrarians.

The secret to investing in Emerging Markets is to recognise that nothing is ever as good as it looks, but nor is it as bad as it seems, and to position yourself accordingly. For the first time in the best part of a decade, Turkey may be on the cusp of embodying the second half of that truism.

Turkey has long been an investment pariah and, to rehash the 19th-century cliché, the Sick Man of Emerging Europe. Shunned by international funds, its relative importance has declined to the extent that it now constitutes less than 0.5% of the MSCI EM Index. For many asset allocators, this made it too small to make a difference, too easy to discard, but now perhaps, at last, it may be too tempting to overlook. 

As recently as 2013, before the outlook began to deteriorate following the Gezi Park protects, Turkey was promoted as the poster-child for Emerging Markets, with its burgeoning middle-class and enviable demographics. Its rapid recovery from the GFC, its growth and reform story, its dynamic free-market practices, the sense that the inflation genie had been rebottled, and a general perception that Turkey was integrating ever more closely to the European political economy all combined into a seductive investment case. 

Unfortunately, Erdogan’s two decades in power emblematised the proverbial game of two halves. If Erdogan’s rule had ended after ten years, chances are he would have been viewed as the most successful economic reformer of recent times but, of course, history is the narrative of everything that needn’t have been that way. The hallmark of a genuine democracy is a peaceful transition of government, yet Erdogan has clung on and doubled down. 

This Manichean inflection point is captured perfectly by the Turkish lira. From Erdogan’s electoral triumph in 2002 until 2012, the currency was astonishingly stable against the dollar, especially considering the near-perpetual degringolade that characterised most of the 20th century. Since then, the lira has lost four-fifths of its value, a damning indictment of Erdogan’s economic policy. It has proven to be the one check on his political power beyond his control. 

To make matters worse, most of the economic damage wreaked was self-inflicted. Succumbing to populism and the demands of the electoral cycle, Erdogan ran the economy too hot with huge external financing, and successive credit-fuelled booms were not tackled with monetary policy orthodoxy from an independent central bank committed to taming inflation. Instead, the Prime-Minister-then-President fired successive central bank governors who didn’t keep policy loose enough for his liking. The currency, not growth, took the hit for the unsustainable current account deficit.

Add to this the breakdown in negotiations to join the EU, poor showings in press freedom and corruption indices, relentless criticism of its human rights record and successive foreign policy misadventures, and the upshot of all of Erdogan’s misgovernance has been a geopolitical and financial ostracism. International ownership of Turkish equities has slumped to its lowest ever at just 42% of market capitalisation. Foreigners represent less than 5% of the holdings of Turkish government bonds. Several years of wild FX volatility has deterred GEM asset allocators and rendered the market uninvestible to many. So much so that a loss of EM status and a demotion to frontier classification has even been mooted.

This is where the opportunity may lie.

Currently trading on just 6x 2021 earnings, Turkey is among the cheapest equity markets in the world, and its 55% discount to GEM peers is the widest ever recorded.

Of course, cheap on its own is never enough: cheap plus catalyst is what’s required, and given the blizzard of adverse newsflow that has beset Turkey in recent years, there is no shortage of market determinants which could rapidly turn positive.

A pre-requisite to successful investing in Emerging Markets is to get the politics right and this is where any constructive investment argument for Turkey must begin. Offshore funds have despaired of ‘Forever Erdogan’, but now, appearing on the horizon for the first time since he was elected, there is the prospect of ‘Beyond Erdogan’. Presidential elections are slated for 2023 and it would appear that he is cornered. His last victory at the ballot box was achieved only through a coalition with the nationalists, but the economic crises and the mismanagement of the pandemic have caused his popularity to plummet. The AKP/MHP combined poll ratings are just over 40%, and some way short of the 55% ascribed to the opposition alliance. This inchoate group of as many as four parties appears to be uniting behind a one-policy manifesto: ‘Stop Erdogan’.

After two decades of dominating the political landscape there are now at least three politicians – Imamoglu and Yavas on the centre-left, and Aksener on the centre-right – who could stand against the incumbent and defeat him. All pledge to reverse the executive presidency and reinvigorate the parliamentary system with a more powerful Prime Minister. Between now and the campaign itself, markets will begin to telescope the likelihood of a change in governance in Turkey. This could be a dramatic game changer for financial assets.

Not only is Erdogan snookered by domestic politics but economics too have stymied his approach and restricted his autonomy. The AKP took a real bruising from the furore sparked by revelations that the Treasury had blown $128bn trying to arrest the lira’s decline in 2020 and that futile strategy now seems to have been discontinued. Turkey’s reserves have plummeted to minus $45bn once swaps are taken into consideration, preventing Erdogan from loosening monetary policy, something he exhorts the CBRT to implement daily. Ex-ante real rates of ~6% are the difference between the lira holding its ground and total collapse. Despite heavy political pressure on the central bank governor, Turkey simply cannot ease. High real returns and the carry-trade stand between the currency and a balance of payments crisis, completing the virtuous circle of bolstering the lira and limiting the inflationary pass-through of energy imports.

The last shoe to drop will be inflation. Forecasts are still rising, albeit more slowly because the market senses Erdogan’s rate-cutting rhetoric is exactly that: rhetoric. Kavcioglu, the most recent appointee as governor of the CBRT, has so far resisted demands – most likely intended for a domestic audience – to make an abortive rate reduction, which is what spooked FX markets back in early spring. The market’s YE21 CPI expectations are for 15.5% versus 17.5% now, but the base effect will start to play into Turkey’s hands and the recent decline in US bond yields suggests that the global reflation trade may well be faltering. All this alleviates pressure on the beleaguered lira, allowing bond and equity markets to breathe a little easier.

When assessing the financial wellbeing of Turks, official statistics often fail to capture the sophistication of domestic investors – especially relative to many Emerging Markets peers – and their ability to negotiate periods of economic turmoil. 56% of all bank deposits are held in hard currency, hovering around all-time highs, and Turks are well-versed in the inflation-hedging characteristics of gold and diversify accordingly. Money under the mattress is not inconsequential for many households. The grey economy thrives. In common with the retail investor base of many countries, droves of Turkish retail investors took up crypto-currency trading with gusto in 2020 as confidence in fiat currencies diminished. This too probably served to cushion some of the obvious wealth destruction caused by the severe decline in the lira in the last few years.

The possibility of a recovery in tourism may also provide grounds for optimism as holidaymakers start to return, particularly as this holiday season may extend into September as foreign vacations are staggered. Russians have already flocked to Antalya in similar numbers to 2019, and by the end of July, it’s likely that European countries will start to relax restrictions on travel to Turkey. After a desperately lethargic start to the vaccination programme, 45% of the population has now been vaccinated at least once, and coronavirus deaths have shrunk to 44 per day at the time of writing. Tourism Minister Ersoy projects revenues to reach US$20bn in 2021, compared with US$10bn last year and US$30bn in 2019. It’s hardly a banner year, but again, nowhere near as dreadful as was originally feared, and upside risk to estimates is apparent.

Having disappeared off the radar of so many EM asset managers in recent years, there are finally some green shoots emerging in Turkey, and some encouraging signals to recapture the attention of value investors and contrarians. The banking sector, well-drilled in firefighting during Turkey’s periodic swoons, and still 20% of the index, is a good place to start. Like the lira, it trades at historic lows. The recent IPO of Hepsiburada on Nasdaq, with a price tag of $3.9bn, illustrates that international investors will pay high valuations for high-quality businesses. The economy remains remarkably resilient in the face of unprecedented challenges and the ability of Turkish households and corporates to manage FX volatility and seesaw growth is surprisingly intact. Turkey has always been a trading nation and that mercantile dynamism is undiminished. 

Important Information:

Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).

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