Retain Turkish Shares at Market-Weight Awaiting Post-Election Policymaking Environment

The outcome of this Sunday’s national elections in Turkey should prove decisive in determining whether or not the governing Justice and Development party (AKP) can capture a supermajority of legislative seats that would make it possible to amend the nation’s constitution and fulfill President Recep Tayyip Erdogan’s demands for additional powers.  If the incumbent AKP were to secure the requisite 367 seats and unilaterally re-write the already illiberal 1982 constitution to empower him accordingly, many fear that it risks transforming Turkey’s fledgling democracy into an autocracy with too few checks and balances in place to curb presidential authority.

Turkish Export and Import Growth and Istanbul Stock Exchange Price-Earnings Ratio Trends

Yet, pre-election voter surveys of late indicate all major opposition parties, including the Kurdish Nationalist Peace and Democracy party (HDP), are likely to attract sufficient electoral support to attain the ten percent threshold, thereby earning representation in the national legislature and denying the president of any opportunity to expand the powers of the executive office beyond the token functionality stipulated in the country’s thirty-two year old constitution.  Such a result would deal a devastating setback to Erdogan’s plans.

Turkish Lira REER, Ten-Year Sovereign Debt Yield and Consumer Inflation Trends

Even within the ruling AK party, moderately conservative members are opposed to granting Turkey’s president all his demands.  Caretaker Prime Minister Ahmet Davutoglu – normally a reliable, though not acquiescent, ally of President Erdogan – has been resisting the latter’s petition for enhanced powers for fear that, in so doing, it would endanger Turkish democracy and not to mention reduce the premier’s power.

Comparative Turkish US Dollar Sovereign Debt Yield Curves

Standing in direct opposition to Erdogan’s proposals for expanding executive power, the pro-secular, social democratic Republican People’s party (CHP), the right wing Nationalist Movement party (MHP) and the HDP would likely obstruct any efforts by the AKP’s leaders to endow the executive with a near monopoly of authority that can only be accomplished through amendments to the constitution.  Nevertheless, an AKP victory short of a supermajority would compel the governing party to negotiate with its legislative opponents all aspects of any planned changes to the constitution.

Since end-December 2014, the performance of the Istanbul stock exchange (Borsa Istanbul) – as measured by the Borsa Istanbul 100 index – has ranked fifth worst globally, surrendering 13.1 and 6.3 percent of its value in US dollar (USD) and euro (EUR) terms, respectively.  Although USD-denominated Turkish sovereign debt has only fallen fractionally (-0.8 percent) during the past five-plus months, rising yields on intermediate- and longer-dated government bonds have prompted the yield curve to pivot off the three-year maturity with interest rates rising on maturities exceeding and declining below three years to redemption.  In yet another sign of diminishing investor confidence in domestic financial markets, the Turkish lira has plummeted nearly ten percent in nominal and 6.3 percent on real effective, trade weighted bases in spite of a steady upturn in yields since January 27th.

Turkish Business Confidence, NEER, and Real Industrial Output Trends

Intensifying market disapproval of policymaking in Ankara in the first ten weeks of the year coincided with two lending rate reductions, totaling seventy-five basis points to 7.5 percent, by the Central Bank of Turkey and an acceleration in inflation to 8.1 percent in March.  Borsa Istanbul lost almost twenty-one percent denominated in USD and 8.5 percent in EUR terms.  Total returns of Turkish sovereign debt issued in US dollars capitulated to selling pressure as well, relinquishing 1.3 percent of its value, as the lira (TRY) depreciated 4.2 and 2.3 percent on inflation-unadjusted and adjusted trade-weighted bases, correspondingly.

Following the March 13th management decision to decrease exposures of the Norwegian sovereign wealth fund to Turkish and Russian debt, domestic financial markets paradoxically rallied impressively through mid-May.  Shares on the Borsa Istanbul compositely gained almost as much (20.5 percent) as they lost (-20.6 percent) in the previous two and a half months, denominated in USD.  Turkish government bonds issued in USD recovered as well, recording a total return of two percent from mid-March to May 18th.  By contrast, lira depreciation continued apace, ceding 4.9 and 2.7 percent in nominal and real effective terms, in that order.

Investor enthusiasm for Turkish equities and debt soon waned in the immediate run-up to the June 7th general elections.  Strident campaign rhetoric across the political spectrum and twin bomb blasts at the offices of the pro-Kurdish HDP in Adana and Mersin aroused risk aversion anew.  With just two days to the ballot, the Borsa Istanbul has declined 9.1 and 8.1 percent in USD and EUR terms, respectively, and USD-denominated bond returns have shed 1.5 and 0.9 percent, correspondingly, of their value since May 18th.  Meantime, the lira’s plight worsened, albeit weakening at a much slower single-digit rate of decrease than those posted in the prior two episodes earlier this year.

On the policy front, pre-election politics should continue to cast doubt on the credibility of the central bank after Sunday’s poll.  Endeavoring to restrain currency-induced inflationary pressures from accelerating further while fending off Finance Ministry pleas to supply more liquidity to the credit market, Governor Erdem Basci will need to muster the necessary courage to justify an increase in interest rates sometime after the election.  In the case of fiscal policy, AKP’s leadership, which has an impeccable record of fiscal restraint, had been pursuing a modestly accommodating budget ahead of Sunday’s vote.  Yet, AKP probably will remain the dominant party in Turkey’s parliament and, once restored to power, resume a disciplined approach to fiscal management.

How well AKP performs in Sunday’s general elections pivots largely on the electorate’s assessment of macro-economic performance.  Last year’s 2.9 percent rate of expansion in real GDP, accompanied by a speed-up in household inflation to 8.9 percent and a rise in joblessness to ten percent, evinced renewed fragility in Turkey’s economy.  Median consensus forecasts, compiled by Bloomberg, expect economic conditions to improve only moderately this year and gradually gain momentum thereafter amid a slowdown in price pressures and a peak in unemployment.  Exports should expand firmly owing to the rapid depreciation of the lira.  Even so, double-digit joblessness will constrain consumer spending and a much-needed tightening of credit policy will probably dampen capital investment by businesses.

At 10.3x, Borsa Istanbul’s one-year forward, positive-adjusted price earnings multiple (p/e) surpasses only Russia (2.4x) among all emerging Central and Eastern European, Middle Eastern and African (CEEMEA) shares markets.  Nonetheless, it exceeds its twenty-year historical high of 9.3x and appears inexpensive in relation to its benchmark, the MSCI Eastern Europe, Middle East and Africa (EEMEA) index, at -0.06.

Beside the fact that the Borsa Istanbul’s absolute and relative valuations appear cheap and macroeconomic momentum will strengthen somewhat in 2015, nothing else in the outlook conveys to us a compelling reason for our recommending an overweight of Turkish equities.  An anticipated underwhelming victory by the AKP in Sunday’s parliamentary election would indeed deprive Erdogan of the opportunity to attain his most coveted objective, political dominion, since his ascendance to the executive office in last year’s presidential vote.  Still, a frail economy, the country’s dependence on short-term borrowing and an external payments shortfall that will likely approach six percent of Turkey’s nominal GDP persuades us, together with a perceptible divergence in fiscal and monetary policies, to advise investors to maintain market-neutrality until greater visibility appears in Ankara’s policy atmosphere.  Shorting lira holdings outright, or hedging them against the USD is advisable for the foreseeable future.  Barbelling Turkish sovereign debt exposures is also recommended in anticipation of both Federal Reserve and Central Bank of Turkey interest rate hikes.

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