Turkey's macroeconomic adjustment will be gradual and manageable, according to Jan Dehn, head of Research at Ashmore.
Turkey’s macroeconomic adjustment will be gradual and manageable, according to Jan Dehn, head of Research at Ashmore.
There is no doubt that Turkey’s economy is in need of adjustment, probably more so than any of the other so-called ‘Fragile Five’ Emerging Markets economies. But while more adverse scenarios certainly cannot be ruled out (especially if the global economy experiences a more serious bout of financial tightening) our base case is more benign than that of Turkey’s harshest critics.
The policy challenge
The origin of Turkey’s external imbalance is excessive domestic demand stimulus. Hence, to address this problem, Turkey needs to restrain domestic demand, particularly private sector demand. The correct policy is a combination of domestic demand restraint and currency adjustment to improve external competitiveness.
Adjustment, not crisis
The good news is that the adjustment is already underway, though it has further to run. The Turkish lira has already declined 12% since April. This will begin to improve competitiveness. But currency adjustment without domestic demand adjustment only provides temporary relief. Ultimately, the adjustment process has to address both domestic and external imbalances, striking a balance between FX and domestic demand measures so as to maximise the efficiency of adjustment (i.e. reducing the economic costs). Finding this balance will be the main challenge. We think Turkey’s policies will be biased more in favour of a weaker currency than higher rates.
Firstly, in our view, the sensitivity of the private sector to a weaker currency is not as great as many think. It is mainly large corporates and banks that have big foreign liabilities and many of these have the means to absorb FX losses.4 Moreover, Turkey’s net central bank reserves (net of gold and liabilities) are only USD 40bn, well short of the gross reserve position of USD 104bn, although if it comes to it, we think Turkey could access a tremendous arsenal of other sources, including swap lines and IMF support. Secondly, Turkey’s property sector is vulnerable to higher rates. Given the poorly developed pension system and a paucity of alternative savings instruments, property is not just an investment vehicle but also a store of value.
What are the main risks facing Turkey as it undertakes its gradual adjustment process?
The single biggest economic risk is a sudden material spike in real US interest rates that would put upwards pressure on the Dollar. The resulting sharp TRY depreciation would force the CBT to hike rates, thus hurting the economy where it is most vulnerable, namely the property sector. In an environment of more sustained pressure investors will also focus on the relatively low level of net FX reserves.
However for reasons we have discussed elsewhere, we think there are serious limitations to the US economy’s ability to handle higher real rates on a sustained basis.5 Moreover, in the longer-term we expect the US to experience inflation, which should put downwards pressure on both the Dollar and real interest rates. In other words, the global environment in the next couple of years is more likely to subject Turkey to interest volatility than sustained
higher rates, in our view.
Looking beyond the immediate cyclical challenges, Turkey, like many other Emerging Markets countries, has tremendous strengths:
• Turkey’s demographics are strong for its income class due to a large population of young people
• Turkey’s private sector is highly adaptable and dynamic
• Turkey’s economy is flexible due to absence of influential unions or excessive regulation
• Turkey has very good infrastructure, including ports, roads, and power
• Turkey continues to occupy an extremely important geostrategic position
• The rapid development of Turkey’s financial markets is likely to continue
What this means for equities and fixed income
Investors have been wary of socio-political issues in early summer, as well as recent currency weakness. As a result, returns in Turkey (both in local and USD dollar terms) have certainly not been impressive recently.
Looking forward, the near-term opportunities in fixed income are likely to be in the short end of the yield curve, although we also see opportunities in tactical trading of the currency and inflation linkers. In general, we favour a tactical approach to fixed income pending full rebalancing of the economy.
In equities, valuations are now at the best levels we have seen in some time. Currently Turkish equities are trading at a PE 2014 of 9.6x and PE 2013 of 10.1x. This is at a significant discount to its historical average, and even to Emerging Markets as a whole, which are trading at 10.2x and 11.4x respectively. When comparing to regional peers such as Europe, the discount is even more dramatic, with European equities trading at PE 2014 of 12.2x and PE 2013 at 13.7x.
We are confident that as the market risks subside and investors recognise the strength of fundamentals and attractively priced opportunities, the market will once again deliver attractive returns.