White-knuckle ride

IFR Emerging Europe and Turkey Special Report 2014
9 min read

Tapering of quantitative easing in the US and political instability may have taken investors in Turkey on a roller-coaster ride in the past year, but there is now hope that the ups and downs will smooth out.

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Thanks to the double whammy of the tapering of quantitative easing in the US and political instability, which have rocked asset prices, investors in Turkey have been on a roller-coaster ride in the past year. Many, however, see little damage to Turkey’s long-term emerging market growth story, despite the headlines.

Last year, Turkey particularly bore the brunt of the US Federal Reserve’s announcement that it would begin winding down quantitative easing. Turkey is particularly vulnerable to any pulling back of foreign investment in emerging markets due to its huge current account deficit and its reliance on external financing.

Just over a week after the Fed’s surprise announcement on May 22 last year, a police crackdown on a small demonstration based in Gezi Park in Istanbul swelled into widespread anti-government protests that raged across the country. The lira and shares dropped further.

“You have tapering coming to the global emerging markets and then you have a period of political instability. It was a very bad combination for Turkey. Not only was the market coming down but the currency was also extremely volatile,” said Emre Akcakmak, portfolio manager at East Capital.

The political instability did not end there. Turkish assets came under further pressure at the end of the year when a wide-ranging graft probe began with a series of dawn raids and arrests that led to the resignation of three ministers and the dismissal of dozens of police officers. It revealed fractures within the AK Party and unnerved investors in the run-up to local elections this year.

Emerging market currencies also came under fire as China’s growth slowed and the Turkish lira fell to record lows in January, prompting the central bank to implement massive rate hikes at an emergency meeting to protect its currency.

However, a decisive win by Prime Minister Recep Tayyip Erdogan’s AK Party in the local elections on March 30, which retained its control of the two biggest cities, Istanbul and Ankara, and raised its share of the national vote assuaged some of the fears of the markets.

“At least in the very short term, much of the uncertainties are removed from the market; now we need to see a bit of stability,” said Akcakmak. “We need to see if we’ve already hit the bottom.”

The long game

Turkey has been the darling of emerging markets investors after notching up 9% growth in 2010 and 2011. Since then, growth has not exceeded 4% and is now predicted to slow down further.

In April, Moody’s cut Turkey’s outlook to negative, saying the political uncertainty in the country would weigh on weak points in its economy, notably its high external financing needs, damaging its growth prospects. The ratings agency also cut its forecast to 2.5% growth this year, citing political and financing concerns.

“Moody’s expects a cyclical slowdown due to lower global capital flows, which will dampen consumption and investment… While these near-term projections partly reflect the dampening impact of a higher interest rate environment on domestic demand, they are a reflection of the long-standing volatility that has characterised Turkey’s growth model,” the agency said.

Market volatility and the glare of the global media spotlight have also dented confidence in Turkey, with the BIST National 100 Index losing a third of its value since the Fed’s announcement last May to its lowest point in early March this year.

“Following Gezi park protests, all of a sudden you have huge coverage from the international media, and then you have the corruption scandal … it’s usually not as easy as it sounds to repair that kind of damage,” said Akcakmak.

An international capital flight that accelerated in the wake of the corruption scandals has raised concerns in the West.

In the context of heightened political risk, it is potential new investors that are impacted by the instability.

“Where it may really [have an] effect is if someone is planning to invest fresh; maybe they might say, we’ll hold back a little,” said London-based Tatha Ghose, a senior emerging markets economist at Commerzbank, noting that regular company operations usually continue at more or less the same pace.

Meanwhile, external headwinds could be a headache for the lira, whose recent rally is not sustainable, according to Goldman Sachs analysts.

“Our more bearish medium-term lira view remains unchanged… This is based on our long-held view that EM economies running large external and domestic imbalances will likely continue to face headwinds, as the US economy and monetary policy normalise and as China growth risks linger,” said the analysts. “A less friendly fixed-income environment, combined with US dollar strength, could serve as a catalyst for a broader EM, as well as a lira correction.”

Opportunity knocks

However, the pre-election period of volatility, which spooked many investors, also created an opportunity for others.

“All in all, the markets in Turkey considerably underperformed the other emerging markets, and it was a difficult time for investors. But if you’re a long-term investor, you do find some great opportunities in times of volatility as well,” said Didem Gordon, CEO of Ashmore Turkey.

“The number one thing [for Turkey] is to stay on course with the economic fundamentals … especially the strong fiscal standing, which is a big plus,” she added.

London-based Nick Darrant, head of CEEMEA syndicate at BNP Paribas, agreed that the recent volatility had presented opportunities, particularly for savvy institutional investors in fixed income that have capitalised on the sell-off by retail investors.

“What we were observing was that how investors were reacting was quite different to how the press was portraying it at the time. We were seeing some very large institutional asset managers not selling but buying, actually perceiving this volatility as an opportunity for them to build on core holdings,” he said.

Turkey raised a record-long 31-year US$1.5bn bond issue in the international capital markets in March, completing more than 70% of its borrowing requirement for the year. The bond offering was a positive move by the Treasury, proving that the sovereign had unfettered market access. This was followed in April by Garanti Bank pricing a US$750m 5.5-year note offering.

“What this says to me is two things: Turkey remains at the very core of the EM investor portfolios. These investors understand Turkey. They don’t operate by knee-jerk reactions to the front page of the Financial Times…[they] are more than willing to shrug off short-term volatility for medium to long-term gain,” Darrant added.

Scream if you want to go faster

For those who can strap into their seats tightly, Turkey’s untapped potential may prove to be worth the white-knuckle ride. The country’s strong fundamentals are uncontested. A young, dynamic and skilled workforce and massive domestic market, a strategic location at the crossroads of Europe, Asia and the Middle East, combined with a stable macroeconomic policy have enabled it to grow rapidly.

“In this region, I see only two growth stories and Turkey is the main one (Poland the other),” said Ghose.

“I see Turkey as a very clear, bimodal business model. Great demographics, great growth story and much of these dynamics can operate irrespective of variations in policies (eg. irrespective of what they do in their mid-term plans). This growth story isn’t going away [because] it’s the only demographics-driven one in the region.”

Even its weak spot, the fact that Turkey is more vulnerable to global shocks due to its high current account deficit, can be counteracted.

“If you have to pay 2 percentage points extra for some kind of risk hedging, businesses in Turkey can afford it because it’s that fast-growing,” Ghose added.

Despite a recent rally, Turkey is not out of the woods yet. As one of the “fragile five” EM countries, investors will be waiting to see to what extent the recent market rally has been a result of an actual shoring up of the country’s key economic weaknesses. One thing is certain, volatility is expected along the way.

“If Turkey wasn’t going through this kind of volatility, we would be calling it a developed market. Democracy doesn’t come overnight. Stability doesn’t happen overnight. These are all things that are part of being an emerging market,” said Akcakmak.