The curious case of Turkey’s runaway stock market – can it continue?

Turkey’s equity market has rallied sharply this year, leaving other global markets in its dust. The MSCI Turkey Index is up 62% in dollar terms year-to-date, as at 21 November 2022. This is an extraordinary performance when compared to the MSCI World and MSCI Emerging Market indices, which are down -17% and -22% respectively. Even more extraordinary given that the Turkish lira has depreciated by -29% against the dollar over this period. 

The contrast in equity and currency market performance is illustrative of the growing macroeconomic risks in Turkey. Real GDP growth may have been stable at 7.6% year-on-year (y/y) in Q3, but higher frequency data shows a slowdown is underway, and headline inflation is now 86% y/y.

This year’s strong performance has primarily been driven by non-fundamental factors.

With broader economic risks continuing to rise, corporate earnings are at risk. The combination of unorthodox economic policy and rising uncertainty ahead of next year’s general elections, mean that the market’s current trajectory seems unsustainable.

The policy environment fanning market moves

Policy under President Erdogan’s leadership has been far from orthodox for some time. The current framework is effectively underpinned by a competitive exchange rate and negative real interest rates. In the government’s eyes, these will help to close the current account deficit, encourage foreign direct investment, and bring inflation under control.

Unfortunately, inflation has soared, exacerbated in recent months by the impact of Russia’s invasion of Ukraine. Official measures show that headline inflation, fuelled by higher energy and food prices, reached almost 86% y/y in October, from around 20% a year ago. There is speculation that actual inflation may be higher still, and our interactions with companies in the region point to this. A spate of changes at the Turkish statistics agency, including the removal of the deputy head last week, has not exactly bolstered confidence in the official figures.

This trajectory is at odds with the official inflation target of 5%+/-2%, as the chart below illustrates. Over the past year the central bank has actually eased policy rather than increase rates. Despite still very high inflation, it has cut rates by a total of 3.5% since August.

It is not a secret that, counter to common acceptance, President Erdogan believes that higher interest rates are actually a cause of inflation. The central bank’s independence has been compromised, and its refusal to lift interest rates in the face of rising inflation has led to currency weakness. This next chart illustrates the extent to which the real policy rate, that is the policy rate less inflation, is in negative territory. This is significant in absolute terms but even more so when contrasted with other emerging markets.

Turkey is a net oil and gas importer, and higher prices have also increased the current account deficit; the value of imported goods and services is increasingly higher than the value of exported goods and services. This has not been helped by a weaker lira and slowing global demand for Turkish exports.

On a 12-month rolling basis the current account deficit is now 4.5% of GDP. Moving into the winter season, tourism revenues will fall, and energy imports will increase, adding to current account pressure. Funding of the current account will become increasingly difficult and expensive due to rising global interest rates and reduced risk appetite from international investors. Financing of the current account in 2022 has been opaque. Net errors and omissions now account for more than 60% of the current account deficit financing.

Given negative real yields, currency weakness and an increasingly challenging economic outlook, international investors’ confidence in allocating to Turkey has waned. As a result, the government has reportedly been seeking financial support from Middle Eastern allies.        

What are the consequences of current policy?

The key issue continues to be that inflation remains above target and accelerating. It is creating broader macroeconomic stress. 

While the lira has depreciated against the US dollar this year, the central bank has used reserves to manage this weakness; total gross reserves fell markedly over the first half of the year. This has now completely reversed, owing to higher bank reserve requirements, but also due to foreign direct  investment from Russia to fund a nuclear power station that a subsidiary of Russian company Rosatom will build. However, investors should pay attention to the net reserves of the central bank. As this next chart emphasises, while gross reserves including gold are in excess of $110 billion, net reserves are (negative) $-60 billion. This difference comes after deducting liabilities related to swaps.

Amid concern over currency depreciation, the government has taken a series of unconventional steps to try to discourage households and companies from holding foreign assets. It has incentivised Turkish citizens to save via lira time-deposit accounts by pledging compensation where lira weakness versus the US dollar exceeds the local interest rate. Meanwhile, exporters are required to sell the central bank 40% of their foreign currency revenues.    

The government has sought to cushion the impact of high inflation on the public with various measures. The minimum wage was increased by 50% in January of this year to 4,250 lira per month, before being raised by another 30% to 5,500 in early July; equivalent to $330. 

These measures may provide some support, but are not sufficient given the degree of inflation, which continues to rise. Food inflation hit close to 100% in October, and transport inflation is at 117%. Sadly, this is leading to a domestic cost of living crisis.

Why political risk is rising

Turkey has played an important geopolitical role since Russia invaded Ukraine, acting as an intermediary between Russia and the West. The country holds a key geographical card through its control of the Bosphorus and Dardanelles Straits. These maritime waterways are the only seaways into and out of the Black Sea, and Turkey has used a historical convention to limit Russia from increasing its Black Sea fleet. Turkish manufactured drones have been supplied to Ukraine, and Turkey has criticised the annexation of Ukrainian provinces.

At the same time, President Erdogan has maintained good relations with President Putin. This enabled him to help broker a deal to allow the export of grain from Ukrainian ports. Erdogan has also remained opposed to Western sanctions on Russia, and has agreed to pay for Russian oil and gas in roubles. In fact, Turkey has seen trade with Russia increase since the war began, and flights to Moscow remain in place.

However, domestic elections are looming. Presidential and parliamentary elections are due in June of next year, and while there is a long way to go, the opposition continue to head the opinion polls in both races. This is despite a slight increase in Erdogan’s popularity on the back of his high profile role in relation to Russia’s war in Ukraine.  

Why has the market performed so well this year?

The primary driver of the market performance this year has been high domestic inflation. With interest rates so deeply negative, and government yields unattractive, local investors have been forced into the market to try to protect their savings from rampant inflation.

While market performance in local lira terms has not been a surprise to us due to the high inflationary environment and the lack of investment alternatives for locals, we would expect performance in US dollar terms to be much weaker. Given the negative real return, a lack of central bank reserves and the high current account deficit, we would expect the lira to come under increasing pressure. Historically, a greater proportion of market gains in lira terms have been offset by currency depreciation.  

While aggregate valuations for the MSCI Turkey Index were reasonably attractive a year ago, these no longer stand out in a wider emerging market context, as this next chart shows, particularly given the wider economic backdrop. Return-on-equity (ROE) has increased significantly, distorted by high inflation. Turkish companies are now required to report inflation-adjusted accounts, and many of those doing so are reporting ROE in the mid-to-high single-digit range.

Foreign investors have become only more fearful of the longer-term ramifications of the domestic policy mix, and the uncertainty it has created. The chart below illustrates how this dynamic has become more pervasive over the last 18 months, with foreign investor participation in the equity market declining further.

What is the longer-term outlook?

There are various long-term attractions to investing in Turkey for foreign investors. Demographics are favourable, with a relatively young and growing population of 85 million people, supporting the domestic growth outlook. Exports have become increasingly important, and Turkey is well-positioned to capture export opportunities within the growing markets of the Middle East. Indeed, we find many well-managed companies in Turkey.

However, the macroeconomic outlook is increasingly vulnerable, with downside risk for earnings, and we could see further currency weakness. In the absence of major policy change, these issues are only likely to grow.

Why we do not favour the Turkish market

We have held a neutral view on Turkey for some time, owing to macroeconomic and policy concerns.

The market has generated a strong gain in US dollar terms so far this year, and outperformed broader EM. As we have explained, this has been driven by non-fundamental factors and macroeconomic policy remains poor. With parliamentary and presidential elections due next year, political uncertainty is set to increase, adding to macroeconomic fragilities.

Against this backdrop, the market trajectory seems unsustainable, and we have become outright negative in our outlook.