2017 in review: a year of economic contradictions for Turkey

2017 was a mixed year for Turkish markets as returns from different asset classes became notably dissimilar. Equities, after having missed the rally in emerging market peers, were in a catch-up mode, posting the highest returns among all domestic assets. That said, the Turkish lira tended to be volatile through the year and renewed its historic low versus the currency basket consisting of the U.S. dollar and the Euro while a bear market appeared in bonds as we saw yields jumping to multi-year highs.

The unshakable optimism was still in place in emerging markets as well as in Turkey over the year that just passed. The key market driver for Turkish equities was the quickening economic activity that led to record earnings growth for companies. Remember that the government’s effort to reignite economic growth through a guaranteed lending scheme, namely the Credit Guarantee Fund, was one of the primary reasons for the upturn from a disastrous period when the economy was overwhelmed by short-dated impact of the coup attempt in July 2016 and other structural issues such as capital deficiency.

Other than being a lifeline support for small and medium size enterprises, the facility brought enormous business volume for financial institutions and supported overall domestic demand.

The European recovery also provided another positive catalyst for the economy that translated into solid revenue growth across Turkey’s industrial companies. To set an example, auto production in Turkey hit an all-time record last year. Turkey’s tourism industry, which reached rock bottom in 2015-16, showed considerable signs of overcoming the crisis and became another market driver that corresponded into significantly high returns in airline and tourism stocks.

Chart 1

Still, the positive outlook in the economy was partly offset by rising political risks and some other deteriorating macroeconomic variables such as accelerated inflation, a widening current account and general government budget deficits.

Despite posting one of the strongest performances in a decade, Turkey’s equity benchmark index could not manage to emerge as an outperformer in the emerging market space (see the chart above). This, on the other hand, highlights rule number one for investing in emerging markets, which is, regardless of good or bad local developments, it is global sentiment that drives the markets. But after years of lagging behind its peers, Turkish equities’ performance this year should be considered as positive.

Turning to the bad news, the Turkish lira and more particularly rates left many investors in the lurch last year. Versus the currency basket ($0.5 + €0.5) the Turkish lira was down 15.6%, which yields on most local currency asset classes failed to exceed, meaning a negative return for carry traders.

The Turkish central bank’s ending the normalisation process in its monetary policy setting and going back to unorthodox methods that ended up with a financial system only funded through a facility where the central bank is the lender of last resort, were the primary drivers of the weakness in the local currency.

Having caused significant deterioration in inflation expectations, Turkish central bank’s ‘too late, too little’ response resulted in further weakness. Now markets seem to have little confidence in a draconian tightening of monetary policy that would stabilise the exchange rate after the central bank’s latest attempt which was basically another rate hike falling well short of expectations.

Chart 2

Once the liquidity in the market was mopped up through a government sponsored lending campaign, one would not rule out a sell-off in bonds. That and more were what happened in Turkish markets last year as Treasury bonds were under selling pressure with yields touching up multi-year highs. What is insinuated by more is, the concerns around the price stability as discussed above, and the higher than planned borrowing by the government which might have been quite a surprise for many market watchers. We saw 10y Treasury yields rising above 13% for the very first time (the Turkish Treasury issued its first 10-year maturity local currency debt in early 2010) and swap rates at the highest levels ever seen in the post-financial-crisis era.

Chart 3

Going forward, the prospect is for an intact economic growth story in Turkey for the upcoming period that would however potentially cause concerns around overheating with rising inflation and a widening current account deficit along with higher debt issue by the government. At this point, with global sentiment remaining positive, it is easy to maintain optimism for the outlook of Turkish assets, particularly for stocks and 2018 seems likely to be the replication of the linked year. However, remember that global equity markets have been hot for a long time now, and hot markets are known for their habit of turning cold after a while.  This adverse scenario would probably end with Turkish markets losing their only working leg and leading a downward spiral across the board.