By Rob Drijkoningen, Senior Portfolio Manager - Global Co-Head of Emerging Markets Debt, and Kaan Nazli, Senior Economist - Emerging Markets Debt
Two weeks ago, the people of Turkey went to the polls and re-elected Recep Tayyip Erdoğan as President for another five years, this time under the new executive presidency that replaced the previous parliamentary system. The electorate also delivered a parliamentary majority for the alliance led by Erdoğan's Justice and Development Party (AKP).
The extent of President Erdoğan's commitment to responsible monetary and fiscal policies will therefore be a key element in Turkey's economic performance. Concerns that the economy is overheating amid a broader sell-off across emerging markets have led to the lira weakening by 22% against the U.S. dollar in the first half of the year. But the newly powerful Erdoğan is far from the whole story.
Inflation and Interest Rates
Even last year, when the emerging world in general was growing fast, Turkey's 7% real growth rate stood out. It has remained strong this year, at 7.4% in the first quarter, driven very much by accommodative monetary and fiscal policies that boosted credit growth, consumption, and the real estate and construction sectors.
This is all in line with Erdoğan's push for mega-projects ahead of the centennial of the Republic in 2023, but it is at odds with the usual Central and Eastern European playbook of boosting value-added in export sectors, and it has left Turkey with significant macroeconomic imbalances. The current account deficit has continued to widen, partly due to higher oil prices (Turkey is a large net oil importer) and partly because foreign direct investment remains low, covering just 15-20% of the current account deficit versus an average of around 80% in the rest of Central and Eastern Europe.
These imbalances have strained the investment environment, fueling the lira sell-off and forcing the central bank to hike rates by five percentage points in a fight to curb inflation. The official inflation target is 5%, but last week's Consumer Price Index print for June showed a rate at 15.4%, the highest since the introduction of a new method for measuring inflation in 2004. Current expectations are for a peak as high as 17%. Turkey's Producer Price Index already shows inflation at 24%.
In short, Turkey's economy will have to adjust through a significant slowdown, with domestic demand growth likely halving from last year. To do so successfully, the central bank will need more space than it has been allowed recently. Before the recent hikes, its ability to respond was impaired by persistent political interference - Erdoğan takes the unorthodox view that higher interest rates cause higher inflation rather than the other way around, and last week, outgoing Prime Minister Binali Yıldırım reiterated that "lowering interest rates and lowering inflation" would be the government's top priorities.
A Position of Strength
Nonetheless, for all the challenges, Turkey's starting point appears strong.
Public debt is only 25% of GDP, and the budget deficit was just 2.1% of GDP last year. While there is a material risk of a rise in non-performing loans given the weak lira and the pending slowdown, on the whole Turkey's banking sector appears healthy and liquid. The economy stands out among countries with external imbalances exposed to higher global borrowing costs, but market discipline as well as the large foreign-exchange liabilities in the non-financial corporate sector serve as an effective check on ultra-pro growth monetary and fiscal policies. Turkey also has a number of structural strengths, including strong demographics and a vibrant and competitive private sector that provides key links in the European supply chain.
We maintain a positive view on both hard currency and local currency bonds.
On the hard currency side, we see Turkish spreads capturing near-term political and geopolitical risks. The bonds trade in line with B+ credits, while Turkey is currently rated BB - which, in our view, does not fully take into account the balance of risks.
In local bonds, we believe that the real yield compensation in the belly of the curve captures the near-term inflation uncertainty. We also think the central bank will keep monetary policy tight to re-establish some credibility. Its recent tightening is likely to cause a significant slowdown in the second half of this year. Should the government refrain from another fiscal impulse - it has traditionally been fiscally responsible, and it needs to adjust after loosening ahead of the election - we believe local currency yields offer potential value. We remain cautious in our view on the Turkish lira, however, as we see further vulnerability to headlines around the new cabinet and potential hiccups in communication.
In Case You Missed It
- ISM Manufacturing Index: +1.5 to 60.2 in June
- Eurozone Purchasing Manager Index: +0.1 to 54.9 in June
- ISM Non Manufacturing Index: +0.5 to 59.1 in June
- U.S. Employment Report: Nonfarm payrolls increased 213,000 and the unemployment rate increased to 4.0% in June
What to Watch For
- Wednesday, 7/11:
- U.S. Producer Price Index
- Thursday, 7/12:
- U.S. Consumer Price Index
- Andrew White, Investment Strategy Group
Statistics on the Current State of the Market - as of July 6, 2018
|S&P 500 Index||1.6%||1.6%||4.3%|
|Russell 1000 Index||1.6%||1.6%||4.5%|
|Russell 1000 Growth Index||1.9%||1.9%||9.3%|
|Russell 1000 Value Index||1.3%||1.3%||-0.4%|
|Russell 2000 Index||3.1%||3.1%||11.0%|
|MSCI World Index||1.2%||1.2%||2.0%|
|MSCI EAFE Index||0.6%||0.6%||-1.8%|
|MSCI Emerging Markets Index||-0.7%||-0.7%||-7.1%|
|STOXX Europe 600||1.4%||1.4%||-1.8%|
|FTSE 100 Index||-0.2%||-0.2%||1.4%|
|CSI 300 Index||-4.0%||-4.0%||-15.6%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||0.0%|
|Citigroup 10-Year Treasury Index||0.2%||0.2%||-2.5%|
|Bloomberg Barclays Municipal Bond Index||0.1%||0.1%||-0.1%|
|Bloomberg Barclays US Aggregate Bond Index||0.2%||0.2%||-1.4%|
|Bloomberg Barclays Global Aggregate Index||0.5%||0.5%||-1.0%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.2%||0.2%||2.1%|
|ICE BofA Merrill Lynch U.S. High Yield Index||0.0%||0.0%||0.1%|
|ICE BofA Merrill Lynch Global High Yield Index||0.2%||0.2%||-1.3%|
|JP Morgan EMBI Global Diversified Index||1.4%||1.4%||-3.9%|
|JP Morgan GBI-EM Global Diversified Index||0.9%||0.9%||-5.6%|
|U.S. Dollar per British Pounds||0.5%||0.5%||-1.9%|
|U.S. Dollar per Euro||0.7%||0.7%||-2.1%|
|U.S. Dollar per Japanese Yen||0.3%||0.3%||2.0%|
|Real & Alternative Assets|
|Alerian MLP Index||0.4%||0.4%||-0.3%|
|FTSE EPRA/NAREIT North America Index||1.8%||1.8%||3.4%|
|FTSE EPRA/NAREIT Global Index||0.9%||0.9%||0.9%|
|Bloomberg Commodity Index||-1.3%||-1.3%||-1.3%|
|Gold (NYM $/ozt) Continuous Future||0.1%||0.1%||-4.1%|
|Crude Oil (NYM $/bbl) Continuous Future||-0.5%||-0.5%||22.1%|
(Source: FactSet, Neuberger Berman)
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