The first half of 2018 was rough for global equities with volatility coming back due to the trade war and the uncertainties in the monetary policy. Volatility in the developed markets has made some pundits believe that we are heading towards bear markets.
The trade war fears took the focus off of strong U.S. economy fundamentals and led to significant sell offs. Given that emerging markets are more volatile, the uncertainty over U.S. trade policy causing a global growth slowdown has led to the run on the emerging markets.
The question arises whether the fundamentals and global economic conditions suggest that emerging markets are done. Is it time to return to the developed markets? I believe that emerging markets are still undervalued and represent significant opportunities.
With strong U.S. economic growth, emerging markets will be able to pick up that growth and provide significant investment opportunities. The trick is for investors to be very selective about the markets and companies they choose.
In other words, buying every single country’s ETF will likely ruin the wealth of the investors. In this environment, active management is preferred to passive management as portfolio managers have significant experience in the markets and have the ability to pick the best companies from the benchmark, those which have outstanding performance under different economic/political conditions.
For passive investors, the best choice is to go with the strongest emerging market counties and avoid countries with weaker fundamentals and political risk. Only active managers will be able to get positive returns in such an environment.
For the last year, the most vulnerable countries have been Argentina, Turkey, and Brazil. Retail investors can find articles online where pundits say that those countries represent a great return potential based on the technical indicators, such as RSI which shows that the ETF is oversold. Based on a limited theoretical basis, if ETF is oversold, it should bounce back. Yet, the truth is that oversold can become even more oversold and investors should be aware of it.
In this article, I will try to look at whether investment in Turkey is a good idea given global fundamentals.
In my previous articles, I was bullish on Turkey based on strong global growth, strong fundamentals, and the unique position of the country between EU and Asian countries.
In 2017, MSCI Turkey Investable Markets Index Fund (TUR) had outstanding performance compared to the rest of the emerging markets countries. The only concern that I always had was a political risk.
Political risk blew up the investment opportunities in Turkey and made me very bearish on the country. Personally, I have sold all my positions in iShares MSCI Turkey Investable Markets Index Fund (TUR) because of the political risk, economic slowdown in the EU, trade war noise, and U.S. monetary policy. I don’t see any potential at the current time.
Here, I will expand on my concerns about the political risk that destroyed Turkey’s strong fundamentals and why it’s not a buy/hold investment.
Turkey is a modern Muslim country which has accepted western values while maintaining orthodoxy. As a reflection of that, the country became a candidate for EU membership. As an EU member, the country could have become a nice bridge between the Western counties and traditional orthodox Islamic values.
Then, the country passed a law that made the army stage a coup against government officials who had become religiously radical. The election of Tayyip Erdogan was a game-changer for the direction of the country and the subsequent coup in 2016, showing that the country was becoming an autocratic regime.
The imprisonment of the opposition and changes in the constitution that consolidated power in the president’s hands showed that the country is moving away from the EU. As a result, many EU countries disapproved of Turkey becoming a member.
The conflict increased when Erdogan challenged Merkel, trying to influence the elections through the Turkish immigrants living in Berlin. Berlin has the second largest Turkish population in the world after Istanbul.
One of the surprising developments was Erdogan calling for early elections in June of this year, while the original elections were scheduled for November 2019. The call was designed to prevent the opposition from becoming stronger and to strengthen his powers. Erdogan’s victory in the elections allowed him to choose ministers, vice presidents, senior judges, and other high-level officials.
The fact of a tight relationship with Russia and increased autocracy in Turkey means that Turkey’s EU dream is almost dead.
Erdogan has always wanted to control monetary policy and independence of the Central bank was a serious concern. One of the first appointments was of Erdogan’s son-in-law as a finance and treasury minister, which raised even more concerns about the independence of the central bank. In the next section, I will explain the risks associated with a dependent Central bank.
- GDP Growth
For the next two years, GDP growth is expected to fall from 7.2% to 4.2% and further to 3.9% in 2020, reflecting the global economic slowdown. Turkey has been struggling with inflation and has been out of the 3%-7% target for a long time.
Thus, monetary policy plays an important role. CPI is expected to decrease from 11.7% to 8.3% in the next two years and is expected to be above the target. CPI has been driven by increased crude oil prices after decreased global oil supply. Currently, OPEC is slowly increasing production to maintain stable oil prices and if demand grows faster than supply, a further increase in pricing and upward pressure on inflation can be expected.
- Budget Deficit
The budget deficit is expected to increase from -2.1% to -2.6% in 2019, meaning that the country will have to borrow more. The country has a 29.60% low Debt-to-GDP and the current credit ratings are BB-/Ba2/BB+ by rating agencies. The credit rating is in the upper band for high yield and, for the sovereign debt, it means a significant risk for higher rates on the new issued debt.
- Currency Reserves
Currency reserves have decreased significantly since the beginning of the year, meaning lower debt coverage. Since the beginning of the year, the Turkish lira has been one of the emerging markets performers and lost 26.37% of its value.
- Currency depreciation
The depreciation of the currency is important for equity and debt holders in local currency as their total return consists of the market return and the currency return. The stability of the currency depends on total balance payments, which consist of current and foreign direct investments accounts. The current account has a deficit, meaning that imports exceed exports.
- Current Account Deficit
Turkey’s largest trading partners are Germany, China, Russia, USA, and Italy. On the other hand, none of those countries represent a trading surplus for Turkey. Also, a depreciation of the Turkish lira increases the current account deficit.
Tourism is the largest source of the current account surplus and contributes 10.9% to the Turkish GDP and 8.3% to overall employment. The number of arriving tourists is in line with the previous years and the depreciation of the lira may attract more tourists due to cheaper costs for domestic currency. The conflict in Syria and increased number of terrorist attacks may decrease the number of tourists this year.
- Foreign Direct Investments
Another important part of the balance of payments is foreign direct investments, which has decreased since the beginning of the year. With a little room for improvement in balance of payments coming from trade surplus and tourism, stability of foreign direct investments becomes key.
Unfortunately, Erdogan’s personality plays a negative role here. Fund managers may wonder why they still keep money in the country. Under such circumstances, it’s extremely important to maintain the confidence of investors.
Considering strong U.S. growth and the hawkish position of the Federal Reserve, many investors have turned cold on the emerging markets overall. Because Erdogan fails to promote optimism among fund managers, further outflows can be expected.
In this environment, monetary policy is very important to keep investors confident and keep the economy solid. High inflation is depreciating the local currency based on uncovered interest rate parity.
The only option for the currency is central bank intervention and interest rate hikes. Erdogan is a known opponent of interest rate hikes and wants to cut the rates. Combined high inflation and a hawkish Federal Reserve will lead to a currency collapse.
The Turkish lira has been under pressure since the beginning of the year. The central bank failed to react on time, showing its dependency. Decreasing foreign currency reserves limit the ability of the central bank to react.
On July 12, Erdogan stated that the economy was doing well and that he will cut the rates and the dollar will depreciate, which led to panic and the largest one day outflow - $5.6mm from iShares MSCI Turkey Investable Markets Index Fund (TICKER:TUR) (1.7% of the NAV of ETF). The next meeting of the central bank is on July 24 and it is unlikely that Erdogan will support the increase in interest rates, even though inflation hit 15.39% in June, the highest rate in 14 years.
In this section, I will provide an overview of the debt and equity markets.
- Debt markets
Despite the high political and economic risks, inflows to the debt markets increased significantly. The reason is a low debt-to-GDP ratio and significantly higher yields compared to the developed markets.
Since the beginning of the year, yields have increased significantly, representing higher risks. Also, investors can avoid currency risk by buying debt denominated in USD. Sovereign debt represents lower risk compared with the same rated corporate debt as the probability of default is significantly lower.
- Equity markets
The fund is cheap based on the fundamentals: P/E – 7.18 vs 12.68 (iShares MSCI Emerging Markets Index ETF (TICKER: EEM)), P/B – 1.1 vs. 1.62 (iShares MSCI Emerging Markets Index ETF (TICKER: EEM)), yield – 3.42% vs. 2.27% (iShares MSCI Emerging Markets Index ETF (TICKER: EEM)).
Nevertheless, the fundamentals don’t show whether the currency will depreciate and how the investors will react on the political headlines. Investors looking only on fundamentals should consider macroeconomic conditions first.
The fund has an allocation of cyclical sectors (79.33%):
The fund has an allocation of cyclical sectors (79.33%):
- Financials - 29.27%,
- Industrials - 21.08%,
- Materials - 14.76%,
- Energy - 6.63%,
- Consumer Discretionary - 6.48%,
- Healthcare - 0.82%,
- Informational Technology - 0.29%.
The remaining 20. 59% is allocated to defensive sectors including:
- Consumer Staples - 12.14%,
- Telecommunications -5.98%,
- Real Estate - 1.43%,
- Utilities - 1.08%.
The worst performing sectors include:
- Informational Technology (-50.02%),
- Real Estate (-46.92%),
- Financials (-44.11%),
- Telecommunication Services (-39.78%),
- Consumer Discretionary (-38.15%).
- Of the individual equity positions, only 3 out of 62 outperform.
They include: Kardemir Karabuk Demir Celik Sanay (KRDMD, Materials) - 18.09%, Anadolu Anonim Turk Sigorta (ANSGR, Financials) - 12.04%, and Soda Sanayii A (SODA, Materials) - 5.12%. The performing companies comprise only 2.3% and confirm the thesis against passive investments under those circumstances.
Financials is the largest sector in the index, and is one of the worst performing and most sensitive to the strength of the dollar.
The weighted average interest rates on deposits has increased from 3% to 3.44%.
The weighted average interest rates for consumers increased from 18.5% to 19.61%.
In order to keep profitability, the banks increased the rates for consumer loans and deposits. One of the problems is high loans/deposit ratio of 122%, out of which deposits are in USD and the lending is done in local currency. Moreover, Turkish banks take loans from foreign banks and are net short in USD, meaning that liabilities are higher in USD than assets.
Thus, in an environment of currency depreciation and uncertain monetary policy, there is even more pressure on the profit margins and equity of the banks.
For the last year, banks decreased the non-performing loans as a percentage of total loans. Based on Moody’s rating agency, the banks can have a jump in non-performing loans if the currency continues to depreciate and the banks will have $78bn in short-term foreign exchange refinancing needs.
Source: Bloomberg Terminal
I have taken the standard scenarios to see which of the sectors is the most vulnerable to negative scenarios and it came out that financials are the largest sector. Considering an optimistic scenario, if equity goes up by 10%, the index will gain only 0.43%. Under current conditions, investment in Turkey represents significantly higher downside risk than upside potential.
Since January of 2018, MSCI Turkey Investable Markets Index Fund (TICKER: TUR) has a strong downtrend and has crossed 50,100, and 200 moving averages in the middle of the February, when the markets started to sell off based on inflation and more frequent-than-expected interest rate hikes.
Since the end of May, the volume has been above average and increased after the elections. Given that the RSI is in oversold and increased volume territory, it is reasonable to expect that the downtrend will continue. MACD supports the overall signal to sell.
- Investment in Turkish equity was beneficial in 2017 because of the strong fundamentals and global growth for the world economy. The only concern for Turkey was the political risk that plays a significant role in the investment in this country.
- Increased fears over inflation and more frequent interest rate hikes have brought volatility back to the developed markets and resulted in a run on the emerging markets.
- Countries with current account deficits were hurt the most and the most vulnerable countries were Argentina, Brazil, and Turkey. In addition to global sell off, the political risk backfired.
- Erdogan won the election and marked the end of Turkey’s EU dream era. Most importantly, investors started to question the independence of the central bank. For the last year, inflation has hit records and intervention of the central bank is needed.
- Indeed, Erdogan wants to cut interest rates, making inflation even worse. The appointment of the son-in-law put more controls on the central bank and the next central bank meeting will shine the light on investors’ fears.
- The country currently has an account deficit, and as the depreciation of the currency widens, the only way to support the currency is through foreign direct investments.
- The last meeting of the fund managers with Erdogan raised more questions about whether they need to take such risk and failed to address the concerns.
- The debt markets and equity markets have different positions: the debt markets saw inflows and made bets on the fear; the equity markets saw outflows with increased volume after the elections.
- The level of risk is significantly different for the debt and equity markets. Debt holders can purchase bonds in USD and local currency and the default probability is significantly lower for the sovereign issuers than for the corporations with the same credit rating.
- Equity holders are taking full risk, the major part of which is currency risk. Financials represent the largest concentration in the index, and are the most sensitive to monetary policy and the currency risk. Given the stress test, it’s the most vulnerable sector of the ETF.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.