Inflation in Turkey ended 2016 at 8.15%, with the central bank missing its inflation target for the sixth consecutive year in a row. This year looks just as difficult, putting pressure on the central bank to raise rates just as growth falters.
The 1.64pp increase in inflation in December, comparing unfavourably with the market consensus forecast of a 0.93pp rise, reflected the impacts of strong FX pass-through and higher global energy prices. The recent tax hikes on alcohol and tobacco also played a role.
The lira, which remains under pressure due to geopolitical risks and domestic political turbulence, lost nearly 20% of its value against the dollar last year. The currency hit a record low of 3.60 against the greenback on January 3 on disappointing inflation data and security concerns.
The main stock exchange index, the BIST-100, was, meanwhile, down by as much as 1.46% on the day, while the yield on 10-year bonds increased to 11.63% from 11.50%.
Most analysts think a weak currency and higher commodity prices will continue to exert upward pressure on inflation and may force the central bank to raise its rate to defend the currency at a time when the country’s economy is slowing.
Sharp rises in food, alcohol and tobacco prices pushed up inflation in the last month of 2016.
Food prices rose by 3.29% m/m, adding 0.79 percentage points to the headline inflation rate. The 7.33% m/m increase in alcoholic beverage and tobacco product prices contributed another 0.37 percentage points to the headline figure.
Transport costs rose by 1.97% m/m in the month, reflecting the effects of the weak currency and higher oil prices.
Due to seasonal discounts, clothing prices fell by 2.55% m/m in December, shedding 0.19 percentage points from headline inflation.
The sharp increase in the domestic producer price index also signalled that cost pressures are intensifying. Producer prices increased by 2.98% m/m in December, bringing the annual PPI inflation to 9.94% from 6.41% in the previous month and. At some point, producers feeling the pinch from the weaker currency may have to pass their rising costs on to the consumer.
The I-index, one of the central bank’s favourite core inflation indicators, increased 0.35% in December versus 0.84% in the previous month. The annual increase in the index quickened to 7.48% from 6.99%. The I-index excludes the prices of food, non-alcoholic beverages, alcoholic beverages and tobacco products and gold.
“The rise in core inflation may be partially stemming from mildly recovering activity in Q4 but exchange rates and higher energy costs are likely to be weighing in on core prices,” Goldman Sachs wrote in a research note on December’s inflation.
Assuming a relatively more stable TRY in 2H17, Morgan Stanley expects CPI to decelerate gradually to 8.0%Y at the end of the year. Yet, it disagrees with the view that subdued demand conditions are restraining inflationary pressures.
The central bank has been arguing that the effect of recent exchange rate movements on core inflation indicators remained relatively limited due to the slowdown in aggregate demand.
Raise or not to raise?
Given the sticky inflation, geopolitical risks and domestic political issues, Turkish assets are now not looking very attractive.
Foreign investors have yanked a total of $2.79bn out of Turkish equities ($96mn) and bonds ($2.7bn) since the abortive coup attempt in July last year, central bank data show.
Analysts believe that as the lira comes under further pressure the central bank will be left with no other option but to raise interest rates. But the bank may also be pushed by politicians to cut rates to boost economic activity in the run-up to the referendum on the presidential system expected to take place later this year, probably by the summer.
The central bank will meet on January 24 to review interest rates.
“Following this inflation print, the ex-post real policy rate in Turkey is now in negative territory, even if one uses the ceiling of the interest rate corridor of 8.5% as the relevant policy rate,” said Inan Demir, an analyst at Nomura.
Demir argues that to beef up real yield support for TRY, the magnitude of the hikes will have to be larger. But, he also notes that the central bank’s response is constrained as evidenced by its inaction at the December meeting.
“This leaves a weaker TRY as the path of least resistance. Following the December MPC meeting, we had revised our three-month USD/TRY forecast higher to 3.65 and noted there was a risk this level could be reached much sooner. After today's inflation print that risk is now very tangible,” Demir wrote in a note on January 3.
J.P Morgan also thinks the central bank policy response is constrained by the weakening in economic activity and the demands coming from political players for lower interest rates.
President Recep Tayyip Erdogan, who describes himself as “the enemy of interest rates”, once again renewed his call for cheaper credit to boost economic activity on January 4. He asked state banks and central bank to cut interest rates, also urging citizens to sell their FX holdings to support the local currency.
Morgan Stanley maintains its view of a 25bp hike in the policy rate at the January meeting. “However, following today's CPI print, the risks to our call are to the upside as the pressure on the CBT to respond is likely to increase,” analysts at Morgan Stanley said in a research note on January 3.
Goldman Sachs believes the central bank is likely to keep the financial conditions as loose as it can in the environment of terror attacks, debates on constitutional changes and GDP contraction, even if this means a weaker TRY and a temporarily higher inflation rate, as long as this adjustment is orderly. “Although there are risks of a more front-loaded hiking cycle present to keep inflation in check,” the bank says.
The rate setters must take into consideration the global environment, especially the appetite towards emerging economies, when they meet later this month.
“At this stage, it seems unlikely that emerging markets will be broadly flooded by a fresh wave of capital inflows as there is too much uncertainty about Trump’s policies,” Rabobank said.
The latest data from the Institute of International Finance (IIF) show that emerging market portfolios recorded the lowest total inflows since 2008, as investors responded to global shocks last year by buying fewer of the developing countries' assets, Reuters reported. Non-resident investors cut inflows to emerging market assets to $28 billion in 2016, with debt portfolios recording substantial outflows, the news agency said, citing a report by the IIF.
Global liquidity conditions and rates picture will still be the main determinants of Borsa Istanbul (BIST) equities in 2017, according to TEB BNP Paribas analysts. But they will still keep a close eye on developments regarding the change of political system.
Since Trump won the US presidential elections, BIST-100 sold off 9% in USD terms, underperforming EM equities by 3%, they noted in their Turkey Strategy report. “But, when we analyse the BIST100 index performance in TRY terms, we see a different picture. Since Trump won the elections, BIST100 index has gained 1% in TRY terms. Thus, it is actually the deteriorating dynamics of the currency and not the equity dynamics that led to the underperformance”. MSCI Turkey underperformed MSCI EM by 18% in USD terms last year.
“We are cautiously upbeat on the stock market and recommend an OVERWEIGHT position on Turkish banks vs manufacturers and the BIST100,” says BNP Paribas.
All in all, 2017 will be a difficult year for emerging markets. And for Turkey, with its large current account deficit, high inflation and the slowing economy, this year will be as challenging as 2016. “Turkey’s economy is expected to follow a highly volatile pattern particularly in the first half of the year”, according to local lender Is Bankasi.