Justin Vela in Istanbul -

The Turkish stock market is setting new records as it pulls in large amounts of foreign money despite the tumult in the country's politics. With valuations of Turkish companies below the average for other emerging markets, analysts expect this strong performance to continue.

On July 29, the Istanbul Stock Exchange (ISE) hit at an all-time high of 60,734 after a week of breaking records. In the past year, the index is up about 32%. The MSCI Barra Emerging Markets Index, which tracks stock performances in 21 countries, was up 8% in July, helped principally by Russia and Turkey, which each posted July advances of more than 10%.

The record setting comes at a time when investor confidence in Turkey has never been higher. Mark Mobius of Templeton Asset Management announced on July 29 that he plans to increase his holdings of Turkish stocks, which rank among the least expensive in emerging markets. "We already have over $1bn invested in Turkey today and expect to invest more," Mobius told Bloomberg. "We remain optimistic about the long-term potential of the Turkish economy and prices are attractive."

With year-on-year GDP growth coming in at 11.7% in the first quarter, Turkey ranks second only to China in the G20. Especially in comparison to other countries in the region, Turkey is recovering quickly from the effects of the global economic crisis. "Turkey is easily leading CEEMEA in growth for 2010, with 5-6% of real GDP growth expected," says Timothy Ash, emerging markets analyst with the Royal Bank of Scotland.

Much of that strength can be attributed to the banking sector, which has performed strongly throughout the global financial crisis after wholesale banking reforms were made during Turkey's last crisis in 2000. Erkin Isik, an analyst with Fortis in Istanbul, points out that with benchmark bond yields declining from about 20% in 2008 to about 8.2%, banks have been hugely profitable. As banks own about 53% of the ISE30 Index and make up a large part of the index, their performance has driven the rise in the index..

Another reason for rise in the stock market is that many international investors who had reduced their Turkish stock and bond portfolios during the financial crisis are now buying them back. "There's a lot of cross-over money coming in," says Thomas Wilson, who runs an emerging Europe fund at Schroders Investment Management in London. "Dedicated money has liked the market for some time. There is now also non-dedicated money coming - global money from a variety of sources."

Wilson says that with interest rate hikes having been pushed out to 2011, Turkey has an interesting near- and medium-term outlook that is driving the market to new heights. "The country has good demographics with a young and growing population and the banking system is very robust, in contrast with developed markets."

Asked who was second to Turkey in growth potential Wilson named Russia. "It [Russia] is also interesting. There are very cheap valuations. The recovery in growth is expected to be similar, but there is a time lag compared to Turkey - we have only recently seen the inflection point in loan growth in Russia, while it is already running at healthy levels in Turkey. Russia is also sensitive to oil price outlook and that effects many aspects of the Russian economy and confidence," he says.

In the long term, both Wilson and Isik feel it's crucial that Turkey approves a bill laying out a new fiscal rule, which has been postponed at least until parliament reconvenes from their summer recess. Called the "fiscal rule bill," the measure's goal is to keep the budget deficit below 1% GDP while target GDP growth in the long run at 5%, which should reducing debt in relation to the size of the economy. "We still hope to see a long-term fiscal rule," Wilson says. "We think it would be very positive for the market and for the cost of capital in Turkey. It is very much in the interest of Turkey to implement the fiscal rule."

With the rise of Kurdish violence in the southeast of the country and a hotly contested referendum on constitutional amendments proposed by the ruling Justice and Development Party (AKP) in September, followed by parliamentary elections in 2011, market stability could be a concern. "The obvious fear is that we will see a loosening in fiscal policy in the run-up to the election," said Ash.

Yet the Turkish economy seems likely to withstand the country's tumultuous political situation. Isik points out that both the fiscal rule and referendum were issues during the last quarter, yet the market still rose to record highs. The only thing that he sees that might upset the markets was if polls indicate there would be a very strong "No" vote for the constitutional amendments, which would mean the very pro-market government would most likely lose power. Isik doesn't think this is likely, however. "In case things work out as expected at the moment, a 'Yes' vote in the referendum, or a very close voting there, then I think that the markets will not be alarmed. The current growth will continue."