Unpromising outlook for Turkish markets in 2017

Unpromising outlook for Turkish markets in 2017
Consensus is that Turkish assets are cheap, but potential risks are high.
By bne IntelliNews December 9, 2016

2016 has been a tough year for Turkey: a coup attempt was averted in July, the currency has lost nearly 18% of its value, tension with the EU has increased, the army is in Syria and Iraq fighting against Islamic State, violence has escalated in the southeast, unemployment has risen and the economy is slowing.

The outlook for 2017, according to some analysts, may not be any better, because the main risks are here to stay for a while: domestic political noise, geopolitical worries, a more challenging global economic environment.

In the face of recent market volatility, the government stepped in to revive the economy and announced a set of measures on December 8.

It promised to create TRY250bn (€68bn) in loans to be extended to local firms, mostly to SMEs, to ease their cash flow problems. Prime Minister Binali Yildirim, who unveiled the anxiously awaited package, did not get into details, but said that the measures would not widen the budget deficit and there would not be any tax hikes in 2017. “Fiscal discipline will be maintained,” he added.

As part of the measures, the government will offer investment incentives to the manufacturing industry and will provide vocational training programmes for 500,000. The capital of Eximbank will be increased to help the country’s exporters. The banking regulator BDDK will allow lenders to restructure loans to the private sector.

Reaction was mixed. The package did not address companies’ FX debt problems, but was still offering something to stimulate economic activity, some local analysts said. “In our view, the authorities’ response to the exchange rate developments have been underwhelming,” commented Inan Demir at Nomura.

Indeed, this disappointment manifested itself in the form of more volatility in the currency. The lira weakened as PM Yildirim spoke. The currency dropped 1.6% to trade at 3.4434 per dollar on December 8. The lira hit consecutive record lows over the past few weeks on worries about domestic politics and the wealth of the country’s $720bn economy. The currency was also hit by a resurgent US dollar after the election victory of Donald Trump.

Besides the currency’s woes and the slowing economy, investors have one other major issues to worry about: politics.

Turkey is heading towards a referendum on the presidential system that could be held sometime in the second quarter or at the start of the summer. The government argues that the presidential rule will ensure more political stability and stronger economy through move effective governance. This may be true in the long run, but investors, who are also concerned about the short-term prospects, fear that the government will spend much of its energy on the upcoming popular vote and forget about the reforms that are needed to reignite the engine of economic growth.

The government forecasts a GDP growth of 3.2% for 2016 and a higher expansion rate at 4.5% in 2017. But, international institutions, including Fitch, the World Bank and the OECD find these estimates a bit too optimistic.

Huge piles of debt

A weaker currency will spell troubles for private companies that are now sitting on a pile of huge debt, accumulated after 2004, making them vulnerable to the fluctuations in the lira. The net FX position of Turkish non-financial companies reached $212.8bn at the end of September, worsening from $195bn at end-Q1 and up from $190bn at the end of 2015. But, some local companies, such as listed carmakers Tofas and Ford Otomotiv may benefit from the depreciation of the currency since nearly 70% of their income comes from exports.

But, a weaker currency at the same time means higher inflation that will erode consumers’ purchasing power. Household consumption, accounting for more than 65% of national income, has been the key deriver behind Turkey’s economic expansion. If domestic political tensions rise in the run-up to the referendum, combined with higher inflation, consumer confidence will take a hit.

Meanwhile, oil prices are rising after OPEC agreed to cut crude output for the first time in eight years. This is bad news for Turkey, a net energy importer, and for Turkish corporates, especially for listed Turkish Airlines and Pegasus Airlines.

Given this backdrop, stocks are not doing great either. The MSCI Turkey index fell nearly 20% over the past 12 months versus 8.81% increase in the MSCI Emerging Market Index in the same timeframe.

Consensus is that Turkish assets are cheap, but potential risks are high.

“Underperformance deepened with post-election uncertainly, with macro vulnerabilities brought back into the spotlight: i) Volatility caused by post-election (US) uncertainty, ii) growing expectations of a more hawkish Fed, iii) elevated domestic political noise, iv) geopolitical risks, and v) weaker macro outlook (i.e. slower growth, higher CPI, relative widening of CAD, etc.)”, analysts at Deutsche Bank wrote in “Turkish Equities Strategy” report on December 1.

They expect 2017 to be a fairly challenging year with global headwinds growing stronger “after Trump’s victory, pointing to the possibility of an interest rate shock and commodity shock hitting the economy at the same time”.

Thus, Deutsche Bank is reducing its exposure to interest rate (banks and REITs) and FX-sensitive sectors. Funding costs are likely to climb higher and NPL formation is expected to accelerate through SME and unsecured loans, according to the analysist. “We believe that the NIM outlook weakened due to a recent upswing in bond yields as deposit rates are expected to follow.”

They also think deterioration in growth outlook and consumer sentiment is likely to weigh on the operating performance of consumer-oriented and cyclical non-financials.

“TR equities are trading at fwd. P/E of 8.9x, and the discount to MSCI EMEA widened to a significant 23% vs. 3Y average of -7%. The valuation gap is unlikely to narrow in the near term.”

Key risks

Analysts at Credit Suisse are not very bullish on Turkey either. They removed their recommended 20% overweight stance on Turkish equities after July's failed military coup, taking the market to a benchmark stance.

And they maintain this equal weighting going into 2017 based on four key risks offset by three positives: “(i) growth outlook is once again subject to negative revisions; (ii) eroding confidence and loan demand may reduce consumer spending; (iii) policy easing and lira weakness may fuel higher inflation expectations; and (iv) the shaky external position warrants the lira's depreciation… However, in Turkey's favour justifying a benchmark: (i) valuations are at multi-year lows and growth forecasts look superior to EM; (ii) bank price-to-book multiples look attractive relative to NIM progression; and (iii) we see 12% potential dollar upside for Turkish equities on our model.”

Credit Suisse picks Koc Holding and Sabanci Holding (industrialists), private lenders Isbank and Akbank, state-owned Halkbank, construction firm Enka Insaat, and carmakers Tofas and Ford Otomotiv as its “inexpensive top Turkish stocks. “

Renaissance Capital’s Charles Robertson seems a bit more pessimistic about Turkey. He thinks a banking or growth crisis in the medium term is a possibility.

“While we remain structurally bearish, the scale of the FX move suggests scope for a limited 5-10% FX led rally in the coming three months,” Robertson wrote in a report, titled “A bear market rally in Turkey?” published on December 5.

Given investor sentiment, and the scale of the recent TRY weakness, there is room for a bear market rally, according to Robertson.  

The most obvious trigger for an FX led rally would be for a Central Bank ‘surprise’ hike in interest rates, he argues. “The unfortunate side effect of this would be to further slow private sector lending, so making weaker GDP figures still more likely in the medium term. Other helpful drivers for the TRY could include a stronger euro, calmer politics, or a pre-Christmas closing of short TRY positions.”

Turkey is cheap, but other EM currencies (including the EGP, MXN and COP) remain far cheaper relative to their own history, according to Robertson, who thinks Turkey needs to shift, as it did in 2001, with the focus this time being on boosting exports and investment.

Renaissance Capital is not shifting its equity underweight on Turkey, because “our views maintain a long shelf-life unless major changes like the EGP devaluation prompt a fundamental review. But investors should beware of an improvement in Turkish assets prices over the coming three months”.

“Turkey’s currency is now cheap, the economy is rebalancing via slower domestic demand, double-digit interest rates on local currency bonds could attract debt investors, and politics could improve in 2017. Erdogan’s efforts to create a more presidential republic may come to fruition in 2017, bringing some stability on that front.”