Turkey’s stock market continues to witness elevated levels of volatility, with Borsa Istanbul losing 8% in lira and 13% in USD terms in just two days from 10-11 July. The local index is now down by 14% in local currency and 29% in USD terms since the beginning of the year.
Volatility started in April-May, mainly in conjunction with Moody’s and S&P’s downgrade of Turkey’s foreign currency sovereign credit rating, the announcement of early elections and a rapidly-deteriorating inflation outlook.
The central bank’s cumulative 500bps rate hikes to 17.75% had calmed down both the lira and the stock market up until President Erdogan announced his new cabinet of ministers. The appointment of Erdogan’s son-in-law as the finance minister, a new decree that reignites debates on the central bank’s independence, and investors’ perception of a “lack of a market-friendly official” in the new economy team, in particular the departure of former minister Mehmet Simsek, have all contributed to a further decline over the following week.
Overall, negative sentiment towards emerging markets globally did not help either. Our understanding of the sharp market reaction in July is that a number of sizeable global investors became increasingly worried about how the economy is run and opted to simply sell in line with the announcement of the new cabinet of ministers.
In terms of economic fundamentals, the situation is tougher than it has ever been over the past 15 years. Inflation was at a 15-year high of 15.4% in June, and we expect it to continue climbing higher in the coming months. The current account deficit, which has historically been the weak spot of the economy but was financed even when it was at higher levels, is now closer to 6% of GDP. External debt has been accumulating, as a large part of the deficit was historically financed by FX borrowing, making Turkey highly dependent on external financing conditions. Non-performing loans are optically low, at only 2.9%, but will increase as indicated by the growth of restructured loans, especially in the energy sector.
What is worse is that it is a self-fulfilling dynamic: Fundamentals lead to lira depreciation, which in turn fuels inflation due to higher prices of imports, calls for even greater monetary policy action and hurts consumer confidence to an extent that the economic activity may slow down considerably from very high levels of 7.4% both in 2017 and in 1Q 2018.
Going forward, we do not think it is a one-way street, especially now given historically-high local interest rates, which might eventually attract investors back, if and when things calm down.
The central bank needs to keep its monetary policy tight and perhaps tighten even more until inflation starts easing. The economy will likely slow down as a response to higher rates, i.e. less demand for credit, and loss of consumer confidence.
A high current account is not sustainable at run-rates of $4bn-$5bn a month, so it should also come down - implying an even slower economic activity.
A rabbit out of the hat could have been fiscal expansion, but it would only worsen sentiment given that it has already been happening in 2017 (i.e. including the Credit Guarantee Fund) and so far in 2018, partially due to the election period.
All in all, the market seems to be in the process of pricing in a new environment, with recent volatility reflecting even some of the worst case scenarios. But we feel that the truth may be somewhere in between if the situation is skilfully managed going forward.
Accordingly, we are cautious but are also conscious about historically-low valuations when it comes to our investments in Turkey. Even though we think that there will be notable revisions in earnings going forward, the headline forward-looking P/E is now close to 6x, with banks trading at the lowest multiples since the global financial crisis in 2008, at 3.6x P/E and 0.5x book value, compared to our stress test P/B of 0.7x assuming a tripling of the NPL ratios towards 10% levels. Non-banks, which may see both positive and negative earnings revisions, depending on the nature of their businesses, also trade at multiple year-low P/E ratios of 8x, on average. Some of them even started trading at valuations that reflect multiple years of depression and a cost of equity that will stay close to 20% for an extended period.
Overall, the market is now trading at a 47% discount to emerging peers – the highest level in a decade. We have been reducing investments in companies that have high foreign currency debt without corresponding FX revenues, and in companies that looked like turnaround stories a year ago. Given anticipated challenges, our flight to safety and quality will continue, especially at times when the market offers very attractive pricing levels that dwarf companies’ intrinsic values. We are aware that some stocks may indeed be “falling knives” at times of extreme volatility, but we believe that some of the best investments can also be made at times like these.
Emre Akcakmak is a portfolio manager at Sweden-based investment fund East Capital. This comment appeared first in an East Capital newsletter.