Turkey, a unique market in the emerging markets space over the past several years given the Erdogan administration’s unconventional economic policy, may offer increasingly attractive valuations, but it has growing macro risks that make it less and less investable for most international investors.

So says VTB Capital in a new report—“2022 Outlook – The Moment of Truth”—that asks whether the country can withstand the pressure and ripen for an unprecedented re-rating from 2023 onwards after the holding of its presidential and parliamentary elections.

VTB proposes that the base case scenario should be survival and a welcome re-rating, noting: “We believe that the main issue with Turkey is the wrong macroeconomic policy rather than fundamental issues in the real sector or the financial sector.”

In the report, VTB equities analyst Akin Tuzun advises: “The 10-year down cycle might be coming to an end. The MSCI Turkey index has been in a down-cycle over the past 10 years, having underperformed the GEM and EMEA indices by 80%, mostly driven by the Turkish lira’s [TRY’s] 70% underperformance against EM currencies during that period. This trend has been particularly more visible in the past five years.”

Looking at 1H22, VTB foresees a stable environment, particularly in terms of the walloped lira (down 44% against the dollar in 2021, broadly stable near the TRY13.50 line in recent weeks), followed by a period of higher uncertainty until the elections in mid-2023. “Despite our view on the ‘new economic model’, we do not think it is likely to lead to a major permanent economic crisis in Turkey,” adds Tuzun.

Turning to investment recommendations for 2022, Tuzun says: “It is still too early, in our view, for fundamental long-only investors to re-position in Turkey, but for hedge funds, we recommend long banks/short TRY.

“For active traders, we recommend certain BIST100 trading ranges. For FX fixed income investors, we recommend holding positions until maturity and a cautious stance for new issuances.

“For lira fixed income investors, we recommend waiting until 2023 for re-opening positions.”

Turkey, observes VTB, is testing a highly unconventional macroeconomic approach, with a Central Bank of Republic of Turkey (CBRT) policy rate well below running inflation (14% versus official inflation of 49%), and the provision of FX-rate guarantees on TRY deposits, “all in a particularly challenging global environment of rising commodity prices, inflation, interest rates and geopolitical risks”. Thus, says VTB, “2022 will be a year in which the Turkish economy’s resilience faces a serious test; however, we think it will still avoid a major economic downturn, despite suffering some bruises along the way.”

VTB treads carefully, concluding that “this is a difficult time to produce a ‘high-conviction’ base-case scenario for Turkey, given the unique macroeconomic, geopolitical and political factors that form the present environment.”

Bearing in mind that caveat, the analysis in the report “simply defines two periods ahead of Turkey. First, the next eighteen months or so, as elections approach. Second, the post-election period, which depends on the composition of the government.

“Recent polls suggest that President Recep Tayyip Erdogan and the AKP have been losing votes, especially in the past two years. The primary reason for this trend appears to be the economy. President Erdogan and AKP management have tried to address this with unconventional measures rather than traditional ones. We believe this increases risk perception both internally and externally, given Turkey has long been a liberal and open economy.

“In our view, it is likely that the current administration (i.e. Erdogan/AKP) believes that this untested economic policy will work over the next 1.5 years prior to the elections, and will thus change the downward polling trend for them. This is perhaps risky, but what makes it even more challenging is that it is being tested in a global environment of QE tapering, higher interest rates, higher inflation, higher commodity prices and increasing geopolitical risks, including energy security.”

VTB’s perspective is that the government’s current economic plan and approach cannot achieve the desired fundamental outcome. “In the first 3-6 months of 2022, it is likely to lead to a stable period, particularly in terms of the Turkish lira. However, in the 6-18 month period, things become more uncertain, and we believe it will become clear that the model is not working,” says Tuzun.

He adds: “The critical question here is whether President Erdogan/AKP will take a step-back if and when this happens. We believe that this ‘new economic model’ will be forced as much as possible during that 1.5 period, and there will not be a major step-back, and indeed, that we are more likely to see the introduction of new unconventional measures. We think, though, that they will all fall short of solving the macro problems of Turkey. We would expect the government to continue compensating for this with short-term fiscal expansion, credit expansion driven by the state banks, and increasing emphasis on geopolitical matters, until the mid-2023 elections.

“While these issues increase risks, and might affect asset prices, we also believe that Turkey is unlikely to suffer a catastrophic crisis. ... Nevertheless this uncertain and risky outlook ahead will continue to discourage foreign investors coming back to Turkish markets in the visible future, we believe.”

Nevertheless, investors might possibly start positioning for the post-election period, and doing so from the last months of 2022, VTB suggests.

Its analysis foresees Turkey’s inflation remaining very high for most of 2022, its policy rate staying constant at 14% and the lira as stable in 1H22 before gradually moving toward a year-end level of 17.00.

So, is it worth investing now in Turkey, or is it better to hold off on a decision until after the elections (scheduled for June 2023, though there is always the possibility of Erdogan going for snap polls any time before then)? 

VTB summarises: “Turkish assets have long looked attractive in terms of nominal and relative valuations. Turkish equities trade at a 2022F P/E of 4.4x, a 60% discount to GEM; banks trade at an even deeper discount, of 70%, and at 2.7x 2022F P/E. On the fixed income front, Turkish Eurobonds (5Y-10Y) offer yields around 7.5%. And in general, the Turkish lira, after being the worst performing EM currency for a long time, looks cheap.

“However, we believe that the bulk of foreign institutional investors (GEM in particular) are unlikely to make a long-term investment in Turkish equities or TRY-denominated bonds prior to the 2023 elections and thus we do not expect a material increase in foreign ownership from historical lows."