Turkey: From a Buy to a Hold

Four months ago we argued that the sharply de-rated Turkish equity markets were a buy. To sum up that argument, we thought that the political risk premium was priced in, and that the conditions were right for a smooth adjustment of Turkey’s large current account deficit. The bet on political and economic stabilisation has been rewarded by a 40% gain in Turkish stocks from their February lows. Looking ahead, a further sharp re-rating of Turkey’s financial assets appears unlikely now that valuations have normalised. But the rally may not be completely over, as interest rates may have further to fall on the back of supportive local and global conditions.

It is now clear that the central bank’s emergency rate hike in January succeeded in halting the Turkish lira’s freefall following its -25% devaluation against the US dollar, helping to engineer a soft landing for the economy. In addition, March’s local elections confirmed prime minister Recep Tayyip Erdogan’s strong hand despite threatening street demonstrations last winter. These developments have led to a strong performance by Turkish assets. In US dollar terms, the MSCI Turkey index has outperformed the MSCI Emerging Markets benchmark by almost 20% over the year to date.

Looking at valuations might suggest that much of the potential upside for Turkish stocks has now been exhausted. The P/B ratio is almost back to its long term mean of 1.75, while the forward P/E ratio stands at 10.5, above its long term average of 9.65, indicating that the Turkish bourse is no longer undervalued. After a violent but temporary de-rating caused by rapidly rising external imbalances, internal political quarrels and concerns about the US Federal Reserve’s tapering, the country risk premium has now fully normalised.

Economic data show that Turkey’s macroeconomic adjustment is going smoothly, with no signs of a reversal. A cheaper lira has boosted exports, while imports are slowing on the back of slower consumer credit growth, which has decelerated from 27% to 15% in six months. Consequently, Turkey’s current account deficit, which stood at almost 8% of GDP at the end of 2013, contracted to 6.5% in first half of the year, and should decline further to 6% or below by the beginning of next year. More recently, inflation has begun to turn down now that the effects of the devaluation have been fully absorbed. After peaking at 9.7% in May, the CPI eased to 9.2% in June, and a favourable base effect should bring it down to around 7% by year’s end. Finally, economic growth has continued to cool off gently, probably reaching a trough of 3% this summer, compared with 4.5% a year ago.

This has allowed the central bank to gradually January’s rate hike. And it has done so without reverse putting downward pressure on the lira, thanks to a dovish Fed and additional monetary stimuli in the eurozone. This is crucial for Turkey, which depends on investors’ appetite for risk, and so on global liquidity conditions. Finally, political continuity looks probable, as Erdogan is widely expected to win a landslide victory in the upcoming presidential election on August 10.

All this should give the central bank room to continue cutting rates, probably by 50-100bp by the year’s end. Given the sensitivity of Turkish stocks to local interest rates-the inverse correlation between Turkish bond yields and equity prices is almost perfect-this implies that there is still some upside remaining for Turkish stocks.