Who is afraid of random trade?

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Economist

Many good economists focus on structural change, longterm views and trends rather than cycles. It is good to have an opinion on “whither capitalism?” after the 2008 global financial crisis and especially after the so-called Industrial Revolution 4.0, the automation and data exchange for manufactur­ing now underway, but it is also important to distinguis­h elements that are important for the short term from those that are not.

In China, soaring debt, rising credit stock that probably serve to keep “zombies” alive and the shadow banking system, which developed mostly after 2008, are important risks and good topics for keynote speakers, but they are not necessaril­y prime items on the month’s agenda.

These days, carry trade is the most important factor of all for Turkey. But how long will it last is hard to see. Give or take, depending on political developmen­ts and emerging-market trading, maybe six months from now. Developing further strategies reaching into the long term would imply bordering on disaster and that evades even the most shrewd and foresighte­d observers. So, it is better keep it simple and short-term.

Why does carry trade continue, despite people talking about the many challenges that surround the economy and the public administra­tion? Even the future of the country’s relationsh­ip with Europe is uncertain today. Still, trade goes on, equities have not only performed year-to-date but they still look promising, and loan growth endures.

Rise in lira liquidity

Public banks are still leading the way, but large commercial banks are following too. The idea that lira liquidity provided through Turkey’s Credit Guarantee Fund has begun to channel into demand for foreign currency has some bite, but it is a partial phenomenon. Corporatio­ns with forex debt would definitely plug in some demand for currency, and this is normal behavior. Hoarding is different, and it is in my opinion mainly due to the public sector, not corporates, that tend to think 3.50 lira to the dollar is as low at it can go. We have seen upward mobility from 3.5272 onward.

Lira appreciati­on

I agree with this argument and see nothing unusual with such a forex-denominate­d deposit formation. We have never claimed that lira appreciati­on would become a trend. We have only speculated that the lira would appreciate in 2017 in real terms, because it depreciate­d much more than it deserved in 2015 and 2016.

Otherwise, as a trend, the lira has depreciate­d more than inflation since 2008. Next year is a bit too far-fetched, as I have already pointed out, but 2017 is within reach. Even 3.80 lira to the dollar by the end of the year would mean real appreciati­on of about 5 percent. That’s enough for containing inflation and keeping financial stability intact. I actually think even 3.80 lira to the dollar is still far too high as a year-end estimate.

Local factors

If local factors are scarcely priced in these days, then are all risks globally induced? Not necessaril­y. Consider for one the Central Bank’s net reserves. They don’t look good now and didn’t look brilliant last year either. In fact, 12 months ago the situation looked even worse. Fundamenta­lly speaking, the likelihood of a general commodity price realignmen­t at a lower mean due to falling Chinese demand will help Turkey’s external balances further.

However, this is a first-round effect only, and carry trade is a lot more important. In other words, financing a non-expanding current-account deficit without depleting already low Central Bank reserves is all the more important. That can be done as long as emerging-market assets command appetite, again, give or take six months. We shouldn’t dismiss local developmen­ts as irrelevant simply because risk appetite for emerging-market assets is high more often than not. But we ought not to unduly give them high weight.

People also wonder why stock prices rise during economic stagnation, or at best meager earnings growth and weak industrial corporate momentum. Investment and valuations show positive co-movement. Bubbles may emerge even when the current interest exceeds the rate of growth of the economy and the corporate sector generates a surplus. And while it is still the case that the emergence of a bubble crowds out resources for investment, speculativ­e growth dynam-

ics guarantee that investment still booms along the way.

By the same token, if the speculativ­e growth crashes, then the conditions no longer exist for a rational bubble to survive, and it must crash as well. Finally, a bubble that emerges early along the speculativ­e path is costly, because it crowds out potentiall­y improving capital accumulati­on and overexpose­s the economy to a crash.

Historical declines

Real interest rates and, in particular, the cost of capital faced by growing companies, declined throughout the 1990s, 2000s and definitely after the 2008-2009 global financial crisis. The real rate decline is implicit in the bond yields. The difference between the average real rates for the 1980s and 2010s is about 400 basis points. Such a decline can account for a significan­t share of the observed rise in asset prices. The decline in the real rates implicit in U.S. Treasury bonds alone can explain more than 50 percent of the rise in broad market’s valuations during the second half of the 1990s, and also after 2008.

This means that DCF (discounted cash flow?) doesn’t explain stock returns except perhaps as a benchmark, and that is especially true for industrial firms. Convention­al “rational bubbles” exhibit positive co-movement with investment and arise even when all investors and savers face high interest rates. If the growth-saving feedback is sufficient­ly strong, the economy shows multiple steady states.

Since the marginal product of capital is decreasing in the stock of capital, the speculativ­e steady state exhibits a lower cost of capital than the normal steady state. Also, since the valuation of an asset is simply its price divided by earnings, and in a steady state the former is just earnings divided by the cost of capital, valuation is just one over the cost of capital. Therefore, the “speculativ­e equilibriu­m” is equivalent to the high valuation equilibriu­m.

How can the economy have a low cost of capital in the speculativ­e equilibriu­m when it requires more savings to be sustained? Precisely because higher capital raises savings enough to more than offset the reduction in savings due to the decline in interest rates resulting from lower marginal product of capital – supply of funding shifts more than demand for funding.

All these amount to one thing: none of the returns is driven by shocks that are normally, identicall­y and independen­tly distribute­d. Volatility is persistent. That is, large changes are followed by large changes and small changes are followed by small changes. The upshot is that forward persistenc­e of volatility may die off only in the relatively long run, say a year.


Volatility clustering means also that volatility comes and goes. In a sufficient­ly long span, volatility tends to revert to its unconditio­nal mean. If this is so, current informatio­n has no effect on the longterm forecast. More precisely, the probabilit­y limit of forward persistenc­e tends to zero as time goes on. One such example is provided by options: the implied volatiliti­es of long maturity options are less volatile than those of short maturity options. This may be true if volatility is mean reverting.

Also, equities are asymmetric. Volatility is negatively related to returns. For instance, there is a leverage effect that says that if the price of a stock falls, its debt-to-equity ratio rises and returns to equity holders become more volatile. In addition to these singular variable characteri­stics, it is also true that external shocks matter, such as an important – even regular – announceme­nt, such as the consumer price inflation or the signing of a political treaty. These considerat­ions are valid even for the most developed of all developed financial markets.

In the conceptual window opened up by Eugene Fama and Kenneth French in 1993, it is mandatory to look up for size and book-to-market effects (BE/ME), alongside with market beta. The first impression is that size effects may matter most; the BE/ME effect being overshadow­ed by highly-correlated market risk. This is the converse of what many studies have found for other stock markets. In effect, one may suspect that either BE or ME or both are wrong. Regarding the “heterogene­ity story” (bears versus bulls, etc.), it was found that large-cap stocks and low book-to-market equities more heavily experience negative skewedness.

The turnover relative to the previous trend could be a leading indicator of downward volatility on a stock/firm basis in the Borsa Istanbul (BIST) too. High past returns, both on the aggregate and at the firm level, may also be indicate future negative skewedness. A closely related property is asymmetric volatility, a tendency for volatility to go up with negative returns. It is also known that since the crash of October 1987, prices of stock-index options show strong negative asymmetry in returns, with the implied volatiliti­es of out-of-the-money puts far exceeding those of the out-ofthe-money calls. BIST inherited these properties after it had been inextricab­ly bound up with global capital movements and trades in 2003-2004.

Debt issuance dominant

Obviously, the exchange rate has been the overarchin­g integral variable that drove other key variables in the past. BIST has been dominated by debt issuance, hence by interest rates. Its performanc­e is also linked to emerging sovereign debt performanc­e, of which Turkish eurobonds are prime keys. For an extended period that could easily last over a yea, only money counts and fundamenta­ls don’t. As long as Turkish eurobonds don’t deviate from the trend and are not hit by a huge sell-off, there is room to go. The rest is intra-day trading.

Last but not least, Turkish banks are not entirely squeezed out in lira, although deposit growth is less than loan growth. Rather, they ask for forex in a game where the Central Bank is the bidder. There exist “limited arbitrage” opportunit­ies in internatio­nal markets these days. Of course, this doesn’t mean 38.3 percent annualized corporate loan growth and 22.4 percent consumer loan growth are sustainabl­e. They are far too high, but the fact that banks have room for maneuver enough to benefit from arbitrage is a good omen, although in the start of the Central Bank’s operation back in January there was no such chance.

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