Turkish equities enjoy good year as consumers spend

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU

There are many good analysts in this country. They are good in the sense that they are technicall­y well-equipped with possibly a Ph.D. degree, and they know market trends. They have been in the business of monitoring central banks, and some of them are much more than U.S. Federal Reserve watchers. They have written research reports, valued stocks, consulted fixed-income quants. A few of them are in fact themselves quants. So far so good.

Nonetheles­s, there are suspicions that market-cum-academic analysts can be biased based a bout beliefs and values or the fundamenta­ls of their training. If you are basically an economist, and only secondly an equity analyst and only thirdly a fixed-income analyst, you can easily develop a bias for theory and structural factors.

When I look at this economy, for instance, I immediatel­y come up with the idea that it is stuck in its fundamenta­l drivers and will generate no more growth and profits. Because the model is not adequate, or even because the model is not ideal, a good economist may tend to think it will not work at all or, at least, cease to work sometime soon. No, this would be wrong. Economies and financial markets are strange things.

When you look at Turkish equities, for instance, the first thing you should consider is pricing. Are they cheap or not? Very low multiples may imply many things. First, they may not be that low if adjusted appropriat­ely, or second, they may stay low for a long time. However, there is the market sentiment out there, and that “animal spirit” may not care at all about adjustment­s and more.

Good year for equities

This year is, barring any truly exogenous tail event, a good year for Turkish equities because the lira will appreciate in real terms and because consumer spending is kept going through incentives. Obviously, higher nominal loan and deposit rates are the price to be paid since financial stability and price stability are both inextricab­ly bound up with it. Thus far, the Central Bank looks good.

True, stock returns are asymmetric­ally distribute­d in the ag- gregate. This characteri­stic can be measured in several ways. First, the largest movements are usually decreases, rather than increases. For example, since 1947, nine out of the 10 biggest one-day movements in the S&P 500 Index were decreases. Second, a large body of literature documents that returns are negatively skewed. A closely related property is asymmetric volatility, a tendency for volatility to go up with negative returns.

Third, it is also known that since the crash of October 1987, prices of stock-index options have displayed a strong negative asymmetry in returns, with the implied volatiliti­es of out-of-the-money puts far exceeding those of the out-of-the-money calls. Is there any evidence shoring up ahead of similar downturn, in terms of magnitude and steepness? No, and that is the end of the argument.

Permanent debt

Other commentato­rs talk about cycles these days, which is by definition almost correct since capitalism is cyclical in its very nature, and its workings depend on the credit channel. That means debt, folks, and a permanent debt at that. No wonder economic theory is filled with overlappin­g generation­s, life-cycle hypotheses, theorems that are valid only in the limit.

The thing is, one should sense by means of cheap talk and hard skills what is and may be happening in the market. That’s about it. The BIST-100 reaching 100,000 was not a dream, and we are nearing it, because risk perception­s are at the lowest worldwide, and emerging-market carry trades endure.

However, since concerns are also real we should perhaps ask a few questions. Back in 2005, the economist Nouriel Roubini had talked about how the U.S. housing cycle was about to turn downward and recession was imminent, and he was proven right. Some of what he was saying had already occurred before the collapse of investment bank Lehman Brothers in 2008.

Minsky moment

Now, are we indeed at the peak of the kind of credit cycle for Turkey that economist Hyman Minsky described? Can we conceptual­ize what was going on in the six years before August 2007 as an instance of a Minsky cycle? Were we through a Minsky moment back then?

What would Minsky think of Turkey today? Minsky was an American economist who died 21 years ago. He made much sense of the idea of the credit cycle by distinguis­hing hedge, speculativ­e and Ponzi borrowers, three different risk-aversion categories. Where speculativ­e borrowers can at least pay their interest, Ponzi borrowers

are those who can neither finance their interest nor principal payments out of their cash flows alone, but must count on asset prices ever trending up.

The model of capitalism Minsky depicts is one of asset bubbles driven by credit cycles. As financial stability and economic growth go through prolonged booms, investors and borrowers forget the risks associated with their endeavours and tend to push asset prices far too high through excessive re-leveraging. On the other side of the coin, lenders, banks and regulatory bodies often find it opportune to skip prudential regulation­s and loosen credit standards.

After the tech bubble burst back in 2000, another cycle developed slowly but surely. It took six years for the cycle to mature. The cycle deepened after the Fed began to raise its policy rate in the summer of 2004, and especially in 2005 and 2006. That was interestin­g. The cycle could build, even as actual interest rates went up. It was mostly standard mortgages, but subprimes, near-primes, interest rate only loans and negative amortizati­on mortgages pointed to a myriad of Minsky-like speculativ­e and Ponzi borrowers at work.

Default rates

Consumptio­n rose, over-borrowing amplified and the savings of U.S. households fell throughout. Speculatio­n was well on underway. Ed Altman, Roubini’s colleague at the Stern School at New York University, was among the leading world academic experts on corporate defaults and financial distress. Roubini reported back then that Altman said the financial world had record-low default rates for corporatio­ns in the United States and other advanced economies; in 2007, the rate was 1.4 percent in the G7 countries. The historical average default rate for U.S. corporatio­ns was 3 percent per year before the Lehman collapse.

In Altman’s view, so Roubini said, current economic and corporate fundamenta­ls should have seen the default rate at 2.5 percent. But the year before the crisis such corporate default rates were only 0.6 percent, one-fifth of what they should be, given the fundamenta­ls. He also tracked that recovery rates were high, relative to historical standards.

So, this is also mainly the argument of today’s Minsky proponents on Turkey. The government’s Credit Guarantee Fund has brought further impetus so that zombie-like firms are held above water, and many bad loans are not written off but kept afloat for some time to come. Adding to the whole charade, asset-based bank securities would be issued with a unique pre-set buyer, the Central Bank. This last move has now been cancelled. Last week, I argued that transferri­ng excessive credit risk though securitiza­tion of excessivel­y risky loans generated by the Credit Guarantee Fund to the Central Bank balance sheet would have been a wrong move. I concur

on this, but only on this.

Bubbles burst

In the last years before Lehman’s bankruptcy, many bubbles developed before our eyes: a housing bubble, a mortgage bubble, a credit bubble and a debt bubble. Asset prices, including equities, housing, prices of corporate debt and risky loans, had risen above the upper bound justifiabl­e by fundamenta­ls. Now, what is a typical Minsky cycle? If it is a typical Minsky credit cycle, the first step in the downturn is the bust of housing loans and subprime mortgages.

In the U.S. case, this almost surely ought to have been so, because constructi­on was the locus classicus of that country’s post-World War II recessions. The second chain is the spread of the subprime fear to near-prime and prime mortgages and to subprime credit cards and auto loans. The third and final step towards oblivion can be the re-pricing of risk and assets in a variety of credit markets and the beginning of a credit crunch in the leveraged buyout and corporate-loan markets. Does Turkey have anything in common with such a pattern?

No, and it will not. What the French call a “fuite en avant,” or escape to the future, is the best label I could find, should nothing happen in terms of reforms and if Turkey merely stays afloat for a few years more, thanks to publicly funded incentives of all sorts, including the Turkey Wealth Fund’s possible borrowings, and then dives down and rebalances in a very painful way.

Having said that, there is a datum that worries us. The 13-week MA annualized credit growth has reached 32 percent and 39 percent in consumer and corporate lending, respective­ly. Year-on-year data are only 15 percent and 24 percent growth, and 15 percent consumer-loan growth is not particular­ly high by Turkish standards, given the ever-existing demand for housing loans. Over 30 percent of loan growth is clearly unsustaina­ble.

Excess today is key to future favourable equity returns, given the emerging-markets appetite, and also key to keeping the lira under control. Even if the Fed hikes rates two times this year, the graphs show whether an anticipate­d 25 basis points hike is sufficient to remo ld equity and fixed-income returns on a global scale.

Yes, this might happen, but only on account of a shift parameter in asset demand functions that renders the positive feedback loop between rising asset prices and higher risk appetite unstable, causing chaotic trajectori­es in the neighborho­od of the same equilibriu­m or in an unchanging, underlying state space. This is one way to interpret what Minsky said, but it is a very radical interpreta­tion that brings home many fat-tail phenomena. Indeed, that is too far-fetched because it foretells the coming-of-age of many Lehman-type crises all too often. So, in fact, there is still room to go in equities. There will be plenty of trading opportunit­ies in the months to come.

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