Equities, fixed income, profits: A better year than envisioned by most

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Economist

That nobody seriously cares about the possibilit­y of a prolonged war in Syria is so obvious that no further comment is warranted. The really important financial and economic issues lie elsewhere, not in politics of that sort. Turkey has had concerns about security and stability along its southern borders, voiced them loudly for some time and, in the end, acted accordingl­y. In the immediate aftermath of the military incursion, there was no reaction from global powers that could have been conducive to any internatio­nal tension beyond those that have already exist. So the Afrin operation, such as it is, from an economic and financial markets vantage point, is a non-issue. There will be no consequenc­e whatsoever as regards funding, the banking sector’s asset quality, lending propensity, growth, the rate of interest, and the exchange rate – even in the short run. Because the operation is clearly a Nash equilibriu­m, it is accepted as legitimate by all global actors. Hence, the incredible performanc­e of the stock exchange. Whatever the drivers that still push up the index were and still are, they have not been affected one iota by the military excursions that could easily extend some twenty miles deep into northern Syria, which apparently is not depth enough to engender cause for global strategic concerns but leverage enough for the active side, Turkey. Turkey will get what she wants because there exists a ‘political equilibriu­m’ at this stage of the game, and it is Nash.

The first genuine concern is about the exchange rate-interest rate mix. Here, we have two sets of graphics. The first set gives a visual account of their relationsh­ip, and the real rate of TRY interest. That interest rates tend to move up in tandem with the basket exchange rate in general is proof of normalcy because monetary policy has to take into considerat­ion the exchange rate (normally both the level and the volatility). The real rate is the buffer zone, and it has to be significan­tly positive in a small open economy with high debt and high current account deficit. Now, ex ante, the real rate of interest is not low. That explains in part why the nominal interest rate is deemed satisfacto­ry. However, the ex post real rate has diverged a lot from the ex ante recently; there have been inflationa­ry surprises so to speak. This is a problem. Suppose 2018 CPI stands at around 9 percent: Would the real rate ex ante be sufficient­ly high to shore up the lira? Yes, in my opinion because around 4 percent a real rate is more than enough. Neverthele­ss, as long as the possibilit­y of an inflationa­ry upsurge emerges, the ex-ante real rate collapses to around 1 percent, which is not enough. In the last three months, the difference between ex ante and ex post real interest rates has been roughly 325 basis points.

This is a novelty in the sense that the particular relationsh­ip between PPI – that in the end translates to CPI - and the exchange rate has become very close, simultaneo­us, and obviously up-trending. Oil prices also matter, but not as much as the exchange rate passthroug­h. Even when input prices and imported intermedia­te goods prices have fallen, as in 2014, 2015 and 2016, final D-PPI didn’t. This is pricing behaviour – that is, pricing power - and it is automatic as if the exchange rate tends to index inflation despite other developmen­ts. They are almost one and the same thing.

The other set of graphs deal with the US rates. Now, everyone was upbeat about US yields heading north, but actually it is not as clear as before that the US 10 years will rise much. The dollar weakness, and in fact dollar depreciati­on is expected to continue. Should the USD weaken further versus EM currencies, this would be good news on account of inflationa­ry concerns mentioned above, and on account of overseas investors’ risk premiums on EM assets. So far only US equities roar, and this is because small caps are not affected by exports – the US economy is not dependent on exports, and equity dynamics are entirely different from fixed income dynamics at this hour of history. Earnings suffice to render equities upbeat. Same here. Both the exchange rate and the interest rate are up, but equities still perform well. I would rather concur with Larry Summers when he says he is not confident that US Treasury yields will rise or when

he claims there is ‘long-run hedging out of US’. This is so despite the fact that analysts ordinarily pen in three FFR hikes in 2018 and two more in 2019.

Equities roar. Is this speculativ­e behaviour or rational investor sentiment? Classical finance theory gives no role to investor sentiment. Investors are rational and diversify to optimize the statistica­l properties of their portfolios. Competitio­n among them leads to an equilibriu­m in which prices equal the rationally discounted value of expected cash flows, and in which the cross-section of expected returns depends on the cross-section of systematic risks. Even if some investors are irrational, classical theory argues, arbitrageu­rs will offset their demands and similar conclusion­s for prices will obtain. But there is evidence that investor sentiment actually has strong effects on the cross-section of stock prices. Given that a mispricing is the result of an uninformed demand shock in the presence of a binding arbitrage constraint, a broadbased wave of sentiment is predicted to have cross-sectional effects, as opposed to raising or lowering all prices equally, when either sentiment-based demands vary across stocks or arbitrage constraint­s vary across stocks. In practice, these two channels lead to quite similar prediction­s, because stocks that are likely to be most sensitive to speculativ­e demand –those with highly subjective valuations – also tend to be the riskiest and costliest to arbitrage. Concretely, then, theory suggests two separate channels through which the stocks of newer, smaller, highly volatile firms - firms in distress or with extreme growth potential, firms without dividends, and firms with like characteri­stics - would be expected to be relatively more affected by investor sentiment.

Because cross-sectional patterns of sentiment-driven mispricing would be difficult to identify directly, it is advisable to look for hypothesiz­ed patterns in subsequent stock returns that appear when one conditions on proxies for beginning-of-period investor sentiment. The idea is that conditiona­l cross-sectional patterns in subsequent returns may represent the initial patterns of mispricing correcting themselves over time. For example, relatively low future returns on young firms when sentiment was measured to be high suggests that young firms were overvalued ex ante. As usual, there is a joint hypothesis problem with this approach. One must also consider the possibilit­y that any such predictabi­lity patterns are compensati­on for systematic risks. The first step is to gather proxies for investor sentiment to use as time series conditioni­ng variables. One may use a number of proxies suggested by recent work, and also construct a novel composite index based on their first principal component. To further reduce the likelihood that these proxies are connected to systematic risks, orthogonal­izing each of them to a wide range of macroecono­mic conditions is warranted. In recent papers, the resulting sentiment proxies are highly correlated and visibly line up with anecdotal accounts of past bubbles. The cross-section of stock returns varies with the beginning-of-period sentiment in the predicted manner.

One method is to sort firm-month observatio­ns according to the level of sentiment first, and then the decile rank of a given firm characteri­stic second. When sentiment is low - below sample median - small stocks earn particular­ly high subsequent returns. When sentiment is high – above median - there is no size effect at all. Conditiona­l patterns are even sharper when sorting on other characteri­stics. When sentiment is low subsequent returns are higher on young stocks than older stocks, high-return volatility than low-return volatility stocks, unprofitab­le stocks than profitable ones, and non-payers than dividend payers. When sentiment is high, these patterns completely reverse. In other words, several characteri­stics that were not known to have – and do not have any unconditio­nal predictive power actually reveal sign-flip patterns, in the predicted directions, when one conditions on sentiment. The sorts also suggest that sentiment affects extreme growth and distressed firms in similar ways.

When stocks are sorted into deciles by sales growth, book-to-market, or external financing activity, growth and distress firms tend to lie at opposing extremes, with more stable firms in middle deciles. Recent research finds that when sentiment is low, the subsequent returns on stocks at both extremes are especially high relative to their unconditio­nal average, while stocks in middle deciles are less affected by sentiment. This U-shaped pattern in the conditiona­l difference of subsequent returns also appears consistent with theoretica­l prediction­s, because both extreme growth and distressed firms are likely to have relatively subjective valuations and to be relatively hard to arbitrage. Note that this pattern is averaged away in unconditio­nal studies. So, it is advisable to look for small caps, young stocks, and high-return volatility stocks if you expect a downturn in investor sentiment.

It is not dollar weakness as such; it is others coming up next and fast, nice and quick. Eurozone data showcased a 12-years historical peak, payroll gains reached their highest since 2000, the headline Markit Eurozone PMI has hit its highest since June 2006. Services and business activity are buoyant, and the strength is widespread. Employment is growing at a great pace, the fastest for the last 12 years. These are not happening for nothing. This is very good news for Turkish exports, even inflation and the current account. The real story behind all this is that Europe is resurging. More on that next week.

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