Political Risk Spikes in Turkey, Roiling Asset Prices

 

July 19, 2016 [Turkey, Politics, Economy, Emerging Markets]
Charles Roth


For longer-term investors, sudden drops in the country’s stock prices can create attractive entry points.

Istanbul

The failed July 15 coup in Turkey served as a useful reminder to investors that emerging market equities, which have been far outpacing major advanced country stock indexes nearly seven months into the year, are clearly prone to political risk and market volatility. But then again, as the surprise outcome of the U.K.’s June 23 “Brexit” vote to leave the European Union, or the twists and turns in the U.S. primary election season have also shown, political risks always lurk around the corner, the world over. For investors, the answer to managing political risk is to analyze its implications against the potential rewards. If an eruption in political risk causes assets prices to tank, has the market appropriately valued them, relative to their intrinsic growth prospects?

Take the case in Turkey. The putsch caused an immediate, sharp weakening in the lira, which dove about 5% on Friday and only partially recovered Monday. Lira-denominated bonds dropped an equivalent amount, while Turkey’s key Borsa Istanbul 100 Index tumbled 7.1%. Anticipating the volatility, Turkish fiscal and monetary authorities on Sunday announced measures to provide “unlimited liquidity” to banks, as well as measures to support the lira.

Turkey’s banking sector does exhibit real vulnerabilities. It depends on short-term funding from external wholesale markets, exposing it to higher funding costs. These, in turn, would pressure net interest margins. The increasing dollarization of liabilities also creates a funding mismatch against its lira-denominated asset base. A loan-to-deposit ratio of 123% at end 2015 is also worrying. That said, “the banking system remains well capitalized,” Moody’s Investors Service noted in an April 6, 2016, report, adding that it expects delinquencies to increase to 3.5% to 3.8% due to the weakening lira and slowing economic growth. By emerging market standards, Turkey’s gross savings to GDP of 15% at the end of 2015 also isn’t that high. The central bank international reserves of $103 billion, equivalent to about six months of imports, are also less than meets the eye, as roughly $90 billion comprise commercial banks’ foreign currency deposits and so shouldn’t be used to defend the lira, according to BCA Research.

Turkey’s $718 billion economy, the world’s eighteenth-largest, faces other headwinds, too. Its current account deficit hit 5.1% at the end of May, which foreign direct investment doesn’t come close to covering. Monthly revenues from the country’s crucial tourism sector have been dropping by double-digit amounts against year-ago levels, largely due to a spate of terrorism attacks, the influx of Syrian refugees and renewed tensions with the country’s Kurdish minority.

Yet gross domestic product still grew 4.8% in the first quarter. And its balance sheet isn’t in bad shape: general government debt-to-GDP stood at a low 33% at the end of last year, while total credit to the non-financial sector, known as “core debt,” was roughly 115% of GDP last September, far lower than the 266% average of advanced economies, as well as the emerging market average of 175%. The country also enjoys healthy demographics, with a median age of less than 30 years and a 93% literacy rate among its 82 million people. That makes it the preferred low-cost labor base of Europe.

Stocks such as retailer BIM Birlesik Magazalar, which sources 100% of its revenues domestically, may see their financials impacted by a potential weakening in the lira if that bleeds through to higher consumer price inflation—which has lately been running around 7% annually—and lighter consumer spending. But at current valuations and a longer-term horizon, the stock has its attractions. The company’s balance sheet is debt light and cash positive, with a ratio of net debt-to-earnings before interest, taxes, depreciation and amortization of negative 0.49. BIM’s annual sales growth has been running around 20%.

Political risk is always present in one form or another in all countries. Turkey is certainly no exception, and President Recep Tayyip Erdogan’s purge of thousands of military personnel, judges and opposition leaders in a clear bid to further concentrate power in his office may longer term only exacerbate tensions in the country. But that doesn’t mean attractive investment opportunities can’t be found there any more than it means they can’t be found in the U.K., the E.U. or the U.S., for that matter.

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