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Turkey left in not so splendid isolation

After one of the most tumultuous years in its modern history, Turkey is struggling to convince global investors to look beyond economic weakness and political risk.

Fund houses willing to bet on countries such as South Africa, where a corruption scandal is consuming the ruling ANC party, and Brazil, where President Michel Temer is battling to save his administration from corruption investigations, say the headwinds facing Turkey outweigh those of every other major developing country.

With investors wary of committing money, the rehabilitation trade that has supported bonds, equities and currencies in four of the so-called Fragile Five — Brazil, South Africa, Indonesia and India — currently eludes Turkey.

“We certainly see better value in other emerging market countries,” says Abbas Ameli-Renani, global emerging markets strategist at French asset manager Amundi.

“These include Brazil, Russia and Indonesia . . . we are of the view that the political and economic cycles have turned decisively in a favourable direction in all these countries. The same does not hold for Turkey.”

The Fragile Five were identified three years ago as the countries most vulnerable to rising US interest rates and a stronger dollar thanks to their large current account deficits. While the rest have recovered their balance and made current account adjustments, Turkey is lagging behind.

And long-term investors say the mood appears bleak.

Turkey remains in a state of emergency following deadly terrorist attacks by both Kurdish and Isis militants, including the shooting at a New Year’s Eve party in an Istanbul nightclub, and a violent attempted coup against Islamist President Erdogan and his AK party. War in neighbouring countries has damaged trade links and resulted in the arrival of more than 3m refugees.

Against this backdrop, the Turkish lira lost 17 per cent against the US dollar in 2016 — the second-worst performance among emerging market currencies after Argentina. Turkish dollar-denominated bonds were the third-worst performing sovereign debt market after Belize and Mozambique — two countries in such dire straits they were forced to seek debt restructurings.

This rout has extended into 2017, with the lira touching a record low of TL3.64 the US dollar last week.

The Turkish government claims that the situation is temporary. Reforms designed to improve the economy will support the lira and reduce the negative effect of geopolitics, while the country’s large, youthful population make long-term growth more likely.

In an interview with the Financial Times, deputy prime minister Mehmet Simsek said that while he understood the short-term question marks, the country’s medium and long-term prospects were “extremely positive”.

“Turkey did really well post the 2001 crisis and the success there is no coincidence. It’s largely built on structural reforms, strong implementation and sound policies,” he said. The country’s demographic advantage was, he added, “still there”.

Turkey’s size, its position between Europe and Asia and membership of Nato ensure the country’s geopolitical importance. However, global forces are working against the economy. The election of Donald Trump as US president has helped bolstered the dollar, increasing the cost of loans that Turkey has borrowed in dollars. A deal between Opec members to cut production has raised the price of imported oil — pushing up the annualised rate of inflation to 8.5 per cent in December.

Worrying for investors, there is a sense that the worse may yet be to come, says Viktor Szabo at Aberdeen Asset Management. “Risks in Turkey are still extremely high as we go into 2017 . . . Turkey’s assets are being tarnished by the politics.”

In spite of weaker asset prices, few bargains appeal to mainstream global investors. As the economy lags behind, Turkish stocks have underperformed their peers — trading at a 35 per cent discount to the benchmark MSCI Emerging Market equities index — and Deutsche Bank equity strategists say they see little reason to buy.

Aside from a number of individual stocks such as Akbank, TAV Airports and Turkcell, which they believe can hold value amid the weakening currency, strategists including Kazim Andac take a negative view on equities.

“Relative valuations look depressed with respect to their historical standards following the sustained underperformance,” he writes. “However, we are not inclined to view this as adequate compensation.”

The problem is that the government opted not to undertake reforms that would tackle the current account deficit and the liabilities of companies that borrow in dollars and earn in lira, argues Sergio Trigo Paz, head of emerging markets portfolio management for BlackRock’s Global Fixed Income group.

Falling oil prices that crushed commodity-exporting countries and necessitated reforms helped Turkey, as did low global borrowing rates. But the reprieve masked problems.

“The idiosyncratic risk premium is part of the story but it’s just a factor,” he says. “They forget to do their homework. The others had to mend their economies and make tough decisions. Turkey did not.”

Should the economy stabilise and halt the currency decline, investors say Turkey must raise interest rates, preferably at the central bank’s next meeting on January 24.

Yet the central bank is caught between investors who argue for rate rises to halt the lira’s decline and a president demanding lower borrowing costs to boost growth. Meanwhile, the country’s foreign currency reserves, which are being sold in order to try to defend the lira, hit a four-year low in December.

“This is a toxic environment for the lira,” warns Tatha Ghose, an emerging markets economist at Commerzbank. “It will probably fall further.”

Via FT