2023-05-09 10:38:02 ET
Summary
- Inflation has been high in Turkey, yet rates continue to get cut.
- The upcoming election will be a catalyst for change in monetary policy.
- Rates are likely to skyrocket, causing the Turkish equity market to crash.
I'm always on the lookout for opportunities that others in the market aren't paying attention to or don't have the insight on. One of these areas of opportunity is making speculations and investments in non-western countries which the average analyst in the Western world is not covering and hence so few market participants know about the opportunity. One of these countries I've written about before is Turkey.
My last article about Turkey was published in 2021 and was titled USDTRY: The Major Hyperinflationary Risk So Few Analysts Are Writing About . I had written the piece at the time as I saw signs that Turkey could potentially go into hyperinflation and that it was sparsely covered by Western analysts. Since then inflation has spiked, the lira has weakened against hard currencies, and Turkish equities have more than doubled in U.S. dollar terms.
With this large move up in equities owing to high inflation, along with an upcoming election which will likely pivot monetary policy, I thought it would be best to revisit the original thesis and create a forecast for where the Turkish stock market is headed from here.
Thesis
My view is that most analysts and market participants are looking at the Turkish equity market in the wrong manner. They are looking at the market as if is a developed country with a stable currency and stable economy, which it is not.
I believe that Turkey is in a damned if you do, damned if you don't crossroad. If Turkey continues to have high inflation then its equity market will perform poorly as most companies wouldn't be able to raise prices in lira quickly enough to compensate for contracting margins, causing Turkish equities and fixed income to suffer in dollar terms. Long-term this would turn Turkey into Argentina.
When it comes to the other side of the coin if Turkey were to raise rates to lower inflation then it would crush the economy. This alone would make risk assets crash. Along with this, the TINA (there is no alternative) trade would end with a rush of capital back into the lira and out of equities. More than anything else though this would reset the risk-free rate of return most investors would be getting; for example, if one could hold liras and get an interest rate of 50%+ with an appreciating currency due to rate hikes, then there is no reason to take the risk of investing in equities only to get a single-digit rate of return.
The upcoming election is the crossroad that Turkey is at. If the AKP wins then Turkey will likely go in the direction of countries like Argentina, in my view making it fully uninvestable due to currency controls and constant economic chaos. If the CHP wins then rates will go up as the economy and markets crash. Again as I said earlier it is a damned if you do, damned if you don't situation, so neither outcome looks good.
The Currency And Rates Is All That Matters
One of the issues I see with those outside of Turkey looking at this market is that they analyse it like a normal equity market when in reality it is far from it.
Normally in other markets traditional valuation metrics could be used. These would be P/E ratios, CAPE ratios, Market Capitalization to GDP etc. In Turkey, all these traditional methods of looking at the market have to be thrown out.
This is because earnings are extremely volatile in Turkey due to the volatility in the economy. Further, due to the devaluation in the lira, things look cheap in dollars when they aren't. As an example below is the P/E on the BIST 100:
The BIST 100 had a P/E ratio of 19 at the start of 2021 and went to a low of 6 in mid-2022. The P/E ratio collapsed all while the BIST 100 skyrocketed.
Below is a chart of the BIST 100 total return compared with the S&P 500 total return over the last three years:
As can be seen, the BIST 100 has a total return of 345.7% over the last three years, with a low to high of over 450% total return. *These returns are in lira terms.
This goes to show that a traditional method like a P/E ratio can't be used to look at the Turkish market; for the P/E ratio to go down and BIST 100 to go up many hundreds of per cent, the earnings had to have gone up over 10 fold.
This creates a value trap where many investors might look at this market thinking it is cheap when in reality earnings have gone up over 10 fold pushing P/E ratios lower, and earnings could just as easily collapse 90%+ in a recession. This is my biggest pet peeve with others on Seeking Alpha analysing the Turkish market, as they base their long bias on a low valuation not understanding that in a market like this valuations don't mean much and that multiples are extremely volatile.
Because of this what mainly drives this market is rates and the currency. When rates are down and the currency weakens Turks will put capital into equities to protect against devaluation and vice versa.
How Turkey Has Dealt With High Inflation and Currency Devaluation In The Past
Inflation in Turkey:
*Keep in mind that these inflation figures are the official inflation rate, but real inflation is significantly higher as the government understates inflation.
Turkish Central Bank Rate:
As can be seen, Turkey has in the past raised rates above 100% when inflation had run away. If it repeats this process then the market would certainly crash.
But there is uncertainty as to whether Turkey will follow in its previous footsteps by raising rates due to the "unorthodox" monetary policy that Erdogan's central bankers have.
Because of this, the upcoming election will decide which direction things go in.
Catalyst: The Election
The upcoming election on May 14 will be the catalyst to determine what direction monetary policy will go.
The two main candidates are Recep Erdogan and Kemal Kilicdaroglu; although Kilicdaroglu is in a slight lead it is a very close election so I will take a look at both scenarios and how it would play out for monetary policy.
Kilicdaroglu has made it very clear that the opposition which he is part of wants to " normalize " interest rates. In the past, this has meant triple digits on the central bank's overnight rate. This would without a doubt crash the stock market and send the lira higher. It would also set the risk-free rate so high that the hurdle rate for taking risks would be a lot higher so most would choose to just hold cash rather than take the extra risk of holding equities; because of this, the equity risk premia would also have to expand.
When it comes to the possibility of Erdogan staying in power the picture is a lot more mixed.
Erdogan has made it clear he will continue to cut rates and the lira will continue to weaken. This will cause a consistent bid under the market as locals in Turkey have to get rid of their depreciating lira and buy something that can hold value. This will likely cause the market to continue to go higher in lira terms, but down in USD terms.
At the same time, Erdogan is likely to implement hard currency controls to prevent lira from being converted to USD. This could be done in many different ways, but the easiest would be to have an official exchange rate peg to the dollar. This would be the official rate and there would then be a separate black market or real rate. This would force locals to hold lira or other Turkish assets rather than exchange to dollars at a far lower exchange rate.
The government already has policies to fight dollarisation. One of these policies came out close to two years back. The policy gave bank depositors the difference between how much the lira weakened against the dollar and the interest rate being paid to hold the lira. I expect more of these policies to come out in the future to prevent the conversion of liras to hard currencies.
Ultimately I believe that Turkey will be uninvestable under a continued Erdogan regime. The economy would likely stagnate further under Erdogan's regime. Economic stagnation and high inflation = stagflation, which is a deadly mix for equities.
Many say that during times of high inflation equities are the best to own as they can just raise their prices. I don't agree with this view especially when the economy is suffering. Throughout history, equities have performed terribly during stagflation such as in the 70s in the U.S.
Equities markets under a continued Erdogan regime will likely weaken in hard currency terms but will continue to perform well in lira terms. For an interesting perspective on this, I would read Warren Buffet's paper on this very topic from the 70s: How Inflation Swindles The Equity Investor. In the paper, he writes about why equities perform badly during inflationary periods and compares them to bonds that never expire providing a fixed coupon that deteriorates in real terms during times of high inflation.
As for a Kilicdaroglu victory, I am confident that the market would crash with his policy of mass rate hikes.
There is also another risk that Erdogan doesn't accept the election outcome as he has been in power for 20 years. I don't think this has been priced enough into the market.
Yield Curve
Depending on what part of the yield curve one is looking at it is either flat or inverted. The two-ten spread is at -321 basis points. My belief is that the central bank in Turkey has been lowering rates to try to prevent the yield curve from becoming very inverted. In spite of their actions, the long end of the curve continues to come down. At some point when the central bank is forced to hike or even pause it will cause a very deep inversion which is a clear sign of a recession.
The Actionable Trade Idea
While ideas like this seem great in theory coming up with an actionable trade idea is tougher.
The first obvious trade and easiest for the average retail trader would be to short TUR.
There are a few other trades here though. One that I like that takes advantage of all aspects of what could happen in Turkey is to short Turkish corporate debt that has to be paid back in lira, but the asset itself is priced in dollars. This provides a few different trades all in one; the first is it provides a short on the lira against the dollar to take advantage of a weaker lira if Erdogan continues to stay in office. The second is that it provides duration risk that will crash the price of the bond if rates go higher. The third is default risk.
There are also many investment-grade corporate bonds in Turkey priced in dollars. Shorting these would be a pure play on default risk.
The main issue with the above trades on shorting bonds is that it is very hard for the average retail trader outside of Turkey to get access to them hence why I believe that a short on TUR is the easiest way to take advantage of a potential downturn.
Putting Turkey On The Crisis Investing Watchlist
As I've mentioned many times before, I'm a macro speculator so I like to take these trade theses one step at a time. But I know many on this site are long-term buy-and-hold investors who have a far longer time horizon than I have. For those who have a long-term time horizon, I expect an upcoming stock market crash in Turkey which could provide a great opportunity to buy high-quality assets at dirt-cheap valuations after the dust settles. This is why Turkey is on my watch list as a place to buy into if the market has a large crash due to the resetting of monetary policy.
The Bottom Line
The bottom line all comes down to the Turkish election which will determine which direction monetary policy will go. The two outcomes aren't good and will both likely lead to a lower equity market; one through massive rate hikes and the other through continued devaluation of the currency causing the Turkish equity market to lose value in hard currency terms.
For further details see:
Incoming Turkish Stock Market Crash Likely