2023-05-11 00:21:49 ET
Summary
- Unorthodox monetary policies led to an unsustainable currency equilibrium in favor of the Lira and created a de facto dual exchange rate.
- Elections will likely be the end of the enforced currency rate and plummet the Lira.
- Our scenario analysis indicates that under the most probable election outcomes, Lira and the stock market will have a tough time in the short term due to the turmoil.
- However, in the long term, the Opposition's victory continued with a smooth transition of power might start a rally in the stock market, and stabilize the Lira.
In my previous article , I analyzed the status of the Turkish markets and the iShares MSCI Turkey ETF (TUR), concluding that it is unlikely to crash before the elections.
Earlier, I stated:
Although I expect the current momentum to continue in the short term, I think Erdogan's unorthodox policies are not sustainable and will eventually fail.
Now elections are at the door, and Erdogan's unorthodox solution to stabilize the Lira started showing some cracks, as we see a dual exchange rate on the streets. The government took extreme measures to hold the currency, pushing all the buttons to avoid a crash. However, these measures limiting access to FX led to a de facto dual currency exchange rate on the streets.
As political uncertainty and instability loom, investors wait for the election results, preparing for various scenarios. This article will explore the potential economic and financial consequences of elections and provide insights into how investors can navigate the uncertainty.
In this article, I will focus on the elections as it is the sole factor that will derive the money and the stock markets for the next month. I will analyze possible scenarios of likely election outcomes in recent polls. I will try to be neutral while assessing the situation, without prejudice or leaning towards any side. To get a better understanding of my arguments and ideation process, you might want to read my previous articles about TUR .
Recap On The Cracking Solutions to Stabilize the Lira
As Turkey's struggle with currency depreciation worsens, Erdogan's government found a last resort to hold the currency until the elections. The unorthodox solution offered high-interest rate FX Linked Deposits (KKM) that offered an alternative to investors to safeguard their investments from the brutal depreciation of the Lira.
In my previous article, I stated: "It will work until It does not." About this new FX Linked Deposits tool called "KKM," I believe we are pretty close to that point. There is a fundamental problem with giving free options to hedge against Lira, as the Central Bank will have to print money to pay the difference from the exchange rate to investors. Central Banks' liability creates a potential vicious circle for the Lira as payouts to the investors lead to printing more Lira, which hikes inflation. Hence the value of the Lira depreciates even further. Which leads to higher payouts to the investors, and the vicious circle continues.
To prolong the inevitable vicious circle Central Bank planned to hold the Lira by limiting the FX demand until the elections. Restricting companies' and individuals' access to FX through financial channels skyrocketed the demand on the street. It created a parallel currency market rate, 5-6% higher than the official rate.
The widening parallel exchange rate is an alarming indicator of the scarcity and the limitations of the FX. Thus, we can argue that the current currency equilibrium is on the edge of the cliff, and Lira is about to take a fall.
The currency rate is a ticking bomb, and many fear Erdogan might try to leverage this card if the elections do not end in the first round.
The Most Important Election
I believe we can all agree on the vitality of the elections. It is in the headlines of most papers ( BBC ). The Economist published this week's cover for Turkey: "The most important election of 2023".
In the 20+ year rule of Erdogan, it is the first time he might lose the elections. Polls show the opposition has the lead, indicating that it might be the end of an era. Still, many fear that a transition in power may not be smooth. After all, markets fear uncertainty, and it is rare for 20+ years of reins of power to change without any turmoil in third-world countries ( FT ).
To predict how markets might behave after the elections, we need to understand the current outlook of the elections by looking at the recent polls.
Officially there are four candidates, but Erdogan and K?l?cdaroglu are the only candidates with a chance to win. However, having other candidates leads to the possibility of a second round if none of the participants gets 50%+ of the votes.
In the end, polls do not show the future, but looking at the consensus, we can argue that there are two likely scenarios.
- The opposition (K?l?cdaroglu) wins in the first round (5 polls).
- Elections going to the second round with Oppositions (K?l?cdaroglu) lead (6 polls).
Possible Scenario Analysis
Scenario 1: K?l?cdaroglu wins with 50%+ votes
If K?l?cdaroglu wins in the first round, one might expect markets would rally, but I doubt that will be the case. Even if the opposition wins and everything goes smoothly, they won't take the ruling power immediately. In the most optimistic scenario, they would get the decision-making power and access to institutions after 1-2 weeks. Considering the current regime has created an artificially strong Lira using all the unorthodox tools and methods to keep the Lira from depreciating before the elections, Lira may plummet as soon as they stop doing so.
In this case, it can lead to a sudden currency shock, and markets will likely follow this crash. Alas, TUR investors would be hurt by both factors.
However, in the long term, if there happens to be a smooth transition, we may see a robust and sustainable rally in the stock market if the opposition wins, as the negative pricing of the Erdogan regime would end.
Scenario 2: Elections continue to the second round with K?l?cdaroglu in the lead
According to the polls and the common verdict , this seems like the most probable scenario. We might expect extremely intense two weeks with many uncertainties. Many fear markets might push chaos by the government to push the narrative that markets fear K?l?cdaroglu's victory to win the elections in the second round.
As Naomi Klein explains the phenomenon in The Shock Doctrin e, many fear Erdogan may use a similar tactic. The government would stop manipulating the currency to lead to its sudden depreciation and even push in the other direction as Central Bank buys FX from the market to increase the demand while cutting the supply of FX to the system.
In this case, there might be an even harsher currency shock than the first scenario, and markets could be affected worse due to the uncertainty. Thus, TUR investors would be hurt even worse by a combination of the falling Lira and stocks.
Bonus - Unlikely Scenario: Erdogan wins in the first round
The artificial currency equilibrium likely would turn normal after the elections as Lira slowly weakens.
On the other hand, we have seen the markets go south when the opposition weakened. Thus, one might argue that markets would not like a scenario Erdogan stays in power. Yet, we believe stability might overpower the negative sentiment caused by Erdogan's win.
In this case, we might see a slightly positive outlook in the markets with a slowly depreciating Lira. Still, TUR investors would be negatively affected by the overall outcome, but it would be a slower impact rather than a sudden shock. We believe the foreign capital leaving the markets would have a minimal effect on the markets as local investors hold the majority.
Conclusion
All in all, I believe the current outlook looks depressing for the Lira and the Turkish stock market under all scenarios. The most probable outcomes of the elections are likely to cause turmoil in the short term as it will likely trigger a negative move in the Lira and the stock market. Nevertheless, we believe a possible opposition victory and a smooth transition of power would be seen as positive by the markets and can start a long-term rally. Although we believe the continuation of the regime would have minimal negative short-term impacts on the markets and the Lira, we see this outcome as unlikely; and unfavorable in the long term for the market.
For further details see:
TUR: Here's What To Expect From Turkey's 2023 Elections