Risks Are Rising for a Hard Landing in Turkey
In mid-July, a contingent from the Emerging Markets Equity team descended on Istanbul.  On the surface, it was a significant allocation of resources that was perhaps out of sync with the relative size of the Turkish market, given its market capitalization of only US$171 billion and its weight of just 76 basis points in the MSCI EM Index.1 However, as Oleg, Tan and I expected, the insights gained in Turkey made it a highlight of our research efforts in recent months. Our twin headline conclusions were:

  • Turkey has a better-than-even chance of a hard landing, which could be a catalyst for massive turmoil across global financial markets via Western European bank balance sheets.
  • Stress in emerging market economies -- and their financial markets -- is largely exogenous. Many of the most pressing EM equity issues are resonating from Washington D.C. through U.S. macro policies (monetary and fiscal) and political swings. The short-term horizon remains treacherous for vulnerable markets, most notably Turkey.

The Backdrop

The Anatolian tiger economy displays symptoms of classic emerging market crisis. Turkey’s economy has been overheating in a volatile fashion for a decade. The economy has expanded 3.5 times in local currency since the great financial crisis, largely because of an ever-increasing dependency on credit. Bank assets have increased an eye-popping amount -- more than 5 times in local currency over this period.

This is NOT at all analogous with China’s great credit expansion over the past decade (up more than 4 times in local currency). While both economies have been supported by generous increases in leverage, China’s has been funded almost entirely through high levels of domestic savings (which last year fell to 45% of GDP), while Turkey has imported capital in ever-increasing dollops.

Domestic savings, or the lack thereof, is THE growth constraint on large swathes of the developing world, including most of Latin America, sub-Saharan Africa, and Central/Eastern Europe. Unlike China, Turkey’s saving rate at approximately 25% of GDP2 fell far short of its investment needs, leaving the country with the largest external imbalances among G-20 and large emerging markets. Moreover, Turkey’s excessive investment growth was largely indulged in the construction sector, which creates little if any long-term competitiveness for the economy.

Enter the decade-long carry trade, which was sponsored by troubled neighbors in Europe and synthetic interest rates globally. The fallout is an unsustainable boom in the Anatolian tiger economy and heightened insobriety in corporate balance sheets.

Clouds Gathering over Sunny Istanbul

Symptoms of Turkey’s overheating economy include elevated inflation, an enormous current account deficit, a boom in unproductive asset investments (real estate, public infrastructure), a widening currency mismatch between corporate assets and liabilities, and pressure on the Turkish lira.

Turkey is in trouble. Investors know this: The Turkish lira is down 24% year-to-date and 122% over the past five years versus the euro. Corporates know this: They are trying to restructure foreign debt maturities and de-lever with non-core asset sales. The banks now know this too: As levered entities, they are stuck as intermediaries between foreign borrowings and corporate loan clients.

The two unanswerable questions are:  

1) Does Ankara (the new-old administration) get it and is it willing to do something about it?

2) Given that the global liquidity tide continues to recede, has the global monetary backdrop changed too dramatically to accommodate anything but a likely hard landing?

These are two unpalatable options, and the choice may not be in Turkey’s hands.

Between a Rock and a Hard Place

Turkey needs to accept bitter medicine, which likely involves a significant and sustained recession. Corporates must restructure, delever, and generate cash to meet foreign obligations. The government must accept the adverse consequences of these actions on growth and employment despite the collateral damage to banks, favored corporates, and political support.

At some point, Ankara also needs to re-anchor to a supranational body, for example, through renewed European Union ascendency discussions. This will help repair the deep damage suffered by the country’s institutional pillars (judiciary independence, press freedom, central bank independence, and bureaucratic transparency and accountability) that has occurred in the past decade as the Justice and Development Party (AKP) replaced the former “deep state” of secular Turkey with a new set of favored untouchables. Alas, we think this agenda is unlikely to be implemented by the country’s increasingly controversial populist leader, Recep Tayyip Erdogan. Instead, muddling through -- with consistent impulses to grow beyond Turkey’s saving limits -- is a more likely scenario.

This brings us to Washington. Turkey’s fate, i.e. whether it has a soft or hard landing, is likely more in the hands of Washington (the Fed, the dollar, global political risks) and Brussels (ECB) than Ankara. This is a theme we will come back to in other notes from the field, namely that many of recent wobbles in the emerging markets are a direct result of policy moves in Washington. This includes headline grabbers like trade wars (China, Korea, Mexico), geopolitics (China, Russia), and monetary normalization (Turkey, Argentina, South Africa).

While the corporates we met during our trip were reasonably well managed, many appear lacking the long-term view needed to deal with the new realities they face. Instead, they are more inclined to either preserve capital or expand marginally outside of Turkey. To some extent, valuations reflect these unfavorable circumstances but the fragile currency, increasingly un-accommodative external environment, and populist government raise the chances of a broad earnings wipeout outside of a very specific group of U.S. dollar earners. Eventually Turkish assets will become interesting to own, but perhaps at a different risk-reward profile.

Navigating the Volatility

At the beginning of 2018, we raised the red flag about volatility as the return of inflation and rising rates made a retreat in global liquidity inevitable.  Volatility is not new to us -- over the almost 23-year history of this Fund, we have navigated several crises in EM.  In fact, volatile markets have historically been where we excel. Why?  Volatility creates opportunities for skilled active managers and represents a threat for momentum or passive strategies that do not, or cannot, discern the underlying drivers and risks of individual companies or the markets in which they operate. We believe this environment favors those with an idiosyncratic approach and we remain focused on unearthing extraordinary companies with real options that manifest over time, paying appropriate prices and constructing a durable portfolio that is well-positioned to outperform.

 
  1. ^Sources: Bloomberg and Factset, as of 6/30/18.
  2. ^2. Source: World Bank, as of 2017. https://data.worldbank.org/indicator/NY.GNS.ICTR.ZS?locations=TR