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Sunday 08, January 2017 by

Turkey: signs of stabilisation

Since our last update a month ago, signs of stability have emerged. Our house view is the US rate and DXY moves are largely done.

Turkey risks are more balanced. That said there are still risks to TRY, but from external factors rather than domestic. Risk/reward is better in EXD than in TRY to position for asset price recovery.

Despite the high inflation print this week, assets have stabilised since our last update on 8 December 2016 (“Cautiously optimistic”). External debt is slightly tighter, and the basis flat. Equities are flat in local terms. TRY has weakened further, though just one per cent vs EUR (to isolate the EUR/USD effect). This supports our view that – barring another shock – risk premiums in Turkey are now appropriate in local debt, and that opportunities have emerged in sovereign credit and in equities. In spite of all the focus on the local story, the predominant risk is global: namely another US rates and USD spike.

TRY now around fair value The real effective TRY is now at the lowest level since 2003 when the current account was balanced (or -1 per cent when accounting for the then lower oil price) (Chart 9). The rollover ratio of external funding for banks is also down to the 100 per cent level that prevailed in 2003 as well as in 2011 (EU crisis) and 2013 (taper tantrum) (Chart 10). That said the roll-over ratio for the – less important – nonbank corporates still appears relatively high. After many years of overvaluation vs our Compass model, the real effective TRY now looks fairly valued, for the first time since 2009. USD/TRY fair value is even below spot at 3.30 – though driven by a misaligned EUR/USD according to our model. The Compass model looks at current accounts, but an alternative focus on external sustainability also suggests that the situation has been stabilising: the net international investment position has been stable at $-400bn since 2013 – though with the caveat that the level vs GDP this is the worst among the GEM-10 and similar to Hungary and Ukraine.

But overshoot risk still high However, if capital inflows decline further, in the short term a fair value that still assumes a sizeable current account deficit would be meaningless. The good news is that even after the recent widening the 12-month trailing current account deficit of $34 billion is still the lowest since 2007 (excluding the global recession). (Adjusting oil higher to the current price would make this $40, still the lowest since the global financial crisis.) However, if net capital inflows dried up completely, the current account would need to balance which requires another 25 per cent real depreciation according to the Compass model.

EXD somewhat cheap Turkey has tightened somewhat since our last update a month ago but still trades between implied ratings of BB- and BB which is again consistent with a 2003 scenario. The last time such a divergence vs the rating emerged was in 2013; then the credit fully recovered after the CBT hike in January 2014. Credit fundamentals have worsened since 2014, and indeed today’s rating is lower. However, with a weak BB+ average rating in actuality and likely further downgrades by Fitch and S&P, we believe Turkey should still be trading as a BB credit which implies about 50bp tightening.

Arguably the market prices a rating scenario where the fiscal anchor weakens a lot. For now, the public deficit and debt are substantially better than for the BB group. Per capita income – empirically a key driver of ratings – is higher than usual for the spread-implied BB- rating. In contrast, the current account and external debt are worse. Bank capitalisation is solid and reserve coverage – while low vs peers – remains in the middle of the IMF recommended range. So the scenario that justifies the currently implied BB- rating appears to be one of a “Brazil style” fiscal – and quasi-fiscal – deterioration in the years ahead. Naturally this cannot be ruled out, but we believe it is premature for the market to price in such a multi-year downside scenario.

The worst is over for TRY, but FX investors should watch EXD to lead the way In sum we believe that the current risk premium is attractive in external debt and recommend an overweight – or at least – neutral stance. Keeping duration short we like the Sep 22s which can tighten about 50bp. Their basis vs 5y CDS can tighten about 30bp. However, valuations in local currency are not convincing enough given the greater risk of an overshoot over fair value, and we are neutral.

The main risk is global rather than local. Remember how USD/TRY completely shrugged off the coup after only one month. Also remember that total return in EUR/TRY (to isolate the USD move) was flat during 2016, except during the four weeks after the US elections. No doubt, a further significant spike in US yields or the USD will be adverse for Turkey – but we are already close to our post-election US treasury and DXY targets. Yet even in case of a further USD rally, sovereign external debt is likely to recover in the medium term as the CBT is likely to tighten policy to prevent double-digit inflation.

By Bank of America Merrill Lynch

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