Turkish Vote Gives $900 Billion Emerging Market a Comeback Shot

Tugce Ozsoy
·6 min read
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(Bloomberg) -- Turkey’s tightly controlled lira is set for a jolt, regardless of the outcome of Sunday’s election between President Recep Tayyip Erdogan and opposition contender Kemal Kilicdaroglu.

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Just how severe an expected plunge in the currency might be — and how quickly it and other Turkish assets subsequently stabilize — will depend on whether the result leads to policy changes that set the $900 billion economy on a more sustainable growth path. At first glance markets appear calm for now, but, just below the surface, they’re going haywire: volatility and risk-protection costs have soared, some trading desks have suspended transactions, and even risk-taking hedge funds are staying out.

“I struggle to find a Goldilocks scenario,” said Viktor Szabo, an investment director at Abrdn in London. “Markets want to see political stability and orthodox macroeconomic policies” and a “large-scale Kilicdaroglu/opposition victory would get us closer to a market-positive outcome.”

President for two decades now, Erdogan has ramped up unorthodox policies since 2018, including cutting interest rates to boost growth even as inflation surged, and micromanaging the exchange rate. Foreign investors have halved their holdings in Turkish equities over the past five years to below 30% of shares, and own less than 1% of lira-denominated government bonds.

Even in the market-favored scenario, the path back to mainstream economics is set to be bumpy as tightly managed markets are first freed and then faced with finding a new equilibrium.

“The execution risks, just from the perspective of economic choices, are high,” said Sebastian Kahlfeld, a portfolio manager at DWS Investment.

Here’s how a group of strategists interviewed by Bloomberg News see different possible outcomes from Sunday’s vote.

Opposition Sweep

VERDICT: A victory by Kilicdaroglu and opposition control of parliament is seen as the most market-positive outcome, albeit with new risks surrounding the reversal of unorthodox policies.

The opposition alliance has promised a return to an interest-rate policy similar to those in other countries and to appoint an “autonomous” central bank chief, highlighting the contrast with Erdogan — who’s chased out three governors since 2019 in pursuit of low borrowing costs.

“There will be high expectations that Kilicdaroglu will turn to more orthodox monetary policy,” said Sergey Dergachev, the head of emerging-market corporate debt at Union Investment Privatfonds GmbH in Frankfurt. This could even stoke some short-term lira gains and tighten credit spreads, he said.

Meeting revved-up expectations will be the key risk. “If there’s a slow and difficult turnaround in policies, then volatility in the lira and credit markets can become heavier,” Dergachev said.

Analysts at JPMorgan and HSBC expect the lira to depreciate to around 24-25 per dollar, from 19.5 now. David Austerweil, deputy portfolio manager for emerging markets at Van Eck Associates, said he would go long on Turkey’s inflation-linked bonds once the lira breaches 30. Options traders see a 65% chance of the lira at 23 against the greenback within three months.

The lira could devalue “precipitously” during the period from the announcement of election results to the current opposition appointing its own people to central bank management, said Austerweil. However, once it hit bottom, “both local depositors and foreign investors will begin to convert dollars to lira” as the new government would be expected to immediately start a “large series of rate hikes to attract foreign capital.”

Cristian Maggio, head of portfolio and ESG strategy at Toronto Dominion Bank, believes a return to orthodoxy would be more gradual because the risk of a blow-up in the currency, which would also suppress economic expansion, would prove too costly politically.

“Dropping all restrictions overnight may be catastrophic,” London-based Maggio said. “They will likely first start hiking rates, also to give support to the currency – not just for the sake of lowering inflation – and then a little at a time reduce restrictions on trading” and shorting the lira, he said.

Status Quo Maintained

VERDICT: A victory by Erdogan and his AKP is widely seen as market negative. While this outcome is mostly regarded as a continuation of unorthodox policies, it raises the risk of further detachment of asset prices from economic reality.

Union Investment’s Dergachev expects a mild reaction in currency and credit markets in this scenario because low foreign ownership limits the downside. “The key question will be whether Erdogan will change his stance on unorthodox monetary policy” or pursue it further, he said.

Many of Wall Street’s biggest banks are predicting that current policies will be reversed even if Erdogan stays in power because they’re not sustainable.

Read More: Wall Street Sees Big Rate Hikes After Turkish Vote

Others expect Erdogan to continue his unconventional policies for as long as possible. “The low-interest-rate policy seems to be a cornerstone of President Erdogan’s political agenda and is therefore unlikely to change if he remains in office,” said Ulrich Leuchtmann, head of currency strategy at Commerzbank.

Even if a policy U-turn were in the cards at some point, Erdogan’s credibility in international markets remains low, especially after he ousted the last market-friendly central bank governor, Naci Agbal.

READ MORE: Erdogan Teeters Before Turkey Vote That’s Got the World Watching

“Maintaining the status quo would mean a continuation of current policies, which have put Turkey into a tight spot and has led to a broad withdrawal of funds by international investors,” DWS Investment’s Kahlfeld said. In this scenario, there’s “little hope for a return of equity and fixed-income investors alike.”

Split Vote

VERDICT: Seen as market negative because it’s set to exacerbate political tensions. In a scenario where parliament and the head of state come from rival factions, it’ll be key who wins the presidency, which was granted sweeping powers in 2017.

A split outcome could lead to heightened political uncertainty, which may trigger a potentially “disorderly” and “sizeable upfront adjustment” in the currency and country spreads, according to Morgan Stanley economists, including Hande Kucuk and Alina Slyusarchuk.

  • Erdogan wins presidency but loses parliament

Erdogan holding on to the presidency and the opposition winning a majority in parliament would be the “worst case outcome” for markets, according to Paul Greer, a London-based money manager at Fidelity Investments. Such a scenario “would likely result in severe policy fragmentation and maximize heightened uncertainty for investors.”

  • Kilicdaroglu wins presidency, AKP retains parliament

For Nick Stadtmiller, head of product at Medley Global Advisors in New York, a victory by Kilicdaroglu “would matter more for markets” than whether the opposition bloc gains a majority in parliament. “The outsized power of the presidency in the Turkish system makes the office the center of economic policy making,” he said.

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