***Below is an institutional research note written by Hedgeye Senior Macro analyst Darius Dale
Last Friday, Keith added the iShares MSCI Turkey ETF (TUR) to our Investing Ideas product as a short. The crux of our structural bearish thesis on Turkey is quite simple:
“Consistent with our view that the U.S. Dollar remains in a secular bull market, we remain predisposed to be short of Emerging Markets that have structural Balance of Payments (BoP) risks. Turkey, with its massive current account deficit, over-reliance upon foreign investment to finance growth and poor positioning within its domestic #CreditCycle, screens as poorly as any EM economy on our proprietary 20-factor EM Crisis Risk Index.”
For example:
- As a ratio to GDP, Turkey’s Current Account Balance of -4.6% compares to our EM sample average of -1.7%.
- As a ratio to FX Reserves, Total U.S. Dollar Debt in the Turkish Economy amounts to 203%, which compares to our EM sample average of 97%.
- As a ratio to FX Reserves, Short Term External Debt in the Turkish economy amounts to 35%, which compares to our EM sample average of 19%.
- Foreign Currency Assets comprise 33% of Total Banking Sector Assets in Turkey, which compares to our EM sample average of just 12%.
- Capital flight risk in the Turkish banking sector is exacerbated by the fact that the Turkish lira is -1.9 standard deviations below its trailing 10Y average on a Nominal Effective Exchange Rate (NEER) basis.
- The aggregate Debt Service Ratio in Turkey’s Private Nonfinancial Sector is +2.1 standard deviations above its trialing 10Y mean, which compares to our EM sample average of +1.0. Recall that a rapid increase in Debt Service Ratios have historically been a trigger for sharp deleveraging episodes in both developing and advanced economies.
- And the kicker: the aggregate NPL Ratio across the Turkish banking sector is only 3.2% – which compares to the prior cycle peak of 29.3% (2001). We’re not suggesting that Turkey is poised to see a retracement to such elevated levels anytime soon, but it is fair to suggest that a downturn in asset quality is more than likely ahead of the Turkish economy than behind it.
Given these dynamics, it came as no surprise to see Turkish real GDP growth dip into negative territory in 2H16 as the dollar started to rally in earnest (-1.8% YoY in 3Q16 and -2.2% YoY in 4Q16E).
A confluence of supportive factors have coalesced to perpetuate a rally in the TUR in the YTD (+7.2%) – specifically a sharp decline in the U.S. dollar vis-à-vis peer currencies and a likely base effects-driven recovery in Turkish economic growth from 1Q17E through 3Q17E.
Regarding the former, a ratcheting up of anti-dollar rhetoric out of key officials in the Trump administration has overwhelmingly perpetuated a -3.3% decline in the DXY from its 12/28 cycle-high. We know this because the DXY has decoupled from traditional fundamentals, such as interest rate differentials. The following chart shows how the USD has traded relative to 1Y and 2Y swap spreads on a DXY basket-weighted basis; note the divergence between policy expectations and the FX market in the YTD.
Regarding the latter, the baseline scenario in our GIP Model has the Turkish economy transitioning to #Quad2 for 1H17E and then #Quad1 in 3Q17E. If we weren’t so bulled up on the U.S. dollar, we’d actually have a positive view on Turkey.
But as we’ve learned time and time again in EM asset price cycles, whenever the dollar is clearly trending in either direction, that tends to be the dominant factor in determining performance divergences across EM (i.e. long low beta, low BoP risk countries/short the opposite in a rising dollar regime; long high beta, high BoP risk countries/underweight the opposite in a falling dollar regime).
Moreover, given its reliance upon international capital to finance economic activity, we don’t have any confidence that the Turkish economy can sustain any fledgling economic recovery to the extent we’re right on our call for the dollar to grind 10-20% higher from here over the intermediate term.
In fact, investors are already over-paying for what little economic improvement we’ve witnessed in the Turkish economy over the LTM. The following scatter plot charts the recovery in Composite PMI readings across the G20 versus the TTM trough-to-present return of the respective country’s benchmark equity market in dollar terms. Any economy above the regression line (as Turkey is) is deemed to be “overbought” from the perspective of its economic performance.
All told, we think the relief rally in Turkish financial assets is long in the tooth and are keen to reiterate our bearish bias – especially with the TUR ETF remaining bearish TREND and TAIL on our proprietary price, volume and volatility screen.
Enjoy the rest your respective evenings,
DD
Darius Dale
Director
